Politics Is Back In Vogue (FT Column)

If you are not a fan of forecasting, and have no reason to be sure what is going to happen over the next 12 months, it makes a lot of sense to start the year, not with a set of predictions but with two lists – a wish list and a watch list. As well as being good for the spirits, positive thinking is helpful from a risk perspective. It is much easier psychologically to take precautions against a wish not happening than it is to assume that a public prediction will turn out to be wrong.

This, in any event, is very much the way that many fund managers seem to operate. I have lost count of the number of times over the years that active fund managers are heard to say that what we are facing is a stockpickers’ market – or, to put it another way, a range-bound market that will reward those with suitable skills. As far as I can see, this more often than not is also wishful thinking.

Even if it is true in one year, it rarely is in the next. In 2009, did you need stockpicking skills to spot and ride the market rally? Not really. The most important thing was to be in equities at all, and then the best thing to do was chuck away your analytical sensitivities and pile into high beta stocks regardless of merit.

With the market having rallied so strongly since its lows in March, it is easy to say that 2010 will be different. The so-called “dash for trash” may already have run its course. Large cap quality stocks must be the better long term bet at today’s values, but that does not make it a sure thing that the rotation will persist throughout this year. 2010 has started with a bad January for equities and risk assets, which if you believe in such things, bodes ill for the rest of the year.

However these are early days,and although sentiment has clearly taken a turn for the worse in the last three weeks, with the hedge funds mounting a concerted assault on the risks of Government bond defaults in the Eurozone, it is still premature to write off the rest of the year. The Bank of England’s decision to call a halt to quantitative easing is a valiant statement of intent that it wants to return to more normal conditions, but it may yet be derailed by a return of investor nervousness. 

Meanwhile, whether or not you buy into Pimco’s “new normal” hypothesis, what is undeniable is that politics has returned with a vengeance to centre stage, and with it the parameters of risk are changing. With unemployment (or the fear of it, as in China) still running high, new political battle lines are already being drawn in many countries. The Massachusetts election result, to give one example, is clearly a potential game-changing event.

For central bankers and politicians alike, operating in unprecedented conditions with the usual inadequate data, the risk of policy errors remains extremely high. The government debt crisis towards which many countries are now hurtling presents plenty of opportunities for false steps, as well as a wonderful scare story for hedge funds to hunt down, as they are doing.

As experience warns us that this kind of environment is one that is full of perils for investors, a measure of caution is undoubtedly justified. In fact, it seems more likely that the markets’ nervous start to 2010 is best attributed to a heightened sense of political risk than to any change in corporate or economic fundamentals, where as far as can be told the recovery in the United States, at least, is so far well up to expectations, with two thirds of companies beating earnings expectations and support from a steep and rising yield curve. The Government debt issue itself is not news, but how well the markets think governments will react to the problem most certainly is.

Top of any wish list for 2010 must be a return to higher interest rates and rising bond yields. Although this prospect is something that seems to terrify many Western governments, faced with spiralling public debt, it is a essential pre-condition of the world returning to normality. A combination of unprecedented public sector intervention and artificially low interest rates, while it may be justified as a short term expedient, is a surefire path to misallocation of capital and economic stagnation. A failed political response to the debt challenge is the corollary for the watch list.

The risk to investors arises from the fact that, while the voters of Massachusetts seem to have recognised the dangers in fiscal irresponsibility, the administration in Washington does not yet appear to share that opinion. Equally concerning is the fact that the Federal Reserve and many other central bankers seem to have become dangerously fixated on low or even negative real interest rates at almost any cost, as if somehow that is a desirable norm, which it most definitely is not.

The point that should worry investors most is that politics is non-linear. The dynamics can change fast and in unpredictable ways. Politicians tend systematically to overlook the second and third order effects of decisions they make today. Given the likely volatility, the odds are that 2010 could be an eventful year, with an emerging story of better-than-expected recovery (as I see it) threatened by shifting investor worries, continued bank frailty and complex but interesting political and policymaking manoeuvring whose outcome is uncertain and imperfectly knowable.

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Q and A on China and Markets: Anthony Bolton

Anthony Bolton of Fidelity needs no introduction to investors, having managed the UK’s most successful equity fund for 28 years from 1979 to 2007, during which period Fidelity Special Situations outperformed the FTSE All-Share index by the extraordinary margin of  6% compound per annum. Late last year, to the surprise of many professionals, he announced that he was coming out of retirement in order to launch a new fund to invest in China. In these exclusive extracts from an extended Q and A with Independent Investor he explains why – as well as what he is expecting from developed markets in 2010.

You have nothing to prove as a fund manager. What is the attraction of managing a Chinese fund?

There are several reasons. The first thing is the general case for China. Here is the third biggest economy in the world, which is likely, this year or next, to overtake Japan and become the second biggest economy in the world. It’s currently the ninth biggest stock market, and in the next 20 years or so, it will become the second or third biggest stock market.

There is also the S-curve effect. There has been a lot of research into emerging markets and when they tend to have their best phase of growth. It seems to be when GDP per capita is in the $4,000-$10,000 range. As the average income goes up, you get a significant and disproportionate increase in the number of wealthy people. That’s what happened to Taiwan and Korea 20-30 years ago, and to Japan before that. The exciting thing is that we’ve never seen an economy as big as China go through this phase.

Although China is a command and control economy, which has some negative aspects to it, what also impresses me is that the top politicians in China are well-educated and international in their outlook. Their plan for what they want China to be in the future is really exciting. When they do things, when they say “we’re going to change the hospital system, we’re going to put in a high speed electric train network” or whatever, it tends to happen, and happen quickly.

The public spending on infrastructure is hugely impressive, as anyone who goes there can see. India and other countries are also exciting, and though I don’t know them so well, it seems that they do get very bogged down in politics. There are obviously some long term questions about the Chinese system of benign dictatorship. Once people become better off, at some stage they want more freedom, and so that’s a challenge for China down the road. But it is still a few years off.

And China looks a more attractive place to invest than many developed countries?

Yes. The second reason is very much what’s happening in the West. My view is this has been a different type of recession to a normal recession. It has been the most extraordinary 18 months, and quite unlike most recessions that I’ve experienced, which tend to creep up on you slowly. You often only realise you’re in one when you’re halfway through it. What happens then is that the consumer tends to lead you out of it.

