Tower: Beating back the bear

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Global markets have been savagely mauled but the signs of recovery should be easy to spot. Tower’s Michael Coote goes bear-hunting.

Thursday, December 11th 2008, 1:11PM

The global credit crunch has driven many asset classes into bear markets as confidence has fallen and finance dried up. The latest OECD biannual Economic Outlook (No. 84) records what has happened in a series of graphs of price trends for key assets:

• Residential property entered its bear market (as measured by inflation-adjusted prices) starting in the United States during the fourth quarter of 2005. This spreading bear market hit other countries, with New Zealand’s beginning in the fourth quarter of 2006.
• Fixed interest bills and bonds of non-government issuers commenced their bear market in the first quarter of 2007 before the sub-prime mortgage market scare broke out mid-year.
• Commodities toppled into a bear market from the first quarter of 2008.
• Equities weakened from the first quarter of 2008 and fell into bear markets in the second or third quarters following (Japan’s was already in a bear market from the first quarter).

All up, 2008 will be remembered as an annus horribilis for investment markets. Price trends for many different asset classes dropped together in a rare example of cross-market correlation convergence.

The convergence effect on modern portfolio theory (MPT) investment portfolios over 2008 has produced an unusually high proportion of assets showing negative returns, an atypical result for diversification strategies built upon low, no, or negative investment correlations.

Correlation convergence can be expected to reverse itself as various asset classes “unbundle” at different times from the common downtrend. Unbundling will arise as governments worldwide implement low policy interest rates, financial system remedies, tax cuts, fiscal expansion and regulatory reforms to restore confidence to markets and ease recessionary conditions in 2009.

Roughly speaking, unbundling should occur as follows:

Fixed interest
Fixed interest investments should rise in value (and, conversely, fall in yield) as publicly-funded rescue plans for supporting commercial lending institutions take effect. This reversal of downtrend can in many cases occur before the real (physical, productive) economy recovers. Examples of relevant rescue plans are:

• The US Treasury’s US$700 billion Troubled Asset Relief Programme (TARP) injecting equity into US-registered banks by buying preference shares in these lending institutions.
• The US Federal Reserve’s new US$800 billion fund for recapitalising government-sponsored enterprises (GSEs) like Freddie Mac and Fannie Mae, purchasing their tarnished mortgage securities and supporting consumer debt securities.

Equity markets
Equity markets are regarded by economists as leading economic indicators, meaning that they tend to turn up before the real economy does. In practice, as early signs of return to economic growth become foreseeable, sharemarkets are likely to begin staging a recovery. The OECD is picking:

• The US and euro area economies should bottom out around mid-2009 and begin growth restoration thereafter
• Japan and the UK will be slower to recover
• Major developing economies like China will retain positive but lower growth rates.

Commodities
Commodities are ranked by economists as coincident economic indicators, in that their prices usually peak and bottom at around the same time as does the real economy.

• There are still critical bottlenecks in commodity production and supply infrastructure which will remain unaddressed due to currently low commodity prices and scarcity of investment capital.
• Much of China’s recently announced US$586 billion 2009- 10 fiscal stimulus package will be channelled into building new housing and infrastructure, requiring substantial imported commodity inputs.

Residential property
Residential property is likely to be the stubborn laggard in terms of timing of upturn due to problems such as; Oversupply of new housing stock in some countries or regions; Lack of affordability; High household indebtedness; Rising unemployment; Credit rationing by banks; Realisation that housing is not a one-way bet for capital appreciation.

In the interim, investors would do well to be reminded of some basics of how to deal with bear market conditions:

• Favour managed funds that have a value investment style, as their more conservative approach to asset selection (seeking out quality investments that are temporarily undervalued by the market) can provide an inbuilt cushion to soften the impact of downturns.
• Avoid the temptation of market timing (selling out of negative performers in order to pick prospective winners) as the actual market bottom will only be known retrospectively and much of the following upswing could be missed. If the investments held were originally chosen for the right reasons, then unless they have revealed serious flaws since, selling out will only serve to crystallise otherwise recoverable paper losses.
• Stick with diversification, because while it won’t prevent losses, it helps limit their damage when it occurs.

As noted above, unbundling of correlation convergence is likely to happen as different asset classes revert to more normal behaviour. Avoid acting impulsively, but instead seek professional advice in order to obtain an objective, third party view. Dollar-cost average by drip-feeding investment into the markets in order to reduce average per-unit acquisition costs (as KiwiSaver contributors will typically be doing). Cut debt (a form of saving) by accelerating mortgage repayments or switching to a shorter mortgage term, and eliminating credit card debts. The interest saved can be invested in the markets instead.

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