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Investment Strategy
Tuesday, August 1, 2006
Stay calm, stay focussed

It was certainly a shock to see almost 17% shaved off the JSE All Share Index from its record peak of 22 094 on 11th May 2006. The ‘correction’ so-called lasted until 13th June when the index had dropped to 18 380. Investors must have been asking if it was time to get out of equities. It would have been the wrong move, of course, as the expected recovery has followed with the index trying to settle over the 20 500 mark. There is nothing new in this sort of behaviour: The index lost 8% in April last year, and 12,6% the previous year around the same period.. It took the index two years to reach back to 11 200 around 4th March 2004 (from 11 198 on 18th March 2002). This all goes to prove once again the longer-term nature of equity investments.

As Nic Andrew, Head of Nedgroup Investments, points out, it is easy to react to headlines, and become distracted. “But it is times like these when you must return to the basics.
“Assuming you have established a sensible investment framework, the second aspect is the more difficult part – sticking to it. This is never an issue when things are going well (or your assets are increasing in value), but is exceedingly difficult when all about is falling down.”
Bear markets come in different shapes and sizes. They can be short and sharp or slow and lingering. Either way, they are normally based on some deterioration in economic conditions that is then magnified by sentiment. Often the second component, sentiment, has the larger impact. The emotion of fear is extremely strong, stronger than the greed investors feel in bull markets.
“All the statements of long-term investing and empirical evidence in favour of equities hold much less influence with investors who have just suffered a 25% fall in their assets with little prospect of short-term recovery,” says Mr Andrew.
So what steps should you take to weather future bear markets when they occur?  “Ensure that the portfolio is well diversified (both in terms of asset classes and within asset classes, particularly the equity portion),” he says. “Keep it in line with one’s framework. In the late stages of a bull market it is easy for investors to drift into holding too much equity simply because that portion has performed so well. Therefore, you should re-balance your portfolio regularly in a disciplined manner.
“Be aware that the equity component of your portfolio is bound to suffer sharp falls (30% plus) from time to time. This has happened seven times since 1960, or once every six and a half years!”


Understand that the reason for investing is a calculated risk to increase one’s real wealth over time. Long-term evidence (100 years) has shown the benefit of investing in riskier equity assets. R1 invested since 1900 has grown to over R95 000 compared to the R480 one would have received if invested in bonds (before tax!). This has come, however, at the expense of periods of extreme discomfort.
Mr Andrew points out that your investment manager is unlikely to see the bear market coming, and unlikely to avoid most of the fall. “Timing the market is exceptionally difficult and requires getting the timing right twice (both when to sell and when to buy back into the market). Very few professionals have been consistently successful at achieving this,” he says.
This point is echoed by Sanlam’s David Crosoer (see accompanying story: Good managers limit loss). He notes that you can limit losses “by good stock picks”.

Temporary phenomenon

Make sure that monies invested in equities are really available for the long-term to avoid the risk of being forced sellers at inopportune times.
Make sure that you select investment managers who manage your monies sensibly with a focus on investing in quality companies that are well or reasonably priced. Companies that are particularly susceptible to bear markets are those characterised by high borrowings, whose growth has depended on share issuance to finance acquisitions, or whose success is closely linked to stock market conditions.
“If you can prepare yourself in this way, it will be much easier to stick with the framework that has been set to achieve your investment goals. A bear market is part of the ordinary market cycle, and however hard to believe at the time, is a temporary phenomenon. It represents the risk in ‘higher risk, higher return’ and in fact provides buying opportunities for patient, rational investors,” says Mr Andrew.

So what happened?

