Eden Wealth Management

Is this a sucker's rally or Is the Global Financial Crisis Over?

How have you faired during the worst financial crisis in 80 years?

If you have managed to preserve the majority of your investment capital you have done well, very well.
If you are still securely employed you are also faring better than thousands of your fellow Australians.
And if you have a loving family that has not been financially torn apart through "betting big" in the last bull-run then you are truly blessed on a global scale.

Those that have preserved the majority of their capital base resisted the temptation to invest heavily throughout 2006 & 2007 - either through luck, rational investment principles, or sound advice.

People, companies, and economies have been devastated by the ripple effect of the Global Financial Crisis (GFC).

We have all seen and heard the horror stories both locally and globally - massive job losses from failed companies, overwhelmed money managers taking their own lives, bankrupt governments, home foreclosures, and the spread of paralysing fear among investors.

Now, with a three month rally in global stock markets, the question on most investor's minds is, "Does this Stock Market rally signal the end of the Global Financial Crisis or is this just a sucker's rally within a much longer bear market?"

Our response to this is, "Well, not likely", and "Could be, but we don't believe so (for the Australian market at least)".

Based on the historic reaction of markets and crowds over many years, this rally seems to be further evidence that excessive fear and excessive optimism tend to drive short term movements in the market.

The wise words of Warren Buffett resound:

"In the short term the market is a voting machine (sentiment / emotion), in the long term it is a weighing machine (sustainable profits / return on capital)".

Just as sentiment turned quickly bearish at the height of the market in 2007, fuelled by a collapse of confidence, the market seems to have turned bullish just as quickly since March 2009.

With a positive profit reporting season not likely until 2010/11, and companies diluting future profits with capital raisings to restore impaired balance sheets, we suspect much of this rally is a vote of emotional relief that finally there are some signs that the GFC is abating.

To provide an example of the diverse emotions that often drive investment decisions, even within our own client base, we have some clients who are nervous about suggestions that we will be advising to start cautiously investing new money in the market, and some clients who are worried that they have missed "the great rally of 2009!!"

Our role, as always, is to remain grounded, as emotionally detached as possible, and to apply rational sound principles of long term wealth creation. This approach has stood our clients well in the face of "the worst financial crisis in 80 years", and we believe will lead to above average long term rates of return in future years.

So let's look at some facts ...

Reasons to be positive

The global economy slowed dramatically in the December 2008 quarter as a result of a major reduction in industrial production and trade. However, economic data released in March 2009 showed the global economy had improved - albeit from a very low base.

Commodities in particular reacted positively to the better than expected manufacturing data from China, and also evidence of an uptick in raw commodity demand - likely due to a re-stocking of inventories or opportunistic build up of strategic reserves by the Chinese while commodity prices are relatively low.

There are also further signs that the record level of government funded stimulus thrown at the global economy has begun to take effect with the intra-bank lending rate continuing to subside indicating that bank credit is being freed.

Domestically, media focus is now on the hope of further signs of economic recovery in the second half of 2009.

The reaction in the markets to this economic news was swift, with a 20% - 25% rally in the Australian stock market from March 2009 to May 2009 - again, from a low base.

ASX 200

Click on the graph above for more detail.

For those that feel they have "missed the great rebound", let's provide some perspective. The Australian stock market fell by over 3,500 points from its high in 2007, and has regained just over 900 points since its absolute low in March.

There is no way of foreseeing, and or confirming, the absolute bottom of the market. Only time will tell whether this was 'the bottom'. When risking your finite investment capital, it is always safer to see confirmation of a supporting trend rather than taking short-term bets.

So while we do believe that this turnaround is significant and potentially marks the bottom of the market, we do not believe that investors should risk immediately pouring all of their money back into the market for fear of "missing out".

This market will be characterized by a number of short term emotional "relief rallies" to the positive, and "fear driven" market falls, with much to be done to restore global economic confidence.

Sustainable wealth accumulation will occur by gradually in the long-term growth trend of the market supported by company productivity and profit growth.

This chart, from the RBA, shows all the major Australian bear markets finding a bottom within 2 years before going on to recover all their losses over the next 1-5 years. Note also that the bear market beginning in 2007 looks set to rival 1973 as the worst bear market ever in terms of market losses, and is likely to take some time to recover due to the extent of the damage in the global economy.

Click on the graph above for more detail.

If history is any guide, the market may have found its bottom earlier this year and recover over the next five years.

Reasons to be Cautious

Other investors fear that the market may pull back below the March levels as we enter another season where companies report declining to flat profits.

In fact, there are a number of factors that are likely to keep the market 'sober' over the coming months:

First home buyers

There is significant evidence to suggest that first home buyers have been over-extending themselves, backed by low interest rates and government housing incentives.

