Picking a safe route

PORTFOLIO POINT: The road ahead for bonds and equities will depend on economic policies. Higher inflation will favour equities, inflation-linked bonds, gold and property.

Since the year 2000, US stocks have seen two devastating bear markets. The rest of the globe followed America into these abysses, though in Australia’s case the first crash was less severe because we have few hi-tech companies.

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The first bear market, the Tech Wreck of 2000-02, cut America’s S&P 500 share index in half and wiped out three-fourths of the Nasdaq’s value.

The second bear market, the Housing Bust of 2007-09, was even more dramatic, driving the S&P 500 below its prior bear market low and gutting its value by 57%.

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Pattern analysts like Elliott Wave International argue that sharemarkets have roughly seven-year cycles and, on that basis, a primary bear market may be due because we are half-way through such a cycle. Note, however, that past crashes usually came towards the end of a cycle, not their middle, suggesting D-Day may occur in 2014 or 2015, not 2013. Also, pattern analysts assume the market always repeats itself, which history shows is not so.

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That’s why I am a trend follower, not pattern analyst, because pattern principles have no empirical basis to support their efficacy as a trading tool. Also, pattern analysts differ sharply on how to read patterns. For instance, Elliott Wave technicians can’t agree whether the US bull market since 2009 is a primary wave within a bigger secular bear market or the first leg of a new secular bull market. At least trend followers have common tools (moving averages and momentum indicators) that unequivocally show an uptrend or a downtrend, so don’t argue over their meaning.

Fundamental analysts warn that a third bear market could be precipitated by the US “fiscal cliff” on January 1, 2013, which if it’s allowed to happen could dwarf the Lehman Bros collapse of 2008 in severity. Fuelling this concern are warnings by technical pattern analysts that a head and shoulders pattern is almost complete, after which the market will slide.

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Recently, Mohamed El-Erian – the CEO of PIMCO, the world’s largest bond fund – named the fiscal cliff as the number one threat to the US economy in the immediate future. According to El-Erian, it is far more dangerous than the euro crisis or even economic slowing in China.

So what’s the fiscal cliff? According to US financial markets writer Thomas Kenny: “Fiscal cliff” is the popular shorthand term used to describe the conundrum that the US government will face at the end of 2012. US lawmakers have a choice: they can either let current policy go into effect at the beginning of 2013 – which features a number of tax increases and spending cuts that are expected to weigh heavily on growth and possibly drive the economy back into a recession – or cancel some or all of the scheduled tax increases and spending cuts, which would add to the deficit and increase the odds that the United States could face a crisis similar to that which is occurring in Europe.”

The following chart shows US federal budget deficits, projected through 2022. The “CBO Baseline” shows the effects of the fiscal cliff under current law as estimated by the Congressional Budget Office. The “Alternative Scenario” represents what would happen if Congress extends the Bush tax cuts and repeals the Budget Control Act-mandated spending reductions beyond the end of 2012. Note that unless there’s political compromise US fiscal policy is set to tighten sharply after the January 1, 2013, which could plunge America back into recession.

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A more sanguine view is that once the November 6 American Presidential and Congressional elections are out of the way, both Democrats and Republicans will reach a compromise to avert the fiscal cliff because neither side wants to be blamed for pushing America back into recession.  

In the meantime both the US administration and Federal Reserve are doing everything they can to bolster confidence in the run-up to the elections, which is why the S&P 500 index may rise a lot further (and with it other sharemarket indices that take their cue from Wall Street, like the Australian All Ords index). The European Central Bank’s decision to bail out member states with unlimited bond buying is also stoking trader sentiment. In China, once the new leadership team is installed, expect bold initiatives to revive the economy since it can’t risk the social and political turmoil of a hard landing.  

As a result the market may well look like the “21^st Century Busts” chart above – a further significant rise before investors become worried as to whether another primary bear market is due in 2013. In the meantime, September is a problematical month in sharemarket history, so we could see a setback to shares before they resume their climb. See next chart.

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An alternative view is that the big bust this time won’t be in shares but in bonds, which are exhibiting a super price bubble fuelled by three decades of falling interest rates. This is a persuasive argument.

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Note how traditionally safe US Treasury bonds now look risky relative to shares.

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As the next chart shows, Australia’s dividend yields relative to bond yields look more attractive than they have been for over 50 years – meaning shares are winning the beauty contest. Investors desperate for income may abandon bonds for shares.

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If any asset is heading for a crash it could be long-term fixed-rate bonds, since interest rates may have nowhere to go but up. When bond yields rise their prices fall.

Any rise in interest rates is more likely to be a consequence of looser monetary policy (in response to fears of deflation) than a sudden revival in real economic growth. As long as developed countries are undergoing bank and household debt deleveraging, private demand will remain subdued. But as 1966-82 showed, slow growth is compatible with high inflation and interest rates, which is why such conditions are described as ‘stagflation’.

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Hence the early 21^st Century might be remembered for three busts, namely:

• A hi-tech bust between 2000 and 2003;
• A property bust (that turned into a bank bust) between 2007 and 2009; and
• A bond bust between 2013 and 2015.

If such a scenario plays out, then investors who after being burnt in 2008 bought long-dated bonds and hybrids as a refuge from shares could find themselves traumatised again when the bond bubble bursts. That’s why bond advisers such as FIIG are telling their clients to restructure fixed-interest portfolios towards shorter dated, CPI-linked or floating-rate bonds as a safeguard against rising yields.

Rather than forecasting what will happen, I simply gauge the sharemarket’s trend so I can stay on the right side of it to catch upturns and abandon downturns as illustrated below.

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In the last crash my trend-following model got out early on both Active and Conservative strategies. So if there is another sharemarket bust in 2013 I aim to do the same. In the meantime the market’s underlying trend is still up, so my signals remain on Buy.

If there is a bond bust in the next few years, it’s likely to be precipitated by investors seeking higher yields offered by shares. In that event, shares could soar while bonds tank. The only way to position for either a sharemarket crash or boom is to time it using a proven trend-following system.

I try not to forecast because my position is that markets can only be trend-followed successfully, since no one knows the future. For me slow trend-trading is a risk-management system that allows a share portfolio over time to give high returns while reducing risks to that of investment grade bonds.

So the bottom line: if the future is deflationary because of deleveraging we should invest in high-grade fixed-interest bonds since they will soar in price (as they did in Japan as it tanked after 1990) or keep our money in government guaranteed term deposits.

But if the future is inflationary because governments and central banks won’t accept another 1930’s style depression, then we should invest in shares, property, gold or CPI-linked high-grade bonds since cash will be trashed (as it was in Argentina in recent decades).

My own view is that I don’t know what will happen (though I incline to the latter scenario), so I am invested in both shares and a mix of investment-grade bonds, both of which can be obtained through exchange-traded funds.

That way I have hedged my bets.

Percy Allan is chairman of Market Timing Pty Ltd. For a three week free trial of its services go to www.markettiming.com.au