Of course, it helps to understand why a market fell, or corrected. That will also underpin the logic of a well-thought out strategy. Of all the reports I’ve read recently, the commentary by Sanlam’s Group Economist Jac Laubscher, is the most concise and intelligent (see accompanying story: A more sound balanced nature). He clearly believes “we are not facing an emerging market crisis,” but rather the global markets (the JSE included) were reacting to “a controlled reassessment of the inflation outlook” and the fear that central banks might over react. This was also a timely “normalisation period of irrational exuberance.”
Comments Paul Hansen, Stanlib’s director of retail investing, “We have merely witnessed a market correction within a continuing ‘bull’ cycle. Further market retreats are possible, but the balance of probabilities is for markets to recover rather than plummet.
Indeed Stanlib sees shares as “still undervalued, as are world markets.” The key assumption being made here is that the big picture remains reasonably intact; that is, global economic strength, relatively low interest rates and continuing real growth in company earnings will underpin improved market performance.
Despite the fall in share prices the index is still up a tad. One must not overlook the fact the JSE has generated returns of over 210% in three years.
Mr Hansen blames the jitters on Ben Bernanke, new governor of the US Federal Reserve Bank who has announced his intention to come down hard on rising US inflation, creating expectations the Fed will raise rates, thereby bitterly disappointing global investors who thought rate hikes were about over.
To rub salt into the wound the South African Reserve Bank also hiked interest rates for the first time in four years, a little unexpectedly, although Mr Hansen admits the Stanlib house view has changed on this issue. Its forecasters now believe our rates could rise by another 0.5% by the end of 2006 (Old Mutual’s team agrees, although Sanlam expects a higher increase, 1% to 1,5%). Meanwhile, in a much anticipated move, on the 14th July 2006 the Bank of Japan officially ended its five year policy of zero interest rates by increasing the key overnight rate to 0.25% effective immediately. Rising interest rates are a sure sign that deflation has finally ended. The largely symbolic ending of zero rates is the first step in the normalisation of Japan.
Says Glenn Silverman, Global CIO, Investment Solutions, “In the space of the past 12 months no fewer than 32 central banks have raised their official interest rates. Increased global inflation concerns and a wave of hawkish central bank responses have unsettled the markets. The US Federal Reserve has now raised rates by 0.25% at each of the last 17 consecutive meetings, taking policy rates to 5.25%.”
Expectations for synchronised global monetary policy tightening have unsettled investors. Rising equity markets both developed and emerging came under pressure, but the emerging market index has fallen far more sharply – 20% from their peak versus the 10% of the developed markets. Equities have since recovered from these levels.
“What is clear,” he observes, “is that a co-ordinated programme is in place and that higher interest rates globally seem on the cards for some time into the future. Rising interest rates are rarely supportive of economies or markets and concerns are growing about future growth prospects especially into 2007.
“Interest rate hikes take some time before they impact on the real economy and hence the seeds are already being sown for a slow-down, and the key question is whether there will be a ‘policy error’ resulting in too high interest rates and a sharp fall in growth and company earnings.”
SA has undergone much structural change. It is in a far healthier position in so many respects – low government deficits, low borrowings (corporate, government and corporates), $20 billion net reserves (versus a deficit of $23 billion as recently as 1998). So SA is better positioned today than in any time in its history to deal with the inevitable exogenous shocks emanating from the global environment.
Says Mr Silverman, “There are though some excesses and imbalances in the system and these do create some risks. SA too shows some signs of excessive risk taking and over confidence. Our property market has run hard, as has the stock market. Consumers have taken debt levels up significantly (from 52% in 2001 to 68% this year). A period of lower growth or even some retrenchment is called for. The SARB’s response of raising interest rates in 8th June (note: along with four others on the same day) seems entirely appropriate, importantly to sustain rather than to abort the cycle.”
Higher interest rate speculation is bad news for equities, but how bad?
The JSE had attracted over R50 billion of net buying from offshore investors so far to June 2006. A similar net amount was registered in calendar 2005. This creates the possibility of a double ‘hit’ for the JSE if local investors and foreigners start selling. Chartist appraisals and technical analysis suggest, however, that any fall would be bearable in the context of the strong three-year run by the JSE.
In support of Stanlib’s largely reassuring position, Mr Hansen quotes the view of independent Toronto research house BCA that global markets are experiencing a mid-cycle correction in an ongoing bull market. The researchers believe ‘the fundamental backdrop to the US and overseas equity markets remains generally positive… we do not believe a major bear market has begun. We do not advocate moving to below-average weightings in equity positions’.
Peter Brooke, Equity Strategist, at Old Mutual Asset Managers says a drying up in risk appetite triggered the sell off in world equity markets with commodities and emerging markets worst affected. As one of the largest exporters of resources and a sizeable emerging market itself, SA has been at the centre of the storm. “Our situation has been further exacerbated by the fact that our current account deficit is 4,5% of GDP, so is reliant on capital inflows to fund it,” he observes.
As for commodity prices, despite recent sharp falls, they are still well up on the start of the year.
The correction does means the market has become cheaper, and so SA is once again trading at a 20% discount to developed markets. The forward price:earnings ratio (PER) — the price shareholders are willing to pay for expected future earnings — is currently 12 times, which should deliver a real return of 7% in the medium-term (double digit nominal returns). “We still expect this to be better than the returns from cash and bonds and therefore see this correction as a buying opportunity,” says Mr Brooke..
Peter Lucas, global investment strategist for Jersey-based investment house, Ashburton, believes US interest rates may have peaked at 5.25% and that the Fed may feel bold enough to hold them at that level to allow more time for them to impact on US inflation. “US house price inflation has eventually responded vigorously to 17 successive US interest rate hikes, slowing from 17% late last year to only 6% at the present time, and hopefully this will introduce a note of caution into US consumer spending.”
Mr Lucas highlights the impact of uncertain economic times on high yield, high risk currencies such as the Icelandic krona, the New Zealand dollar, the Turkish lira, South African rand and even the US dollar. He says all these countries have large current account deficits and yet their currencies have been relatively robust in buoyant economic times, simply because the attraction to lend money to them, given their higher interest rates.
“Come less certain times and there is a flight of funds out of these currencies to safer more reassuring havens such as those in Sweden, Norway and Switzerland,” he notes. “Most equity markets had recovered their poise, but the extent to which this will continue is questionable if the hoped for interest rate respite in the US is offset by flailing investor confidence.
“One more esoteric reason for our concern is the co-called Presidential cycle, which has produced a US market low every fourth year since the Second World War. That, combined with the one-year seasonal cycle and the 10-year decennial cycle, has the market rallying into August before falling sharply into an October low,” says Mr Lucas.