This recession is different because it’s been very much driven by corporates, not consumers. My explanation is that when the financial crisis hit the headlines in the third quarter of last year, CEOs immediately said “We’ve got to batten down the hatches”. They cut inventory, they cut cap ex, and they cut labour, and for the first time ever, that happened globally all round the world. That’s why we had such desperate economic figures in the fourth quarter of last year and in the first quarter of this year.

Now we are experiencing the reverse of that. Obviously, not all the economic data is universally bullish, but the stuff that we look at suggests that there’s a pretty strong recovery and we think earnings are going to surprise on the upside because corporates, particularly in America, have really cut back so far and so fast. So while in some ways, the situation wasn’t quite as bad as it looked in the headlines at the end of last year, and at the beginning of this year, I think the reverse is true now. This fast upturn is making things look better than they really are.

What does that mean for stock markets over here?

My view is that what we’re going back to once this recovery phase has run its steam, which I think will last through the first half of next year, is lower growth in the West. Particularly in the UK, the US and Europe, governments have mortgaged the future to get us out of this crisis, so they’ve got to increase taxes or reduce spending. Secondly, consumers are over-indebted and have had a shock. They need to rebuild their balance sheets. I don’t think they’re going to lead the recovery. Thirdly, there’s less credit available for everyone because of the banking crisis than there would be in a normal cycle. What that all means, as far as I am concerned, is not that we are heading for a double dip or going back to a recession, but that what we are facing is a period of slow growth.

That has got quite big implications for the leadership of the bull market. Once this becomes apparent next year, the stocks that are leading the market are going to change. There will be a broad move away from cyclical companies, and commodity companies in general (though there could be some exceptions to that), towards more growth-oriented stocks. If you’re in a low growth environment, predictable high growth is going to have rarity value and that will be bid up by investors. I don’t think it’s a bad environment for equities generally.

Does that mean a renewed bear market, as many are predicting?

I don’t think the bull market is about to end, but it might have a big pause. We haven’t had a big pause yet, so as the leadership changes, we could have a three month or so of setback and consolidation in markets before the next stage. In this lower growth environment, governments are going to be very slow to exit their support measures. I think that markets can take some rise in interest rates. I don’t think the first rise would kill the bull market, but if we then get into a succession of interest rate rises, at some stage that will stop the bull market. I suspect that is a 2011 rather than a 2010 story.

Meanwhile all this is positive for China and Chinese equities in particular?

Yes. What it means is that if China can continue to grow, it will look increasingly attractive. While it is obvious that emerging markets are not immune from growth trends in the West, if an emerging market, through the momentum in its domestic economy, can continue to grow at above the world average rate, that will make it more attractive to Western investors. The net effect of what I see in all this is that more money will flow from Western investors into markets like China.

At the same time, while there seems to be a case against every other currency, most people would agree that the remnimbi is undervalued. It seems likely therefore that if you invest there, you are going to make a currency gain there. Nobody quite knows when they’re going to relax their currency policy, but it is almost inevitable that they will. Their programme is to gradually open up the currency, and that must lead it to appreciate.

What sort of fund do you expect your fund to be?

It is going to be volatile, and so you’ve got to know the animal. That’s one reason why I have something of a preference for a closed-end fund, or an open-ended fund that has some restrictions around it. You need that as China is a market where people can panic very easily, and if something goes wrong, you don’t want to have to liquidate everything you own. Continued growth is near the top of the list of what the regime wants. (Editor’s Note: At the time of the interview, the final details of the fund had still to be detailed. It will be launched formally in the second week of February 2010).

Your focus will be solely on Chinese companies or will you playing the theme other ways as well?

I’ll have some room. The bulk of the fund will be in Chinese companies, by which I mean (a) the ones listed in China either H-shares, A-shares or B-shares; (b) Chinese companies that are listed in America (there are quite a few of those in the technology area); (c) and Hong Kong listed companies that are a play on China. I see that being the main part of the portfolio. I will have some room though to buy Chinese plays elsewhere in the world. What I mainly want to do is focus on a smaller universe than I’ve been used to. I don’t want to have to look at every market in the world. I mainly want to focus on listed Chinese companies, but if something comes up elsewhere that has a strong Chinese angle to it, I don’t want to rule it out. I could have 10 or 20% in those stocks. The prospectus may alter that slightly, but that’s the sort of range I have in mind at the moment.

What resources will you have to help you manage the fund?

We’ve been investing in China as Fidelity for about 15 years. We have three managers there who run Chinese-focused or Greater Chinese funds, about $4 billion in total. There are five analysts who focus solely on Chinese shares plus our sector analysts. The oil analyst for example covers all the oil shares, including the Chinese ones. We’ve also had a private equity business in China for 14 years. We only do private equity with our own money. It’s a way of diversifying the balance sheet as a private company. We own property, such as this building, and we also have private equity, including some interests in the UK. What the private equity people have is a god network. Knowing who you can trust and who you can’t trust is very important. Being able to plug into that network will help me a lot in the corporate governance area.

I’ve already seen a lot of companies with H-shares, well over a hundred in the past six years. I need to do more work on A-share companies. As you know, for A-shares you need a quota. We’re negotiating one now. You never know when or how you’re going to get it, but in the meantime, you can use broker notes as an interim measure. I have invested in some A-shares in the Special Situations Fund. It’s quite a big market and it’s one of the areas I’m going to be focusing on in the run-up to the launch of the new fund.

What about the trading characteristics of these shares: are they not less liquid and so on?

The trading is tougher. You need traders and you need to be patient. You can’t always buy them on the good days. You may have to buy them on the bad days, but I am used to that in medium and small-sized stocks here. Taking a slightly longer approach should help with the trading, so I’m going to be a bit contrarian in the trading. Relative to the funds we have, I will have a higher tracking error and more active money, and probably more in medium and small sized stocks.

There are some very lumpy shares at the top of the list. China Mobile is nearly 10% of the index, and some of the banks are 6% to 7% of the index. China Life is a similar size. So if I like them, I might want to have quite big holdings. I used to start at 25 basis points in Special Sits. I’d hope I might be able to start at 50 basis points here. We will have a more concentrated portfolio than I did in Special Sits, but it depends on the amount of money we have, and other things. I very much want to cap the amount of money. That’s my ambition.

