When the facts change
This post is a guest contribution by Niels Jensen*, chief executive partner of London-based Absolute Return Partners.
“When the facts change, I change my mind.” John Maynard Keynes
In last month’s letter I looked at the challenges confronting the world’s baby boomers based on the assumption that we are in a structural equity bear market, which implies below average returns for equity investors for several more years to come. Central to this forecast is my expectation that household de-leveraging, which is now underway on both sides of the Atlantic, has much further to run. In other words, we are in a balance sheet recession. When that happens, debt reduction becomes the priority. Savings rise and consumption falls at the expense of economic growth.
Please note that this forecast is predicated on a 5-10 year time horizon. Within a structural bear market – which is characterised by falling P/E ratios – it is certainly possible to have cyclical bull markets, so it is by no means one-way traffic. As you can see from chart 1, since the 1982-2000 structural bull market came to an end, we have enjoyed two powerful cyclical bull markets; however, global equity prices remain at 2000-levels.
Chart 1: Return on global equities since January 1970
That pretty much sums up the key findings in last month’s letter (which you can find here in case you didn’t read it). This month I will look at an appropriate investment strategy for such an environment, so let’s get started. I will make five specific recommendations. Here is the first one:
# 1 Beware of echo bubbles
We are currently in what I like to call echo bubble territory. I assume that most of our readers are familiar with the DNA of an asset bubble (even if Greenspan isn’t). Echo bubbles are children of primary asset bubbles and are usually conceived when monetary authorities respond to the bursting of an asset bubble by dramatically reducing policy rates.
In the current situation, banks have suffered the worst; low policy rates help banks rebuild their damaged balance sheets as they benefit from the steep yield curve. The dilemma now facing policy makers is that the extraordinarily low interest rates we currently enjoy are encouraging another bout of excessive risk taking before bank balance sheets have been restored and the economy is back on its feet again. If monetary authorities were to raise rates now in order to avoid the formation of echo bubbles, it would almost certainly kill the fledgling recovery. The pressure is therefore on them to keep rates low and for that very reason asset bubbles are often followed by echo bubbles.
So how do you spot a bubble? Edward Chancellor of GMO has recently published a paper which I recommend you read from A to Z (you can find it here). It is a brilliant account of all the features which characterise asset bubbles. The scariest part of Chancellor’s story is that China ticks virtually all the boxes. I would actually go one step further and urge you to beware of emerging markets in general. They have shot up over the past year as a result of massive inflows from European and US equity investors. We are not yet at ridiculous valuation levels, so the bull market probably has further to run; however, investors seem to be forgetting why emerging market equities usually sell at a discount to US and European equities despite their superior earnings growth. There are risks associated with investing in emerging markets which are quite conveniently being ignored at the moment. Sooner or later, something will happen which will remind investors that those risks still exist.
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* Niels Jensen has 25 years of investment banking, private banking and asset management experience. He founded Absolute Return Partners and is its chief executive partner.
Source: Niels Jensen, Absolute Return Partners, April 2010.
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