Martin Spring: Positioning Yourself for a Tough Time

One of my favorite analyst Martin Spring argues that in the coming months, rising interest rate environment increases the risk prospects hence the financial markets may experience some degree of volatily or turbulence. However he also recommends of a rentry to equities particularly in the natural resources sector and in Asia when the US Federal Reserves CEASES to raise interest rates. While Mr. Spring thinks that this should transpire by next year, my opinion is that this will happen during the second semester of this year. I hope you enjoy reading his insightful article...

Martin Spring: Positioning Yourself for a Tough Time

The next few months are likely to be unpleasant for equity investors.

► The period from May to October is usually (though not always) a time of stock market weakness. In America, the market has made very few gains during this period over the past half-century, the exceptions being during major bull markets (which we’re certainly not currently experiencing). In Britain, the worst months for equities since 1966 have been September, June, May, July and October (in that order). In Japan, too, average returns since 1970 have been almost exclusively negative over the June to November period.

So there is validity in the old British stock market adage: “Sell in May and go away, stay away till St Leger’s Day” (mid-September). “No wonder American traders prefer to wait until Halloween (31 October) before they buy back into their markets,” says James Ferguson in MoneyWeek.

► Corporate earnings, whose strength has driven the bear-market rally of the past two years, will come under pressure from slowdown in all the major economies, higher energy and materials costs, and more expensive labour. In the US the biggest gains in productivity from applying infotech are coming to an end, while the costs of employment benefits, especially healthcare, are soaring.

Earnings growth in America peaked at around 20 per cent last year. HSBC Global Research predicts growth will fall to 10 per cent this year and to 2 per cent in 2006. The markets won’t like that, as rising profits have been an important rationale for share valuations that are high by historical standards.

► Interest rates are likely to continue rising because we’re now in a phase of worsening inflation in the US and Europe. Because of the way equities are valued, this will make shares look “too expensive.” Costlier credit will also be a source of pressure on corporate earnings.

In particular, rising rates squeeze profits from financial services. The latter now account for an amazingly high share of corporate earnings. One study puts the figure at 44 per cent of all profits in America. And Marc Faber suggests this may even be a significant understatement, if you add in “financial earnings from industrial companies such as GE Capital and General Motors’ financial subsidiaries, and the profits earned by large multinationals from their treasury activities, which resemble hedge fund-type financial transactions.”

► Global markets for all investments, not just equities, have been put on a starvation diet with the withdrawal of the massive stimuli that have boosted them in recent years – an abundance of credit creation by central banks, government spending increases and tax cuts. For various reasons, we’re not likely to see a repeat of those stimuli for some time. Meanwhile, ominously, the growth rate of global liquidity is plunging towards zero.

► Economic growth and investment gains have been driven in recent years by one important chain reaction. It’s this… A real estate bubble in the Anglosphere has been inflated by cheap credit; which in turn has encouraged and made it possible for consumers to borrow heavily against the collateral of their rising home values to finance their profligate spending. In the past, the resulting boost to imports would have triggered a balance of payments crisis, devaluation and a big hike in interest rates. But that hasn’t happened this time, because exporting nations have been recycling their trade surpluses back into the bonds and bank deposits of the trade-deficit countries, holding down their interest rates and keeping their property bubbles expanding.

We’re now seeing early signs that this comfortable process may be about to come to a painful end. The real estate boom in some countries (Australia and Britain) is being choked off by softening demand – potential buyers can’t afford the high prices. And the cost of mortgage finance is creeping up.

In the US, consumers are so heavily in debt that they are starting to lose their enthusiasm for taking on more. And rising interest rates are making it harder for them to finance what they already owe.

► There is now risk of some kind of financial crisis within the next 12 months, which would be a major shock to business and consumer confidence – and to the values of all except the most conservative investment assets, such as cash, gold and government bonds.

Years of cheap credit, with interest rates almost nothing in nominal terms and negative in real (inflation-adjusted) terms, have stimulated a global financial bubble of enormous proportions.

Managers of pension, insurance and trust funds, as well as banks, hedge funds and wealthy individual speculators, have been using cheap credit to buy exposure to risk in various forms, in their hunt for higher returns. One example of the extremes to which this has been taken, according to CLSA’s Christopher Wood, is “highly leveraged funds-of-funds invested in highly leveraged hedge funds.”

No one knows how large the financial bubble has become, nor how risky it is, as so many of the transactions involved are beyond the purview of regulators.

It would only take one unexpected event, such as a terrorist act, natural disaster or business shock (a fraud or bankruptcy involving a major group) to trigger a crisis that bursts the financial bubble, as those exposed to risk seek to unwind their positions or are forced to raise capital to cover them.

What conclusions should you draw from this increasingly threatening environment for your personal investment strategy?

► Raise the cash in your portfolio relative to your equity holdings. Possibly raise your gold holding, too, as the metal now looks cheap.

► Get out of, or at least reduce, your equity holdings in the most dangerous sectors such as finance, technology, media, and many of the cyclical industries. However gold mining should gain, while oil and natural gas and other sectors being sustained by China’s demand should be resilient in the downturn.

► Shift from high-yield corporate and emerging-market bonds into lower-yield stuff, such as the government securities of major nations, particularly euro-denominated ones.

► Use the next six months to research and prepare for major re-entry into equities. The best sectors to move into for the next major rally will probably be Asia and natural resources (especially energy).

The timing signal to watch for will be the first indication that the Fed is going to stop raising interest rates, and is about to resume its policy of pumping out abundant cheap credit.

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