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Time to be contrarian
This article appeared in the February 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Learn how 'big picture' threats and opportunities will affect your returns this year.
By John O'Brien, van Eyk
From 2003 to 2008 there was broad consensus by analysts on the investing outlook across virtually all asset classes. Since then that consensus has been fragmented into a multitude of views, some positive and some markedly negative.
In addition, because of the speed at which information travels around the world, and advances in trading technology, investing with a long-term outlook has rarely been more challenging than today. This article outlines how investors should respond to the challenges presented by this fragmentation of views, and what van Eyk expects for 2012.
Today there is a multitude of voices saying either that things are OK and are going to get better, or that things are going to get worse. Who should you believe?
For us it comes down to a question of momentum investing versus value investing. Momentum investing (trading the trend) which gained prominence in the late 1990s as a recognised force (coincidentally with the rise of electronic share trading) is certainly alive and well. It will continue to drive short-term returns as investors show an increasing tendency to follow the herd.
The growth in algorithmic trading (computer-driven trading), which accounts for probably a majority of trading in all major markets, including Australia, is a leading driver of momentum investing and will continue to have a short-term price effect, adding to market volatility and potentially giving investors false leads about the longer-term direction of the market
Value investing, on the other hand, works on a different time scale. There is no immediate gratification in value investing and investors must be prepared to stick with a strategy for a long period of time, although they should continuously review it to make sure it is still appropriate.
This year will almost certainly be an eventful one with plenty of opportunity for unexpected news to magnify market volatility, so it is important to keep a long-term perspective on the benefits of buying assets at good valuations for the long term.
There are three key themes that we believe will be important this year:
1. Political risk
We still believe that political risk as it affects market returns is underrated. We were correct when we thought it was highly underrated in 2011 and we think it will be this year. Iran, the Arab world, Latin America, even stable countries such as Thailand, could all have problems in 2012.
Even the European Union, which although not a political union is nevertheless a group of countries economically linked together, could form part of this year's political risk, especially if the economic situation there deteriorates much further. That informs our short-term view on emerging markets, which is that they are a strong long-term growth story but not enough attention is paid to the political components of the story, probably because each country is different and it takes real effort and skill to analyse each country individually.
2. Inflation risk
There is high inflation all around the world, but low inflation in Australia, the US and Western Europe - so far. Currency management by countries will continue to play a role in either creating or dampening inflation in their export destinations; if prices from China began to increase there would be inflation in the US and Australia. High inflation may be part of our future, but for now it is only a smouldering fire that probably will continue to smoulder for the time being this year.
3. Financial system risk
Increasing financial market regulation will continue to make banks difficult to work in, or to invest in. Also, the large global banks dominate the financial system after a string of acquisitions over the past two decades, and such market concentration introduces its own risks if one bank gets into trouble. This trend may reverse if some banks are forced by authorities to divest assets to reduce such risks, an event that would pose its own risks for markets.
Here is van Eyk's broad asset class outlook for 2012:
The ASX 200 index is on a price-earnings (PE) multiple of 11 times forward earnings, the MSCI World index on 12 times and the MSCI Emerging Markets index on 9.5 times. These are not outstandingly good valuations, but they are not bad.
Compare shares to something like residential property, where the PE might be 30 times, then you might say that the value in equities is not bad. The performance of Australian equities is influenced in the short term by macro-economic uncertainty, particularly in regard to Europe. The reality is that Australia is still beholden to the forces of the world market.
But for 2012, we dare investors to be contrarian. After several years of negative returns, many investors appear to have lost faith in equities. The difference between the benchmark US Treasury bond yield of less than 2 per cent and the equity earnings yield of 8 per cent is as stark as ever. We can certainly say that piling into low-yielding assets, like bonds, at ever-higher prices, is not a long-term solution.
Government bonds were one of the best performers of 2011. A flight to quality by risk-averse investors and a shrinking universe of perceived quality assets is driving returns. We have estimated that $1 trillion of AAA-rated assets disappeared during the GFC because of structured credit downgrades, and there are only a handful of AAA-rated countries left in the world, including Australia. Bonds, especially government bonds, are certainly very expensive now, almost as much as equities were during the dot-com era. But only sustained economic growth in the safe-haven countries or inflation will cause this trend to reverse. Many managers, including some of the respected ones in the world, have called this one wrong to date.
Corporate bond default rates in 2011 were among the lowest in history. Although we do not expect a repeat in 2012, the fundamentals for the asset class are attractive. From a regional point of view we favour the US and Australia; the range of possible outcomes in Europe is too large to get a comfortable estimate of default risk in credit markets.
Alternative assets such as commodities and gold will continue to be volatile. With the likelihood of reduced demand for commodities, driven by anaemic growth in the US and Europe, the outlook for commodities remains modest, in our view. Gold has continued to benefit from a number of factors, including risk-aversion, short-term purchasing, government purchasing, and many of the factors that make up momentum investing. Although the fundamentals for gold remain sound, the recent strength of the US dollar against some currencies (despite its troubled long-term fundamentals) has dampened the upside of the precious metal and may remain a hurdle for its performance this year.
However, with rising geo-political risks and Europe increasingly struggling to find a tenable solution, we have maintained an exposure to gold (albeit underweight relative to our strategic target) and will look to increase exposure at a more compelling entry point. Hedge fund strategies are another important part of the alternative assets universe. Here, the skilful managers should be able to outperform the market - not every month, but over time.
About the author
John O'Brien is head of research at van Eyk, a leading investment researcher.
SMSFs provide useful information about the basics of establishing a Self-Managed Super Fund. Also featured is an ASX video on SMSFs, in which the television presenter Anne Fulwood interviews Graham O'Brien of ASX business development.
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