What do you say to those who say you will not be able to succeed in China – the different culture, the language and so on?

There are obviously some factors that are unique to China, and it doesn’t have the really attractive valuations that Europe had in the 1980s, when I started my European fund. But while China is different, I feel strongly that the basics of investment are the same whichever market you’re in. There are also many similarities to the situation in a market like Germany at that time. I remember in Germany, when I first started going there, that local investors were very short-term. They couldn’t understand why were we interested in meeting the companies and understanding them and trying to work out where they were going over the next one or two years.

At the time all they were interested in was trading. I see that as one of the characteristics of a market that has not yet fully evolved. China is at a similar stage. Part of the Chinese trading mentality is to do with that. Also, there’s an issue of loss of face. They don’t like to be associated with things that are not doing well. All that makes it an interesting place for a value investor such as myself, despite the conventional wisdom being that you have definitely got to do it differently in China.

An American organisation called Empirical Research, which is very quantitative in its approach to markets, has done some excellent research on emerging markets. They did a big piece earlier this year on emerging markets, which showed that valuation is the major driver of returns in emerging markets, and that it’s an even bigger return in emerging markets than it is in developed markets. It applies both in general and specifically to China H-Shares. (They haven’t analysed the A-shares yet). So that’s exciting.

The other aspect is that China’s going to have a lot more IPOs, and more of them are going to be coming in the companies which are oriented towards the domestic economy and service industries. Again, that’s a bit like Europe in the 1980s, where the history was manufacturing, and to some extent financial, but then you had more and more companies coming to the market from retailing, advertising, media or whatever. China is going to do the same thing.

I think that people like me who have seen similar companies over so many years have an advantage. For example, the first Chinese drug distributor, Sinopharm, was listed recently. It has gone to a very high valuation today, so in the short-term it’s probably not that interesting. But the point is that Chinese investors had not seen a pharmaceutical distributor before, so they are not sure how you should value this kind of company. There will definitely be cases where my knowledge of those industries in other markets will help me locally.

On the negative side, policy is undoubtedly both a risk and a reward in China. Because it’s so centrally driven, they can change the rules overnight. The first thing to be aware of is that that’s a risk. You’ve got to try and work out which companies are more exposed to that risk than others. Obviously you need to do some listening to people who are close to the politicians, to get an early warning of change.

What about corporate governance? Surely that is a big concern for any Western investor?

Corporate governance, the quality of the information, the quality of management, etc is a much debated issue. Hong Kong listings certainly provide better quality information than the Shanghai and Shenzhen listings. My experience of the companies that I’ve seen, and there are a few now that I’ve seen half a dozen times, is that the good ones are as good as anything in the UK or Europe. Quite often, these are private companies run by Chinese people who’ve lived in the West. When China has opened up, they’ve come back to China, seeing the opportunities. On the other ones, the bad ones are pretty bad. There’s a wide spectrum.

If we had met a year ago, I would probably have said that I would mainly want to focus on private companies. I spent quite a lot of time talking with my analysts about that when I was in Hong Kong. They persuaded me that avoiding all state-owned companies was too black and white a view of the world. Some of the state-owned enterprises are actually run by decent people. Some of the people who run companies are quite politically ambitious and they want to prove themselves as a stepping stone to bigger political ambitions. So, if they mess things up, that’s a problem.

There are also specific issues for specific industries. The one that my colleagues particularly talked to me about was property development, where, they say, the state-owned enterprises tend to get better deals because they’re closer to the local politicians. If you’re a private company, it’s more difficult to get the good land deals that are at the heart of successful property development. But the last thing they pointed out is that the biggest scandals over the last couple of years have mainly been in private companies rather than in state-owned companies. I am going to buy some private companies and some state-owned enterprises. They both have their risks and rewards. I’ll put a lot of time on trying to work out who’s good and who’s bad.

Have you come across corruption issues? People have had those issues in Russia and elsewhere…

I was debating with one of our analysts about a stock that she was following. It was on six times earnings, and she said: “It’s really cheap – should I recommend it?” I said: “What’s the snag?” She said, “The management’s been moving interest between the listed company and their private companies, to the expense of the listed company.” My reply was: “If they’re doing that sort of thing, you shouldn’t buy it at any price. There isn’t a known valuation that compensates for that.”

There is also the case of Gome,, which has been in the papers. It was the Dixons of China, the biggest of the electrical/electronic retailers. I met them three times. I met a lady director, and it was only on the third time that I clicked who she was. She was the wife of the Chairman. (Husbands and wives have different names in China). I said to her in the meeting: “I wish I knew that before because that’s a material fact“. But she couldn’t understand why it was relevant. She said, “Just because I’m married to the Chairman, what’s that got to do with it?” It so happened that Gome then blew up and the Chairman’s currently in jail, so I was lucky to avoid that one.

So yes, there are risks there, and I’m sure we won’t discover every one. We will make some mistakes, but hopefully not too many. When I am talking to the team, if I go through the list and come up with the stocks that look really cheap, one of the three fund managers may say to me, “Anthony, we don’t really trust them. Make up your own mind, but our advice is don’t invest in that.” I’ll normally go by that.

How much time are you going to be spending in China as opposed to working from Hong Kong?

I haven’t finally worked that out. Hong Kong is a pretty good place to see Chinese companies, because one of the problems in China is that companies are quite spread out geographically. I will definitely go to China, but how often I haven’t decided. It must be at least every six to eight weeks, I would have thought. I want to go to some of the second and third tier cities, which I’ve not been to before. Nevertheless, if China companies go anywhere to see investors, they go to Hong Kong, and then there are quite a few key conferences which is a very efficient way to see a lot of companies in a short space of time. We tend to go and have our own agenda of one-to-one meetings at the conferences.

Have you found that getting access to people is any easier than it was in Germany in the 1980s?

Access can be an issue, but companies are starting to find it more interesting to meet. They’re also at the stage where they’re now realising too much of it can be rather a bore as a management, so they’re getting a bit more discerning about who they see. With Fidelity’s influence, and hopefully now with me going there, and all the publicity around that, if anyone can get access – well, if we can’t, I don’t think anyone can. All three of the managers and the five analysts in our team are all Chinese, and I’ll work pretty closely with them. The language is obviously an issue. I’m not going to learn it. I’m not good at languages. But that was an issue, again in Europe, and that never seemed to be a problem. I will need to use the team to help me on the nuances that don’t come across in the translation.

