A disturbing thought has been dogging me: we may not be about to enter a “normal”, cyclical bear market of 25 to 30 per cent losses, but may instead endure a bear market akin to Japan’s, where returns on equity are pounded down as successive waves of rallies are consumed in a wider sense of gloom and re-rating.
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David Stevenson: Go on the defensive to avoid fate like Japan’s
By David Stevenson
Published: August 15 2008
A disturbing thought has been dogging me: we may not be about to enter a “normal”, cyclical bear market of 25 to 30 per cent losses, but may instead endure a bear market akin to Japan’s, where returns on equity are pounded down as successive waves of rallies are consumed in a wider sense of gloom and re-rating.
SocGen’s chief bear, Albert Edwards, leads this school of thought. Supporters maintain that the FTSE 100 is charging down towards 3000 and that the damage to the wider, real economy will be immense and long-lasting.
An equally prolific and articulate spokesman is Nouriel Roubini, NYU’s top economist and founder of the excellent www.rgemonitor.com.
He has chillingly spelt out the “12 step pathway” to financial chaos (if you email me, I’ll send you the rather depressing document). According to Roubini, we’re already at step 6.
Personally, I don’t think it’ll be that bad. I reckon there’s probably another 10 to 15 per cent left to go before the FTSE 100 hits bottom. Even so, adventurous investors may want to build some insurance into their portfolios. And, over the last few weeks, a number of ideas have been suggested to me.
Albert Edwards himself is big on bonds. He recommends that investors cut global equity exposure in their portfolios to 30 per cent, and keep 50 per cent in AAA-rated government bonds.
He forecasts that US 10-year bond yields will bottom out below 2 per cent, compared with 4.1 per cent now, which implies a doubling in bond prices.
For UK investors, a sudden cut in interest rates next year, in reaction to a major economic slowdown – and much lower core inflation – could force a similar result. So I think a position in the iShares FTSE UK All Stocks Gilt ETF (ticker symbol: IGLT), yielding 4.9 per cent, might be in order.
If you think inflation will be a persistent problem in the next few years, I also suggest you have a good look at iShares latest offering: the Global Inflation Linked Bond ETF (IGIL), which groups together index-linked government bonds from around the world including the US (22 per cent of holdings), the UK (23 per cent) and France (16.5 per cent).
Gold could clearly do very well, too. Some gold bugs even reckon that the clamour for the metal could force the authorities in the US to ban physical ownership of the stuff.
But that presumably wouldn’t stop you owning gold through a UK-based physical allocation tracker, such as ETF Securities Physical Gold ETC (PHGP). Even so, I can’t say I’m terribly excited by the idea of holding 20 per cent of my portfolio in the metal, as the gold bugs suggest.
I’d rather take out some cheap insurance via deep out-of-the money gold covered warrants. SocGen has a series of $1,500 call warrants, with exercise dates from December 2008 and beyond, that can pay out up to 20 times your initial investment if gold suddenly spikes upwards – or become worthless if the price stays where it is or falls back.
So you could put a tiny percentage of your portfolio into one of these warrants, and roll over the position as the warrants expire.
A more obvious strategy for making money in a steeply declining equity market is to short that market.
SocGen has a range of warrants that will make you money if the FTSE falls, with gearing that ranges from 1:1 through to 1:50 for far out-of-the-money bets.
But my worry is that you could easily be caught out by a sudden equity rally that inflicts huge losses on a short position. So is there a viable alternative?
How about going long on some shares that might do well in both a nasty bear market and a bull rally?
Blue Sky Asset Management and its research firm Red Tower have recently explored this idea. They have suggested something called a “defensive+” strategy.
Essentially, this involves putting together a portfolio that has some defensive qualities in case the bear market lasts three years or more, but offers some upside exposure if a recovery comes more quickly than expected.
So their “defensive+” portfolio invests in the following FTSE 350 sector indices: electricity, pharmaceuticals, food and utilities. They also suggest some shares in food companies and retail/consumer goods groups that could do well in a “stagflation” situation – plus some commodity (precious metals) and foreign exchange exposure.
Blue Sky and Red Tower have tested this strategy since 1990 and the results are impressive. “The clear-cut observation,” according to Blue Sky, “is that the defensive+ strategy is not bad as a standalone idea!” – even in bull markets.
This support for classic defensives was echoed by Albert Edwards in a recent conversation.
He noted that, in the Japanese bear market, these kinds of shares shot up in value even as other shares crashed back – with investors chasing utilities up to ridiculous price/earnings ratios.
But I think there might be an even more interesting long-term strategy: investing in value stocks. Clearly, that’s a daft suggestion at the moment. Even SocGen’s value fiend James Montier accepts that value shares have underperformed massively of late.
However, he points out that these short-term returns are inevitably followed by rapid bounce-backs as investors dump “glamorous” cyclical stocks from the resources sector and emerging markets.
According to Montier: “Following a period of marked glamour action, value outperforms by nearly 17 per cent per annum (for an average of 7 years)”.
That time may soon come.
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