Secrets Of Success: Don't panic; we've been here before
Saturday 19 August 2006
Are investors drawing the right inferences from the rising price of oil and other commodities? That is the interesting question posed this week in a note by Tim Bond, the global strategist at Barclays Capital.
Looking back at the last time we faced a soaring oil price, which was the 1970s, does not provide much in the way of comfort. If we are facing anything like a similar environment, the prospects for investors will be dire. The 1970s, after all, were a time of economic disruption, soaring inflation and serial pain for investors.
As the table shows, it was a decade when positive real returns were hard to come by. While shares over the course of the decade eventually produced a small positive return after inflation, this crumb of comfort masked a traumatic ride that, at the low point, saw even the bluest of blue-chip companies trading on p/e ratios of six or less. At its nadir in 1974/75, many in the City genuinely feared we might be seeing something close to the collapse of the capitalist system.
In the event, the crisis passed, but investors were scarred by the experience. The figures show that property as an asset class did produce a small positive return in real terms in the 1970s (though the figures gloss over the issue of liquidity; how easy it was in practice to realise those returns). Meanwhile, both bonds and cash were hammered, and proved disastrous investments.
In fact, the only major asset classes to produce consistently high returns were oil and commodities, whose soaring prices were themselves a major trigger of the crisis.
"To a considerable extent," Bond observes, "the experience of the 1970s directly contradicts received wisdom about the benefits of portfolio diversification. The only portfolio structure that would have generated a positive real return in that decade would have been characterised by a narrow focus, concentrated on one or two asset classes and two or three equity sectors. Any other conceivable portfolio structure would have lost money."
If you look at the sectoral performance of the UK stock market, the same pattern of highly concentrated performance is clearly visible. Only three of 14 sectors managed to outperform the All-Share index in the 1970s - banks, energy (oil and gas) and industrial goods and services. All other sectors underperformed, and as many as half of them actually produced a negative real return over the decade as a whole.
Any repeat of this kind of scenario would clearly be traumatic for anyone pursuing a typical balanced broad market investment strategy. The point that Bond makes is that if history is any guide, the only real hedge investors have against the impact of rising oil and commodity prices is to own a heavy weighting in shares or funds whose returns are directly linked to those prices. (This advice has the great merit of being common sense as well.)
We have already started to see imbalances emerging in the sectoral behaviour of the stock market over the last years as oil and commodity prices have risen.
For example, if you analyse the different contributions that the various sectors made to the FTSE All-Share index in 2005, the result is very lopsided. Resource stocks (mining shares and oil and gas companies) accounted for more than a third of the overall market's 22 per cent return on a capitalisation basis. In the first seven months of this year, the same two sectors (plus electricity and gas utilities) contributed the bulk of the market's return.
In other words, if you haven't had at least a market weighting in these sectors, your relative performance is likely to have been poor. As stock markets have been rallying strongly for most of the past three years, the damage done by not owning resource stocks has been masked to some extent. It is only an opportunity cost at this stage. This would change if shares in general began to fall, when not owning resource sectors might be the difference between making and losing money.
The risk that we may be facing a re-run of the 1970s may still be low. So far, the global economy has weathered the storm of rising oil prices surprisingly well, though the easy money policies of the Federal Reserve have clearly mitigated the impact they might otherwise have had.
There are several good reasons for thinking that a repeat of the horrors of the 1970s is unlikely this time around. If logic prevails, neither producers nor consumers of oil should want to throw the world into a renewed oil-induced recession. Although it is rising, inflation isn't yet out of control. There is, however, a lot of complacency, as reflected in the still unprecedentedly low risk premiums on many assets.
For investors, the dramatic globalisation of markets is a further potential line of defence against a meltdown of the kind that was seen in the 1970s.
With hindsight, it is clear also that investors over-reacted to the crises of the 1970s. Surprisingly perhaps, corporate profits did not suffer anything like as badly as the performance of the stock market might suggest.
The worst damage was done by panicky investors slashing the prices of shares to levels that could not be easily justified on any rational basis. Franco Modigliani, the Nobel Prize-winning economist, pointed out in an influential paper a few years later that investors seemed to have misunderstood the positive impact that inflation would have on corporate earnings, a mistake that may not be repeated this time round.
Although speculation clearly drove prices of many commodities ahead of themselves earlier this year, the longer-term supply and demand imbalances in oil and other industrial commodities will still take several years to put right. That is why, from a strategic point of view, you are taking a risk if you opt to be underweight in these sectors.
Oil and gas, at its peak in 1980, came to account for 25 per cent of the overall capitalisation of the stock market in the UK. Today, the energy sector accounts for just over 17 per cent so, for all the gains we have seen so far, we are not yet back to those levels.
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