How well did you do with the Chinese companies you invested in through the Special Situations fund?

I did well. I don’t have any detailed attribution statistics to prove that to you, but were a couple of pretty successful domestic companies. Li Ning, which is a sportswear retailer, which did pretty well for us. Another retailer called Ports Design is China’s only women’s fashion retailer and they’re trying to build their Ports brand, which they want to become a world brand in women’s fashion. And there were others. The market is definitely inefficient when you get outside the leaders and the very fact that you can have the same company with A-shares and H-shares on completely different valuations is a reflection of that.

There’s a company in one industry that I’m interested in and it’s on about 11 times earnings and some of its competitors are on 30 times earnings. I can’t currently understand why there is such a big difference. There are going to be a few outright value stocks, but my approach will I think be more of a GARP-like approach than pure value. There are a group of stocks in China which have potentially 10 years of growth ahead of them. They are not cheap, but they’re not highly valued as similar US and Australian companies whose valuations might be in the high teens or low twenties.

If the long term story is good enough, I’d be prepared to buy stocks like that, even on a 20 multiple, if the franchise and the long term prospects are good enough. Value doesn’t mean it has to be only a single figure multiple. I can’t argue that the whole market is very cheaply valued. It’s more in line with its average over history.

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Pricking China’s Bubble Won’t Be Easy

I share the view of my friend and colleague Edward Chancellor, the financial historian now working for Jeremy Grantham at GMO,  that it will take more than one interest rate rise by the Chinese authorities in order to prick the blatant bubble that is developing in Chinese real estate and the less obvious one that may be developing in the Chinese stock market. You may find it interesting to compare Edward’s view in his latest Financial Times column with that of Angus Tulloch (posted at the weekend) and the interview with Anthony Bolton that I expect to post tomorrow. What happens in China matters because what the authorities do there is most likely to be echoed before long by their slower moving Western counterparts.

By Edward Chancellor

Recent moves in Beijing to tighten lending conditions have spooked Chinese investors. Given that easy money fuels asset price bubbles, it is tempting to believe that the withdrawal of liquidity signals an imminent end to the good times. However, history suggests that once a boom has got going, it takes several sharp blows with the monetary cudgel to extinguish the speculators’ animal spirits.

Around the middle of January, Beijing made clear that it wanted to bring to a halt what one regulator described as a domestic lending “binge”. Admittedly, this declaration only took place after a pick-up of lending in the first two weeks of the year, which saw more than Rmb1,000bn (£90.7bn, €105bn, $146bn) of new loans originated. This rate of lending growth was some three times higher than last year’s already inflated levels.

Several banks have apparently been ordered to suspend all new loans. Credit Suisse reports that letters of credit have suddenly been withdrawn. “Mortgage lending has been virtually suspended,” claims the investment bank, “leading to a slowdown in property transactions”. The Shanghai Composite has swooned in sympathy.

This lending diktat coincides with other measures, including an increase in bank reserve requirements and stricter mortgage rules, to tighten credit conditions in China. Beijing apparently wants to control the various real estate bubbles that are popping up around the country. Home prices in the coastal regions were up more than 20 per cent in the last year. Despite low interest rates, new homebuyers in Beijing are spending up to 70 per cent of disposable income on servicing mortgages, says CLSA. High end property sales more than doubled in 2009, says the brokerage firm. A large portion of these purchases were made by investors.

The lack of affordable housing is fast becoming a political issue in the capital. A popular television drama, Snail House, which deals with the travails of “mortgage slaves”, has recently been taken off the air. Furthermore, inflation is picking up, hardly surprising given that the money supply growth approached 30 per cent towards the end of last year. In theory, tighter monetary conditions should raise the cost and limit the supply of credit, thereby helping to cool the financial markets. In practice, however, great booms tend to continue long after policy has become restrictive.

For example, the Federal Reserve raised interest rates in January 1928 with the intent of halting speculation on the Big Board. Despite this, US stocks rose by a further 70 per cent over the following 20 months before finally peaking in September 1929. The end of the tech bubble followed a similar course. Although the Fed Funds Rate was increased in June 1999, the Nasdaq nearly doubled over the following 10 months. Other stock market booms have likewise continued long after tightening commenced.

Real estate booms appear even less responsive to the initial tightening. In 1989, the Bank of Japan started a series of five hikes that saw interest rates climb from 4.75 per cent to 6 per cent. Although the Nikkei peaked towards the end of the year, Japanese commercial real estate continued rising until late 1990, by which time land prices had risen a further 45 per cent.

The recent US housing bubble also took a long while to cool. The Greenspan Fed raised rates in June 2004. Some 24 months and 16 rate rises later, US home prices finally ground to a halt. The S&P/Case-Shiller Composite Home Price index had climbed 25 per cent since the first rate increase.

The last time the Chinese authorities attempted to deflate an asset price bubble was in January 2007. At that time interest rates were raised, bank reserve requirements increased, and important officials spoke openly about the need to quell speculation. Several commentators anticipated an imminent collapse of the Chinese stock market, which had doubled over the previous year. The outcome was rather different. Over the following months the Shanghai Composite entered a period of exponential growth. The market finally peaked in October 2007 after five rate hikes and 13 increases in bank reserve requirements since the beginning of the year.

Experience suggests that recent tightening in Beijing is unlikely to mark the immediate demise of the frenzied Chinese real estate boom. Nevertheless, it brings that end one step closer.

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Reasons To Be Cautious About China

Angus Tulloch, joint managing partner of First State Investments in Edinburgh, is one of the UK's best known and most experienced Asian investors, having first moved to Hong Kong as long ago as 1981. Debating the outlook for China with Anthony Bolton of Fidelity last week at an event organised by fee-based advisers Saunderson House, he gave his reasons for being cautious about the prospects for China and the rest of the Asia Pacific region. (I was chairing the Q and A session at this debate. You can read a full length interview with Anthony Bolton about China here shortly).


Setting the scene

If any of you be hoping for a confrontational debate, you are likely to go home disappointed, because I am a dyed in the wool Asiaphile! Ever since I moved to Hong Kong in 1981, I have been a passionate advocate of the Asian growth story. I have watched China develop from an iron rice-bowl, inward-looking economy to becoming the undisputed factory of the world. I have witnessed India emerge from the fetters of the licence Raj to produce some of the globe’s most confident, dynamic, effective and internationally aware business leaders around.

