Buy small to beat the bear market

This is one mean market: too cheap to ignore, yet too risky to try.

Wait a while and it might not be cheap any more. Buy and it's bound to drop. But then you don't want to be caught out by rising inflation and falling returns from a bank deposit, either.

Fair enough, cash is safe. Apart from being eroded by inflation, that is.

And self-funded retirees must wonder whether a volatile sharemarket is worth it.

After all, the returns from shares and cash have been almost identical for the past 10 years, though there's no beating the bonus of a 30 per cent tax credit from franked dividends.

But in asking whether the thrills and spills of the sharemarket are worth it, remember bank deposits aren't entirely risk-free themselves.

And that's nothing to do with the government guarantee on savings deposits expiring in October since it's bound to be extended.

Rather, there's the problem of falling interest rates. Stay in cash and you could be stranded like a shag on a rock.

Savings rates are coming down irrespective of what the Reserve Bank might, or in this case might not, do. Just as the banks trumped the Reserve as rates were going up, they're leading the way down when it comes to deposits.

Term deposits are already falling and the online cash rate must be next.

As if to rub salt in the wound, the sharemarket thrives when interest rates are falling.

Not only could you be squeezed by a lower rate but if the sharemarket takes off, you'd miss a great opportunity.

Mind you, any take-off would be in fits and starts. As the adage goes, the market climbs the stairs but goes down in the lift.

The biggest one-day gain the market has had - 7.4 per cent in February 1975 - is no match for the single biggest one-day drop of 24.9 per cent in October 1987.

So is this the start of a bear market, where share prices are stagnant, if not falling, for a long time, or a correction in a bull market where they'll eventually rise? Sorry, but we won't know until it's already happened.

Except for the fact that when a recession is caused by a financial crisis, as happened to the US and Europe in 2008, it takes the economy years to be set right.

Debt de-leveraging, as economists call it, chases its own tail. As debts are paid back and more is saved, there are fewer profits to be had.

New houses aren't being built - a backlog of foreclosures in the US is also keeping values down - and so there's less spending on furniture and appliances.

Jobs are hard to come by, creating a vicious circle of even more saving.

Still, all's not lost. Eventually share prices have to rise because they're based on profits, which must increase in a growing economy.

As it happens, US corporations have never been more profitable, thanks to the weak US dollar, historically low interest rates and their own stinginess.

Higher profits have been reported in every quarter of the past two years and in the latest, almost three-quarters of companies still managed to beat analysts' forecasts.

Better still, they've already started to invest in new plant and equipment, which in time will create jobs.

Free money

Wall Street doesn't seem to appreciate what a friend it has in Ben Bernanke, the head of the Federal Reserve, which sets interest rates.

Or rather abolishes them. The Fed has set the official interest rate at near zero.

Imagine what our market would be doing if the official cash rate were 0.25 per cent instead of 4.75 per cent.

And for all the talk of debt crises, most economies are growing. Greece isn't but Germany is. The US might be sluggish but China is soaring, even if not as fast as last year.

For all their exposure to bankrupt nations, European banks have no problem raising funds either. That's a vast improvement on two years ago at the height of the GFC.

The same goes for American banks.

If they find themselves short of cash they just have to go to their friendly central banker who'll lend them all they need at an annual interest rate of just 0.25 per cent.

Come to think of it, at that rate a bank would probably want to be short of cash.

Anyway, for American investors it's the sharemarket or nothing because rates are so low. Who'd want to invest for two years in a bond that pays less than the inflation rate? Anyone for 0.18 per cent?

So it's not as if it's all gloom and doom out there. More your slow-and-low growth and confidence.

The trouble is that in this globalised world what happens there can change the market here. It's hard enough getting a handle on one economy without having to take into account the credit ratings of the US, Europe and goodness-knows-who.

Nor is there a rule about how long bearishness lasts. An entire bear market was compressed into one morning on Wall Street last year.

In the flash crash, the Dow plunged almost 1000 points, 700 of which occurred in a matter of minutes.

Yet bear markets can be home to some spectacular rallies, though they eventually fizzle out.

This time, with central banks handing out free money, a crash would be struggling to go on for too long.