This is a matter of serious concern in an artificially low interest rate environment with inflation looming and one in which unemployment is expected to rise.

A report from property valuation firm LandMark White this week showed that new records are being hit in terms of both the number and size of loans granted to first home owners. Job numbers released this week also indicate that the supply of labour is increasing while the demand for labour has fallen and is likely to fall further.

Therefore, increased interest costs are not likely to be supported by increased wages at a time of flat company profits and in a market where firms are able to choose from a larger pool of prospective employees.

Rising bond yields

Global financial uncertainty remains and the fear of looming inflation is growing. Reflecting this, yields on long term bonds are rising and this places extra pressure on companies as their term-loan rates are often linked to the bond rate, and in the US, home mortgage rates are linked to the bond rate which may introduce a fresh round of US mortgage defaults.

Corporate capital raisings

Capital raisings have continued in the last month across all industry sectors. Capital raised from shareholders through newly issued shares are used to repay debt, converting debt to equity on the balance sheet. The likely outcome of the capital raising will be dilution of earnings metrics (e.g. earnings per share, return on equity) in the coming profit reporting season.

We believe that these issues, set against the backdrop of a Global Financial Crisis that is still working its way through the system and likely to reveal more high-profile casualties, will keep markets volatile, and range-bound for some time to come.

Is the price right for cashed up fund managers?

Having said this, we are of the view that any pullback will be pounced upon by cashed up fund managers waiting for an entry level into the market, and who may be willing to write-off the coming reporting season with a focus on a turnaround in company profits in 2010/2011.

Thus it is not inconceivable that we will experience a wide trading range with 10% to 15% pullbacks and upswings for a number of months.

Ultimately, whether to start moving your capital from the safety of cash into quality growth assets is all about price and your investment timeframe. If the market has priced in all of the fear and negative sentiment then the market will start to recover (in fits and spurts) despite the lag in the recovery of the global economy.

Daddy, what did YOU do in the great downturn of 2008/2009?

We believe now, that investment capital should be cautiously allocated to quality long term growth assets. Capital impairment and risk adjustments have largely been priced in and dividend yields compared to cash returns have not looked better in years.

Those that do not invest over the next 12 to 24 months are likely to look back and kick themselves in 10 years time. Cash has served its purpose and now is the time to allocate for the future.

We will be seeking to prudently build client portfolios over the coming months focusing on the greater earnings certainty that can be found in Mining, Energy, and defensive sectors such as Telco, Healthcare and Consumer Staples.

An allocation to the Australian banking sector also seems prudent at this point. The relatively strong global standing of Australia's banks should help the sector to recover despite some headwinds posed by doubtful debt provisioning and capital raisings. In fact, any debt provisioning that has been too generous over the last 24 months may actually be a boost to profits in the future.

Investment commandments for 2009 and beyond

Going into 2009/10, it may be wise to remember the following investment commandments ...

Though shall ...

.. approach investing patiently and rationally (leave the emotion for your family).
.. use sound and solid research when making investment decisions.
.. create a balanced and diversified portfolio.
.. avoid following the herd.
.. be cautious when investing borrowed money. Borrowings must be repaid in full while investments can fluctuate in value.
.. avoid selling investments at the bottom of the market.
.. avoid buying investments in a bubble.
.. avoid making investment decisions based on short-term data and on the spur of the moment.
.. take prudent investment risks, otherwise risk falling behind.
.. accept that mistakes will be made - investing involves risk and is not an exact science.

Themes for 2009 and beyond

We lead in with the closing commentary from Bill Gross, managing director of PIMCO, the world's largest fixed interest portfolio manager, in his June Investment Outlook report:

"Staying rich in this future world will require strategies that reflect this altered vision of global economic growth and de-levered financial markets. Bond investors should therefore confine maturities to the front end of yield curves where continuing low yields and downside price protection is more probable. Holders of dollars (USD) should diversify their own baskets before central banks and sovereign wealth funds ultimately do the same. All investors should expect considerably lower rates of return than what they grew accustomed to only a few years ago."

Below we discuss some of the key investment themes for 2009 and the coming decade. Future Wealth Reports will discuss further themes/sectors that we think are important for investors looking for sustained growth in the future.

The US economy does matter ...

The paradigm of many people who invested debt-funded millions into commodity stocks in 2007 was - "The US economy doesn't matter anymore, we have China!"

What they failed to ignore is:

The US economy on its own is larger than the next 4 major world economies combined.
It has been estimated that for every 7 shipping containers that leave China, 1 goes to Walmart alone in the US.
Looking at the bigger picture, US world-trade dominance cannot be overcome by force - the US has world military dominance protecting its trade across the Atlantic and the Pacific.

Click on the graph above for more detail.