Every time I return from a trip to the region, I despair at the way we are living on past glories and on the family silver. The growth pendulum seems to swing ever further in an easterly direction. I certainly do not believe that this good news story is over – for China, India or indeed any other part of Asia. In Vietnam, for instance, it has hardly begun.

However, I see my role today as that of Devil’s Advocate. The best stories usually contain a dark chapter or two. Even where this is not true, a good story – as we all know to our cost – may prove a poor investment. In playing this role, I will first ask the question “Is the Chinese Economy in Trouble?” Secondly, I will highlight some of the political factors that might yet derail progress in the region. These are too often overlooked. Finally I will make a few observations on valuations and other relevant stockmarket inputs.

Is the Chinese economy in trouble?

It is a well known fact that China has embraced stimulative financial and fiscal policies with the same, if not greater, fervour than we have in the West. Fear of unemployment leading to social dissent has always been at the heart of Chinese economic policy.

The Global Financial Crisis struck China with the same collapse of business confidence and paralysis of liquidity as experienced elsewhere. Its Government thus moved rapidly to prevent growth falling off a cliff. Banks were told to lend and this being China, they did (well over one trillion US dollars worth of loans were made in 2009, almost double the figure for 2008). Purchase taxes on cars and household durables were reduced and, together with the banks, the public authorities orchestrated a massive housing construction program. The pace of domestic economic recovery has been truly remarkable.

But, as in the developed world, the jury is still out on the long term success of quantitative easing. China like the West has yet to jump off the treadmill of artificial stimulus. It remains to be seen whether the huge amounts of liquidity that have been injected into the system, will cause speculative bubbles in the real estate and stock markets. Recent evidence suggests that loan growth continues at an unsustainable level, and that residential property prices are still rising too rapidly.

A report issued last year by Pivot Capital Management provides a welcome counterpoise to the usual ‘China is wonderful’ commentary issued by deal-seeking investment banks and we asset gatherers as well. The author points out how much of China’s recent growth has been dependent on capital spending, and on how well developed the country already is in terms of physical infrastructure. He argues that capital spending will fall sharply and that, as consumption growth cannot take up the slack, we should expect much slower rates of growth in the future.

In support of these arguments the report points out that capital spending accounted for over 70% of growth in 2008 and 90% in 2009. The ratio of gross capital formation to GDP is expected to exceed 50% in the current year, a much higher level than ever recorded in the German, Japanese or South Korean development boom periods.

Since the beginning of the decade, domestic credit has expanded at 50% more than GDP. With a credit to GDP ratio of 140%, China is already beyond the levels where credit crises have occurred elsewhere in the past; indeed if loans were to continue growing at their historic rate of 35% per annum, the credit to GDP ratio in China will be close to 200% by the end of 2010 – and that is even assuming 10% economic growth in the current year.

Among other highly relevant points evidenced in the Pivot Report are the following:

• Chinese exports have benefited enormously from the global credit bubble with net exports rising ten times between 2003 and 2008;
• The effectiveness of domestic credit in generating growth in China has collapsed;
• Chinese Government debt is vastly understated (by as much as 40%) as is the degree of the country’s urbanisation (by 20%);
• China has 32% excess capacity in steel and 25% in cement, but already produces more steel and cement per capita than the USA (although China’s GDP per capita is one eighth of the USA’s);
• China has been building 15,000 bridges every year for the last decade and now has more bridges than the USA, though boasting only one fifth of its rivers.

To add to this gloom, I would point out that a number of observers, including the Government and industry participants, are already indicating that they regard the local property market as overheated. Real estate prices have trebled over the last five years. Moreover, we can only expect the USA to become much more aggressive on the dollar/renminbi currency link in this congressional election year.

I certainly do not think that we should assume Chinese growth rates of 10% per annum from now on. A soft landing (6%-8%) would be tolerable and should allow careful stock pickers to produce reasonable returns. A hard landing (under 5%) could give rise to serious social unrest and political turbulence. It is of course impossible now to look at much of Asia, or even the world, separately from China. If China sneezes much of the world, especially commodity producers such as Australia, Brazil and Russia, will catch a cold. In Asia, the Indian sub-continent would be least affected and Hong Kong, Taiwan and Korea the most. Cyclical industries everywhere would suffer.

Will politics become more relevant?

We have become very blasé in Asia, and for that matter, in all emerging countries on the subject of politics. The region has been largely free of major strife for many years now and democracy seems embedded in most countries of the area, albeit in some places more firmly than others, Burma, China, North Korea and Vietnam being the exceptions.

There are, however, a number of geopolitical issues which we should not overlook. Pakistan is far from stable, and the Kashmir issue continues as a running sore between that country and India. With the Himalayan glaciers providing the main water source for almost half of the world’s population, arguments between China, India and South East Asia over river diversions have already begun. There is no sign yet of North Korea wanting to behave as a responsible international citizen. China is inevitably becoming more conscious of its economic power, and is no longer prepared to let ‘Pax Americana’ rule the waves. Problems with minorities such as the Tamils in Sri Lanka, Uighurs in China and Muslim secessionists in the Philippines are unlikely to disappear overnight.

The most likely source of major political difficulty in East Asia over the next decade is Mainland China. I believe that it is only a matter of time before the Communist Party’s hegemony in that country will be challenged – probably at a time when economic progress falters and a leadership contest ensues. This fear is clearly at the forefront of the current leadership’s thinking. Although some progress has been made in terms of elections at local level and also in tackling corruption, there have been no signs under President Hu of a more tolerant approach to political dissidence. Recently, the opposite appears to have been the case.

Very few surrender absolute power voluntarily, and it is hard to see a transfer of power taking place in China without significant accompanying turbulence. Such turmoil preceded the establishment of democracy in both South Korea and Taiwan, and there is no reason that China will be any different. Yet, overlooking the very sad human dimension that such turmoil involves, this transition will provide one of the most exciting buying opportunities of the twenty-first century.

With the benefit of hindsight, one would of course have been much better ignoring this and other latent political issues over the last twenty years. However, I suspect that if we did see an economic slowdown in China, political developments could suddenly have a seriously negative impact on Chinese and most, if not all, regional stock markets. Inflation could well be key here – Tiananmen Square was preceded by a period of rising prices.