Besides, sharemarkets are unusually cheap.

Ours is valued at just 11 times its earnings (the price/earnings ratio) when the norm is 14 to 15.

Or to put it another way, it's about 20 per cent undervalued if you go by the historic average.

That's made even better by the unusually high dividend yield of 4.5 per cent, or 6 per cent after franking. Take out mining stocks and it's closer to 6.5 per cent or 9 per cent with franking.

One toe at a time

Even so, jumping full bore into a cheap market, especially one as moody as this, is still risky. It could always become even cheaper.

Then again, avoiding it altogether could be just as bad. You won't lose your capital but you won't make any either.

And remember, there's a rising inflation rate with which to contend.

Fortunately, there's a tried and tested compromise. Buy - but only in small bites at a time. Known as dollar-cost averaging, you set an amount you want to invest - say, $2000 - and then buy stocks at regular intervals, maybe $500 worth every quarter for a year.

You pay more brokerage that way - although this can be as low as $9.90 a trade at CMC Markets - and you're never guaranteed you'll get the lowest price.

But you won't have paid the highest either.

OK, you might on one occasion, but it's bound to be higher or lower on the next.

The beauty is that by fixing the dollar amount, you always pick up more shares when the price is low and fewer when it's high.

So the average cost of the shares is dragged down over time.

Unfortunately, it doesn't work so well in reverse when you're selling.

Setting a fixed amount would only mean you'd be selling more shares at a lower price, which isn't the idea. But knowing when to sell is just as critical as deciding to buy.

Get that wrong and you'll miss the spoils of the next bull market or, worse, end up selling in another, grrr, bear market.

The way around this is what the experts call re-balancing. Again it's an almost automatic adjustment to market conditions, this time taking some profits to buy bargains.

But it only works with a portfolio of shares, something you should aim for anyway.

Holding only one stock is risky, even with dollar-cost averaging, because you're putting all your eggs in one basket. You can't afford to get that single call wrong.

So once you've decided what proportion of your portfolio you want in each stock, every year you rejig the holdings so as not to drift off course.

That results in selling some of the stock that's jumped in price (and so has become a disproportionate part of the portfolio) and buying others that have fallen but which still have good prospects.

The only catch to rebalancing is that it presupposes you got your original allocation right - but I can't help you there, I'm afraid.

Oh, unless you're a day trader and don't miss your sleep, forget about borrowing, especially a margin loan, to invest in this market.

Property trusts set for the upswing

THE most bombed-out stocks are in retailing, media and property, thanks to an uncharacteristic urge to save, not shop.

For once it seems the market is being logical fewer sales in stores, less advertising in the media and lower rents for property trusts that own the shopping malls.

But two out of three will have to do, since there's no sign of falling rents.

The giant shopping centre owner Westfield Retail Trust, for example, bases its leases on minimum contracts, not the shop's sales.

The only threat would be a tenant going under and we aren't at that stage, not that you could rule it out entirely. Retailers are hanging their hopes on an interest-rate cut but there's no guarantee that will get the shopping trolleys going.

At least property trusts are halfway there. They compete with term deposits, where rates are falling, for investors.

The yield from the average real estate investment trust (REIT) of 6 per cent, plus some deferred tax benefits, is better than a term deposit.

They have another advantage, too. The yield will grow because leases are indexed to inflation.

Best of all, though, you can buy REITs for at least 20 per cent less than their properties are worth.

That's like paying $40 for a $50 pre-paid mobile phone card.

How can that happen?

Because the market has never forgiven them for what they got up to just before the GFC and assumes a leopard can't change its spots.

In their heyday, REITs delivered high and growing yields from the properties they managed but they got greedy and borrowed to the hilt so they could expand into property development, as often as not in other countries they knew nothing about.

In the GFC, REITs were forced to raise huge amounts of money from their shareholders, slash distributions and sell off properties they should never have owned, just to stay afloat.

No more. Instead of issuing new equity at giant discounts to the market price and emasculating their existing unit holders, REITs are buying back their stock.

With fewer units on issue, there's more profit to go around.

And wouldn't you know, just as REITs are retreating from their offshore adventures, foreign wealth funds and private equity are taking an interest in them because they're so cheap.