Secrets Of Success: I'll play it safe at this end of the bull
Saturday 18 March 2006
As the FTSE 100 Index broke through the 6,000 mark for the first time in five years yesterday, I was struck by this week's thoughtful words this week from the experienced technical analyst David Fuller. He is currently facing a difficulty that faces all experienced investment professionals when markets start behaving the way that they are at the moment.
All the surface evidence suggests we are seeing a typical late bull market flourish, with prices of all sorts of strongly-performing financial instruments still moving sharply upward, seemingly without regard for considerations of value.
Those with long memories know that these times, when market momentum parts company with valuation constraints, are always the most difficult conditions for those who genuinely hold their clients's welfare dear to their hearts (which rules out a big chunk of the retail financial services business admittedly, but that is another story).
The problem is that "experts" rarely get thanked for giving an early warning about the imminent end of a market phase (and certainly not in the final stages of the financial year, when fund and broking sales teams are in full cry).
Because price advances tend to accelerate ahead of a final market peak, many investors find themselves becoming newly enthused as markets power ahead, even though hindsight suggests they should be cautious. It is natural enough to think that those advocating caution at this point are losing the plot, or at least their bottle.
It is easy to forget how scornfully Internet nuts dismissed those who were predicting the end of the bubble in 2000, on the grounds that they simply "didn't get" how new technology was rewriting the way the world worked.
In his book The Future for Investors, the Wharton professor Jeremy Siegel recalls how the dean of his business school received scores of letters and emails calling for him to be fired after he wrote an article in The Wall Street Journal in 1999 saying Internet stocks could not possibly be worth the price at whichthe market was valuing them.
One of the politer letters read: "Not only is this guy a dinosaur, but he knows absolutely nothing about Y2K and forward business models... I hope that he may soon retire from dear old Wharton... or to the funny farm - whichever comes first. He is nuts, period, and should have a muzzle."
What prompted Fuller's concern was a suggestion from the economics consultancy GaveKal that we may now be entering a dangerous period when central banks are clearly trying to clamp down on overblown asset markets through a co-ordinated round of global interest rate rises.
The central banks are, says GaveKal, withdrawing liquidity from the markets, but at a time when commercial banks are still lending without much restraint. In other words, credit is still growing, while money is being restricted.
"If this scenario is indeed the one we face today, and I believe it is," says Fuller, "then we are entering a period of increasing risk relative to what we have become accustomed to over the previous three years. But there is a danger in issuing warnings, effectively crying wolf, because in terms of crowd sentiment the psychological Rubicon from bull to bear has yet to be crossed.
"Therefore, people who are feeling increasingly nervous and cutting back on exposure, me for instance, see an opportunity cost because old reliables over the past three years, such as gold and silver and leading stock markets, are still rebounding following short-term reactions. Frustration over opportunities missed can tempt one to dismiss risk perceptions to make up for lost time.
"I've certainly done that before. Remember, the most overleveraged and complacent fool will look like a genius, until the day markets turn down and keep falling for a few months.
"Will that happen? Honestly, I don't know, and neither does anyone else. But I've seen enough, not least in terms of what are now synchronised monetary policies by the Fed, ECB and BoJ. I can also see some overextended trends, some of which show a loss of momentum.
"I fear that markets are waltzing into a cul-de-sac. If so, we could see a cascade effect, in which markets look as if they have suddenly gone over a waterfall. But remember, I'm only looking for a medium-term correction, with the most likely danger period being 2Q and 3Q 2006."
Apart from the fact that this is close to my own view (always a worrying sign), this seems to me to sum up the situation very well. Other professionals I respect, such as Derek Stuart, the manager of the Artemis Special Situations fund, take a similar view,
The other telling point that was made in the GaveKal analysis is that investors seem to have convinced themselves now that central banks have lost the power to restrain markets, just as in 2002 it was hard to find anyone who thought central banking policy could pull the markets out of their then tailspin.
In the event, the cheap money policy the Federal Reserve has pursued since mid 2003 has worked like a dream. It is true that nobody knows how far the Fed and its new chairman Ben Bernanke will eventually want to go in raising interest rates now that rates are back up to a more normal level (4.5 per cent), but the risk is that more is needed.
Despite the well-publicised dangers of market timing, my view is that smart investors should not be afraid to be too early in conditions such as the one we are in now. The risk of egg on face is ever-present in this business. A number of holdings in my equity portfolio are up by 15 per cent or more already this year. While I normally keep it fully invested, it looks to me prudent on risk grounds to bank at least some of those gains now, knowing full well that such a move could look pretty stupid in six weeks time, if things go higher still.
One thing I left out from my piece about Warren Buffett last week was an elegant passage in his latest Letter to Shareholders in which he highlights the way that intermediaries - fund managers, brokers, hedge funds, financial advisers, consultants and so on (a group he ironically refers to as the Helper family) - are taking an increasing proportion of the aggregate returns that the stock market produces.
This is the concluding sentence: "The burden of paying Helpers may cause... equity investors, overall, to earn only 80 per cent or so of what they would earn if they just sat still and listened to no one". I fear there is more an ounce of truth in this.
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