Are Asian stockmarkets overpriced?

The brief answer, taking a short view at least, is yes but not ridiculously so. On trailing price to book and price earning ratio terms, the Asia ex Japan Index is priced near the top of normal range but somewhat below its peak. Earnings growth estimates come in at over 20% for 2010 and most observers expect a currency fillip too; but we all know that such projections can prove very mercurial at the best of times. Asian governments are showing very little desire to raise interest rates in the fear of attracting hot currency flows, though both China and India now appear to be trying measures other than interest rates to pre-empt the formation of bubbles. Higher food and raw material prices are already leading to sharp upward revisions of inflation. From the bottom-up, we currently find it particularly difficult to find reasonably-priced companies in China and India; wage pressures and skill-shortages have also recently emerged in both countries.

Fund flows from abroad have been substantial with GEM funds overall taking in four times as much in 2009 as they lost in 2008. GEM markets tend to perform best when the global appetite for risk is increasing; judging by the very low current VIX Index level, and the spreads between GEM and US Treasury debt, it is hard to envisage that this appetite can grow much further. A major short-term concern is the large amount of GEM capital raisings in the wings figures of around US$250m in the region, of which US$150m relates to China, are currently being forecast. Anecdotal evidence of hubris would include large amounts of empty and underutilised commercial property in China, and the Rusal aluminium flotation in Hong Kong and Paris. With Asia Emerging markets up 84% from their March low, I would not be adding aggressively to the region as a whole, especially China, at this time.

But money can still be made

Putting aside these potential pitfalls, careful stockpicking can make all the difference in this area. The region is much less well researched than the West, and what research exists is much more deal driven too. With Asia’s large aspirational population, the scaleability of successful concepts, (such as the Li Ning brand in China) never ceases to amaze. Above all the calibre of company management and corporate governance is improving at an astonishing pace. However prone to hubris these markets may be, anomalies still abound. Contrarian investors like Anthony will flourish in these markets...... but we at First State would hope to do even better!
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Put Not Your Trust in Forecasts

Never invest on the basis of forecasts. So says James Montier, recently anointed the dean of behavioural finance in the UK. Glance at the index of Value Investing, his superb collection of essays on the subject, and you will find that “forecast” appears more often than any other, with the exception only of the holy of holies, Ben Graham himself. References to the former are as consistently negative as those to the latter are positive.

“The evidence on the folly of forecasting is overwhelming” Montier concludes, whether you are talking about economists or stockbroking analysts. “Frankly the three blind mice have more credibility than any macro-forecaster at seeing what is coming” is his verdict on economists. As for analysts, he notes that the average forecasting error in the US analyst community between 2001 and 2006 was 47% over 12 months and 93% over 24 months.

And what does Ben Graham say? Simply this: “Forecasting security prices in not properly a part of security analysis”. Judging by the response to my last column, which described John Templeton’s approach to the forecasting business, this is a view that many participants in the securities business share. The only professionally acceptable response to any question on the subject of analyst reports is to say “Well, I read them – but only for the data, you understand, not for the recommendations”.

The only problem with all this is that it doesn’t seem to be true. It would be nice to meet a few professional investors who don’t in practice, either implicitly or explicitly, rely quite heavily on forecasts to inform and justify their investment views. This has prompted me over the years to formulate some other rules which I have found helpful in distinguishing between useful and useless research.

The first of these is this: “Don’t rely on what anyone says they are doing. Look at what they are actually doing”. Just as comment is free, but facts are sacred, so too market punditry is cheap, but actual investment decisions are the only thing that really matter. I recall a meeting of IFAs in March 2003 at which, on a show of hands, a clear majority of those present disputed a claim by Anthony Bolton that his then public bullishness on equities was a contrarian call.

A second show of hands then revealed that, although being bullish was what the majority professed to believe, only a tiny minority of those present had actually positioned their clients’ portfolios to reflect that view. While the audience was talking about loading up on equities, Bolton was one of the few who had already done so. A year later many in the audience were still struggling to catch up with the renewed bull market that they had called, but signally failed to act on.

A second valuable rule is “Never waste any time on investors who appear to be telling the markets what to do”. Saying something will happen is a good way to generate a headline, but a poor way to make money. Every investment call can at best be an assessment of probabilities. Those who proclaim that an outcome is a virtual certainty are either deluded (if they believe their own pronouncements), charlatans (if they don’t believe it, but go ahead and make it anyway) or professionals who are paid to believe it (brokers and headline writers being good examples). Those who are hesitant and make liberal use of phrases such as “my guess”, “the most probable outcome” and so on are the ones talking the true language of the market.

A third useful empirical rule is “Don’t use Japanese experience as proof of anything”. Many of us have fallen at this hurdle over the years. Just as the great equity bull market of the 1970s and 1980s powered on beyond any possible rationalisation, so too the subsequent 20-year period has been full of commensurate disappointments.

The Japanese economic experience of the last 40 years serves only to demonstrate that Japan, for reasons that are open to analysis, marches to different rules from almost every other market, society and economy. It is the exception to almost every rule in the book. Those who currently claim that the US must inevitably follow Japan into 20 years of debt deflation are breaking both the second and the third rule.

If forecasts are no use, then what is the basis on which investors can or should make decisions? Value has to be part of it. Momentum is also a useful tool: wonderfully consistent as long as it works and then periodically catastrophic when, as invariably it does, it breaks down. Technical analysis, if used as a guide to probabilities, has a place; ditto good fortune. A good deal of the time however, including most likely the present, markets can appear to be neither obviously dear nor cheap. Who, though, one wonders, is buying Government bonds today out of unalloyed conviction?

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Market Q and A: Bill Mott

Bill Mott is one of the UK’s longest serving and most experienced equity income fund managers. For many years he ran income funds for Credit Suisse and after taking a break for a few years is now doing the same job at the boutique firm of PSigma Investment Management. In this Q and A he describes how he is positioning his holdings for the future.

How are you positioning your fund now?

There are a number of different themes in the portfolio today.

