The subsidence of fear

How quickly fear subsides. Not so long ago, the Eurozone crisis was going global, Greece was going under and Spain and Italy were going with it.

The United States, rent asunder by a failing political system, was all but broke. Only an ailing Chinese economy offered some succor. Unless you happened to be the lucky recipient of a few billion dollars from a central bank, state owned capitalism in the east was the only hope for private capital in the west.

Such was the prevailing view of the global economy mid-last year, a time, not coincidentally, when our Buy list featured over 40 compelling investment propositions (it’s now a mere 21). Debt, it was thought, would be our downfall.

Then the European Central Bank, reversing its long-held anti-inflation policy, addressed the problem of debt by printing more of it (see The Credit Father from 6 Mar 12). The money markets were flooded with liquidity that happily found a home in Spanish and Italian bonds, bringing down the cost of government financing in those countries.

Relief rally

A deal was done with holders of Greek debt and the very public insanity of the US political system was replaced by the circus of the equally insane US primaries. Withering stories of Mitt Romney’s treatment of his roof-riding pets took precedence over debt ceiling debates.

The relief came slowly, but come it did. On 23 Sep 11, the All Ords Accumulation Index was trading at 3,979. On Wednesday 4 Apr 12 it closed at 4,419, a rise of 11%.

Within that impressive but, for reasons we’ll explain, slightly alarming statistic, rest a host of recommendations that have performed even more strongly.

Table 1 lists the blue chip recommendations made in August last year when, on one particular day, the local market fell by 5% in a morning. If you want more background, see Opportunities amid the falls, Chaos amid the storm: The upgrades and Blue chips dominate best buys from that period.

Now, as pleasing as these figures might appear, it’s important to note that some of these stocks were recommended at higher prices, albeit with less strong recommendations. Some members will have done better than others depending on which recommendations they followed, but if you invested during the panic last August you will be glad you did. Investing is never easy, but it was more difficult than usual at the time.

Either way, our general approach to diversify internationally, hold more cash and deploy it by purchasing high quality blue chips stocks at attractive prices has thus far proved reasonably effective.

The performance of our model portfolios (see Filling portfolios with cash from 3 Apr 12) in the first three months of this year lends a little support to this view.

Back pat?

So, let’s all pat ourselves on the back, put our feet up and enjoy the rally.

Err, not so fast. The Church of Fatalistic Tendencies has a little sermon in reserve from which it is about to preach.

Let’s start with global debt. There’s something intrinsically problematic about making money cheap and plentiful by issuing more government debt. If debt was the source of the troubles, how can it also be the solution?

As noted in Keyes versus Hayek, the monetary expansion is more than a confidence trick, although that’s part of it. The idea is to encourage borrowing to the point where economic activity rises. This, in turn, increases government revenues, thus making the debt easier to service.

Around the world, governments are using debt to grow our way out of the problem. Hayekians, on the other hand, argue we must shrink our way out of it, as we did with overwhelming success in the 1930s (for all you libertarians out there, that comment was ironic. No letters necessary—Ed).

Historically, Keynesians have the edge in this argument but it’s hardly a conclusive victory. Debt remains a major, enduing issue. Only the reporting of it has lessened. This is not a problem that has gone away.

China slowing

Nor have concerns regarding the slowing of Chinese growth. In fact, since the publication last December of our special report The Coming China Crash (no hedging of opinions there, you’ll agree), the issues it highlighted have gone mainstream.

Take this comment in Bloomberg from Adrian Mowat, JPMorgan Chase & Co.’s chief Asian and emerging-market strategist:

‘If you look at the Chinese data, you should stop debating about a hard landing... China is in a hard landing. Car sales are down, cement production is down, steel production is down, construction stocks are down. It’s not a debate anymore, it’s a fact.’

The Chinese, hardly known for their statistical honesty, have even lowered their own growth forecasts. Whilst this may be a case of confirmation bias on our part, the data appears compelling. The poor performance of BHP Billiton and Rio Tinto suggests the market is coming around to the idea. A Chinese slowdown is now more a fact than a theory.

This presents investors with a testing conundrum: Share prices are up, optimism is returning and yet the very things that were the source of so much anxiety a mere five months ago have, if anything, got worse. What to do?

We’re going to recommend six steps as an immunity-boosting response to the prevailing optimism:

1. Accept that your portfolio is different now than it was eight months ago: Back in August last year, acting on our two Strong Buy recommendations on Macquarie Group at $22.97 and QBE at $14.62 (and four more times at much lower prices) required some psychological fortitude. It also means your portfolio is not as it was. There may be other stocks in your portfolio that have also risen markedly. Adjustments are almost certainly required as a result. Remember that the best portfolio today is almost certainly different to the best portfolio of eight or even three months ago;

2. Exercise the psychology of self-restraint: There’s no need to become frustrated and start buying overvalued or fairly valued stocks just because everyone else is. Please be patient. There will be plenty of opportunities for long term investors. The last thing you want to do is lose money because you joined the herd or your cash holdings burned a hole in your pocket;

3. Increase your cash holdings: The recent portfolio update explained how we’ve increased our cash holdings. Consider doing the same, using the rally to lock in some profits and trim your holdings of those stocks that have performed strongly;

4. Watch portfolio limits: In Table 1 you’ll notice a portfolio limit for each of those blue chip stocks recommended in August last year. Please take note of it and consider reducing your holdings in those stocks where recent price rises have meant these limits have been breached;

5. Sell down cyclical, low quality businesses: If your portfolio is still a home to low quality businesses like AGL, Incitec Pivot, Fortescue and Rio, now’s a good time to get rid of them and set the cash aside in preparation for opportunities to buy better quality businesses down the track. For particular analyst picks, see Blue chips and barge poles: Stocks to avoid from 29 Apr 11.

6. Examine current pockets of value: While it’s true that, whereas many of the stocks on our buy list in the middle of last year were either Strong or outright Buys, most of the current 21 stocks are Long Term Buys. That’s purely a function of rising prices. Don’t let that deter you. Sensible purchases of these stocks, but not at the expense of your cash holdings, can be justified. The performance report also shows that our Long Term Buy recommendations have performed almost as well as our outright Buy recommendations, and that we have a bias towards underestimating stocks in this group. 

As for your analytical team, we’re not resting on our laurels. As the Friday Fishing series hopefully illustrates, we’re constantly researching new stock opportunities. Please note that we won’t publish full reviews in future unless we’re considering commencing coverage of a stock or strongly believe it should be on your watchlist. We value your time.

Whilst the past few months have made finding value more difficult, there’s always something around for those prepared to look. Yes, it’s back to the grindstone for us.

Finally, if you haven’t yet inspected our latest Performance Report, please do so by downloading it here. It’s probably the most comprehensive and transparent document of its kind. As the grateful recipients of your financial support, it helps us tell you exactly what you’re getting for you money in the most elemental way.

Lastly, a warm welcome to Richard Livingston, another straight-talking refugee from Macquarie Bank and now CEO of Walnut Report, our new publication that helps you organise your investments tax-effectively, offers structured product advice and helps you use an SMSF in the best possible way. As an Intelligent Investor member, you've already been set up with a free trial to the Walnut Report. You can log in, using your existing Intelligent Investor username and password, by following this link.