As for local investors Old Mutual notes they should consider the following points:
• Don’t panic. The key to saving is consistency and the best defence against volatility is time in the market. If you have a long-term investment horizon, exposure to equities is important, as equities will outperform other asset classes over the long term.
• Ensure that your portfolio is adequately diversified, both locally and internationally. Reassess your investment strategy with your advisor regularly to ensure you have an appropriate asset allocation that reflects your risk appetite and long-term return needs.
• If you are overexposed to equities, consider adjusting your exposure to a more appropriate level as we would expect continued volatility.
• Regular savers, who are early in the capital accumulation objective, should ignore markets and continue investing as market dips present an opportunity to buy at lower levels.
• If you’re a medium-term investor or cannot afford to experience any volatility, consider managed solutions and absolute return funds as an option. While these funds will typically under perform market-related funds in the long-term, they do offer diversification and lower levels of volatility.

And perhaps the last word should go to the second richest man in the world, who acquired his wealth through investing. Warren Buffett wrote in the preface to Benjamin Graham’s Intelligent Investor:
“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insight, or inside information … what’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”
Establishing a sensible investment framework is relatively easy - it simply requires the discipline to define clearly one’s investment goals, specific circumstances, time frame and ability and willingness to accept risk.

By Nigel Benetton

Copyright © Insurance Times and Investments® Vol:19.4 1st August, 2006
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