1. Search for Yield

Interest rates will remain very low because the eventual removal of Quantitative Easing and the inevitable heavy tax increases will be sufficient to slow the UK economy. Those UK companies which have maintained or increased their dividends during the last two years are very unlikely to cut them now that the recovery has begun. We believe that a key theme for at least the next 12 months is that investors will become ‘yield hungry’. There are a number of larger UK companies which currently yield significantly more than 10 year gilts and we believe that these companies will undergo positive re-ratings. Their yields will gradually fall as share price appreciation delivers capital growth. Our favourites here are the integrated oils (BP, Royal Dutch Shell ‘B’), pharmaceuticals (AstraZeneca, GlaxoSmithKline), telecoms (Vodafone, Cable & Wireless) and utilities which all appear attractive on this basis, as do a number of companies from a variety of sectors such as RSA Group, Standard Life, British American Tobacco and British Aerospace.

2. Sterling Weakness and Overseas Stocks

Our view on sterling is that it is likely to be a weak currency for a sustained period of time. As well as having a very overseas -orientated UK portfolio, we have in addition allocated around 9% of the portfolio to overseas companies in sectors that are internationally priced and where there is a restricted number of UK companies that fulfil our requirements. This is a tactical rather than long-term strategic move. Our positive view on telecoms, pharmaceuticals and utilities has resulted in us adding to the portfolio some European stocks – KPN (yield 5.3%), Telefonica (yield 5.1%), Deutsche Telekom (yield 7.7%), Sanofi-Aventis (yield 3.9%), E.ON (yield 5.2%) and GDF Suez (7.25%) and the US Pharmaceutical Pfizer (yield 4.3%).

3. The ‘Nifty Fifty’

Assuming a very low growth environment in the UK and an anaemic recovery elsewhere, those UK companies which can deliver growth considerably in excess of the average will be re-rated in a return to the ‘Nifty-Fifty’ style of the 1960s and 1970s when the top 50 most popular large cap stocks led the market and rewarded a ‘buy and hold’ strategy. These companies will be able to deliver this superior growth because of their high geographic exposure to faster growing areas of the world, or because of the industry in which they are operating, or because of their superior technology, or management ability. We are balancing our high-yield portfolio with a number of companies which we believe will deliver superior growth. Companies in this category include Tesco, Wm Morrison, Reckitt Benckiser, Inmarsat, Healthcare Locums, Serco, Xchanging, Compass and Arm Holdings.

4. Consumer Staples

A particular sector we like globally as they benefit from a fast-growing global population. Their ‘global footprint’ makes them ideally placed to exploit the growing middle classes and their aspirations in emerging markets. In general they have underperformed the market rally as they are perceived as defensive. We believe they will be able to grow much faster than the corporate average in the future and will be in the forefront of the new ‘Nifty Fifty’. In the UK, we hold Unilever, Reckitt Benckiser, Diageo, British American Tobacco and Imperial Tobacco, whilst overseas we own Nestle, Johnson & Johnson, Procter & Gamble, Colgate Palmolive and Coca Cola.

What are your views on the global economy?

Unprecedented fiscal and monetary stimulus has allowed the world to recover from the financial crisis. The big question now is what happens when the stimulus is withdrawn. All the major deficit countries, such as the US and the UK, will have to reduce their budget deficits to retain the support of bond investors. However, with the private sector still de-leveraging, it is neither likely nor desirable that the recovery will be supported by increased private sector consumption. This would increase leverage and be a negative.

The traumas of the last three years were caused by global imbalances which allowed western consumers, particularly in the US and the UK, to become over-indebted. Global financial rebalancing is needed to sustain a durable recovery. Without this rebalancing, there will either be a prolonged global recession, a renewed bout of borrowing by an already over-indebted private sector, or ultimately unsustainable fiscal deficits. The big question is: how can this global re-balancing be achieved?

Given the impotency of the large deficit countries, attention will move to the high surplus nations such as China and other emerging and developing countries. These countries (particularly China) need to change their economic models, and they will need to change from targeting output to targeting growth. This can be done by focusing on growth in domestic demand rather than targeting growth in domestic supply. However, this change cannot occur whilst exchange rates in emerging economies are pegged at unrealistic levels to the US dollar.

If currency adjustments are not made, the results will be inflationary excess demand in surplus countries and deficit demand in deficit countries. These exchange rate changes are becoming essential to facilitate the global re-adjustment and ensure a durable global recovery. One consequence of this is that China will have to accept huge losses on its dollar asset portfolio. Even assuming that these currency adjustments are made, the global recovery still needs to be anaemic so that the adjustment is gradual and not disruptive.

Where does this leave the UK economy and stock market?

The UK is uniquely poorly positioned in the evolving economic landscape. Over the last 15 years, Britain has become disproportionately dependent on financial services, property speculation and consumer spending to fuel its £1.3 trillion economy. The UK will thus have a much bigger hangover from the credit boom than most other nations. Although the UK manufacturing sector is benefitting from the weakness of sterling and attracting orders from overseas markets, it comprises too small a share of the economy to pull the UK’s economy out of its slump on its own. What is more, as we have already pointed out, emerging economies need to change their economic model towards consumption and therefore traditional UK manufacturers may not benefit as much as expected.

Major policy errors by government and Bank of England have added to the UK’s problems. In essence, government and Bank of England inflation-targeting in the years leading up to the Credit Crunch allowed interest rates to remain too low for too long. The globalisation of the world economy with cheap products flooding in from emerging markets should have led to a major decline in inflation, but inflation-targeting allowed the Bank of England to achieve its inflation goal when every other economic indicator (house prices, consumption etc) was flashing red. This was the environment which fostered irresponsible behaviour by bankers, consumers and the government.

As Derek Scott, former economic adviser to Tony Blair, recently pointed out: “In an inappropriately low interest rate environment, investment spending is brought forward by households and businesses from tomorrow to today, so that when tomorrow arrives, budget constraints reduce spending at precisely the time when yesterday’s investment comes on stream, adding to supply.” The only way to keep things going is even lower interest rates, more Quantitative Easing, and even more government spending which, of course, brings forward even more ‘jam’ from tomorrow to today. So far, all the various fiscal and monetary measures have delivered stability and gentle recovery by bringing forward spending from tomorrow to today.

So you are not optimistic about the prospects for the UK?