It is also important to understand that China is made up of 1.3 billion people. 1.1 billion who live in the impoverished agrarian interior of China, and 200 million who live in the relatively affluent coastal areas with their income substantially reliant on exports - US, Europe, and Austral-Asia.

This is not to say that the Chinese economy will not grow creating internal momentum and structural change. In fact, China's 2 trillion dollars in reserves will go a long way to stimulating the local economy. It simply highlights that its rate of growth is still attached to, and will ebb and flow with, the US economy.

... and the US still has huge problems

So far, we've seen the debt bubble burst in the private sector. But what is happening now is the creation of a public debt bubble.

This is the $70 TRILLION or so in debts Washington has incurred comprised of more than $10.6 trillion in national debt, $58 trillion in unfunded Social Security obligations, and the additional burden of unprecedented fiscal stimulus programs.

And Washington only has two assets to back up those debts:

Its ability to tax its citizens and pay off the debt from future revenues, and
Its word that it will make good on the debts to the bond market.

Recent trading action in the bond market, and comments by China that it plans to move a substantial amount of its reserves away from US bonds, suggests that bond investors are losing confidence.

The repayment of this government debt is likely to be an anchor on the US economy, and the resultant increase in money supply is likely to lead to long term inflation. More on this below.

Inflation

Shrinking US Dollar

Evidence of long term inflationary pressures are building.

The threat of inflation and concerns over the US paying back its debts with a seriously devalued currency is unsettling large US long-term bond holders such as central banks and sovereign wealth funds.

Stories have emerged in the global media about Russia and China's intention to sell US Treasuries to buy IMF bonds.

In reaction, long term bond yield are rising with significant global implications. The US bond market dwarfs the stock market, and while a sell-off in bonds may initially benefit the stock market, long term high interest rates will put pressure on the market especially in the infrastructure and utilities sectors.

Consider the following from The Wall Street Journal:

"About eight months ago, starting in early September 2008, the Bernanke Fed did an abrupt about-face and radically increased the monetary base - which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash - by a little less than $1 trillion. The Fed controls the monetary base 100% and does so by purchasing and selling assets in the open market. By such a radical move, the Fed signaled a 180-degree shift in its focus from an anti-inflation position to an anti-deflation position."

American economist, Arthur Laffer, has warned that the huge growth in the U.S. adjusted monetary base is bad news for investors everywhere. Writing in the Wall Street Journal, Laffer says,

"The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10.

Further he says, "It's difficult to estimate the magnitude of the inflationary and interest-rate consequences of the Fed's actions because, frankly, we haven't ever seen anything like this in the U.S. To date what's happened is potentially far more inflationary than were the monetary policies of the 1970s, when the prime interest rate peaked at 21.5%."

Gold

Gold

For the reasons outlined in previous wealth reports, and information available in the Knowledge Base section of our website for private clients, we continue to firmly believe that a proportionate portfolio holding in gold is essential given the impending risk of growing inflation and devaluation of the US dollar over the coming decade.

The acceleration of the monetary base through massive global fiscal stimulus has only heightened this necessity as gold becomes viewed more and more as a hard-currency.

Recent action in the gold market has confirmed its upward trend and provides the backdrop for a potential significant move above $1,000 over the coming months.

Commodities & Energy

We are still of the view that commodities are in a long-term bull market because of decades of underinvestment in productive capacity and ongoing demand from the developing world.

Commodity-based shares have responded strongly to China's positive economic numbers and predatory strikes at key bulk commodity producers around the world - including our own Rio Tinto.

The Chinese authorities have a number of "strings to their bow" with which to stimulate their economy and to take predatory advantage of the current 'cheap' commodity prices. Firstly their economy is centrally planned with absolute government power. Then there is the 2 trillion dollars or so in foreign reserves that can support over a decade of required infrastructure spend.

"We know that this is a perfect economic storm," says Mitch Hooke, the CEO of the Minerals Council of Australian to the Australian Financial Review. "There is going to be some wreckage, there is going to be some damage and there will be a drop in supply. But demand will come back and then outstrip supply, and when that happens there will be a rapid recovery in prices and then production."

In fact, BP recently reported that for the first time in ten years, global proven oil reserves have fallen giving credence to many industry views that the capital spending collapse in the oil industry in 2008 is going to lead to a supply shortage in the coming years. When this fact collides with recovery in demand growth, you will are likely to see much higher oil prices.

While the decline in proven reserves doesn't mean the world is going to run out of oil next year, investors should factor in the energy section into to their stock selection in the coming months.

Look out for up-coming Wealth Reports where we will discuss further themes/sectors that we believe are important for investors looking for sustained growth in the future.

To speak with an Eden Wealth Strategist about professionally managing your investment portfolio call 03 9572 0524 or fill in the form below.