The bond market in the UK will force the government to adopt a more prudent approach following the next election which is in May at the latest. It is time to face up to the fact that policy makers will have to tolerate a long period of very slow growth and high unemployment whilst the excesses of the past are worked out of the system in terms of both private and government consumption. In our view, Quantitative Easing should now be withdrawn. It has facilitated some re-financing of bank debt by large corporations, but only at the expense of an unnecessary rise in asset prices which increases the risk of inappropriate consumption by the private sector.

Cuts in the budget deficit need to be draconian both in terms of public spending and tax rises in order to persuade international investors to own sterling assets. The removal of Quantitative Easing and draconian fiscal action (huge tax rises) will be enough to keep growth at well below previous growth rates to allow for the long-term re-balancing that the economy needs. This will allow interest rates to stay at current very low levels for some time before eventually normalising as the anaemic recovery begins to build over the next few years. All the economic dynamics point to sterling being a weak currency for the foreseeable future. However, it is to be hoped that, if policy is appropriate then the downward adjustment of sterling can take place in an orderly fashion over a long period of time and not through a one-off precipitous fall of the pound against other major currencies.

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John Templeton’s 2020 vision

The only sure way to make market forecasts that have any enduring value, I have learnt, is to follow the formula successfully deployed by Sir John Templeton. His technique was to look a fair way ahead and come up with a number that sounded impressively large – impressively large, that is, until you examined his assumptions and worked out what compound rate of return his forecast actually implied.

So for example with the Dow Jones Industrial Average at around 800 in 1980, having convinced himself that stocks were cheap, he boldly predicted that the market could reach 3,000 before the end of that decade, and could easily rise 20 fold by 2020. That sounded extraordinary at the time to a generation which had just survived the 1974-75 bear market.

Yet in practice, given his premise that inflation would continue to double the price level every ten years, the 3,000 figure represented a real compound rate of growth (after inflation) of 8% per annum. That was certainly some way above the long term average growth rate for US equities, as the historical average is a total return calculation.

But given that starting valuations in 1980 were already very depressed by historical standards, the headline-grabbing forecast was nothing like as wild as it might at first have appeared. For the Dow to reach 16,000 by 2020 from its current level of around 10,500, incidentally, it will need to rise at a compound rate of 4.5% per annum for the next ten years – so even though inflation has fallen dramatically in the interim, the original 1980 forecast is still by no means an unlikely target.

For good measure, although Templeton liked to give a specific end point to any forecast he made, he was too smart to commit himself more directly to when his target might be reached, leaving plenty of room for relapses and consolidations along the way. (A more cynical version of this approach to forecasting was summed up by the economist who said “if you have to forecast at all, forecast long and forecast often”).

What Templeton was however was a self-confessed optimist, who continued to believe right up until his death that, while the market would continue to suffer periodic setbacks of 30%-50%, those who predicted a new Great Depression were wrong. He had great faith in the hunger and resilience of the American people and in the capacity of humankind to make progress. Market setbacks were the price you paid for long term equity returns.

For example, in 1987, with what turned out to be uncanny prescience, Templeton said that he fully expected an imminent fall of 30%-50% in the market. It duly happened, but within weeks of Black Monday in October of that year he was reiterating his arguments about the Dow reaching 3,000, and celebrating the fact that investors had been given a second chance to get in on the ground floor of what he remained convinced would prove to be one of the greatest bull markets of all time.

The following year he became bolder still. His study of market history over many years had convinced him that bear markets rarely last longer than 15 months. If markets have not breached their previous low within 12 months, he argued, the odds are very high that they won’t go on to do so again. (If that assumption still holds, it makes it virtually certain that a new test of the March 2009 bear market lows is unlikely this time round).

Speaking in 1988, Templeton discounted the prevailing fears of doomsters of the day, arguing that all the major problems that preoccupied the markets at the time were already known and consequently priced in. “The fact that we have a terribly unbalanced federal budget” he told one interviewer “is already in share prices. The fact that we have a bad balance of payments in foreign trade is already reflected in share prices”.

It was wrong to assume that trade or budget deficits would lead to either depression or deflation. Anyone who studied financial history, he believed, would see that large budget and trade deficits only ever resulted in inflation. By the same token, like many of his generation, he was confident that politicians had learned the lessons of the Great Depression and would never allow the economy to slip into deflation.

Would he still think the same way today? He is not around to tell us, but close analysis of his thinking over many years suggests to me that notwithstanding the unprecedented scale of the global financial crisis, he would be on the bullish side of the consensus. Having clearly identified the severity of the looming housing market bubble five years ago, and seen the market tumble by 50% from its peak, I don’t think he would be betting against the resilience of the US economy now.

It is easy to be daunted by the enormity of the task that lies ahead. Where is the political will to eliminate the extraordinary pile of public sector debt that the crisis has engendered? Where will the jobs come from? How can future banking crises be averted if the banking lobby succeeds in blocking the reintroduction of a badly needed modern version of the Glass-Steagall Act?

We don’t know. Nothing can be ruled out absolutely. But without falling into the trap of making a specific year ahead forecast, the odds still surely favour the Dow making Templeton’s target of 16,000 before 2020 a very reasonable bet.

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A Positive Feel About Equities

While forecasting the market’s behaviour for the year ahead is a mug’s game, some good reasons are emerging for thinking that the recovery in the equity markets could have further to run in 2010. My most recent column in the Financial Times picks up on this theme, with reference to a recent visit to London by Bill Miller of Legg Mason.  The key point to note is that while many pundits are now belatedly talking bullish (normally a worrying sign), investors collectively are still not acting that way. Of course it will turn when the bond market finally seizes up, as all bets will then be off. In my view, however,despite the sudden strength of the dollar, we are not at that point yet. There is bound to be an early correction in 2010, but the year as a whole could easily accomnmodate a further 10%-15% rise.

A few years ago it was standing room only at the Savoy Hotel when Bill Miller, the celebrated manager of the Legg Mason Value Trust, came to London to impart his latest views on the market. While on his way to 15 successive years of outperforming the S&P 500 index, a feat that no other US fund manager has achieved in modern times, his fund rode a wave of popularity. As is the way, Miller’s every word on the markets was assured of a reverent hearing.

Last week, with the Savoy still out of action, Mr Miller made an altogether quieter appearance at the London Stock Exchange. Having misjudged the credit crunch, and seen his fund languish at the bottom of the performance league tables for many months, it was perhaps no surprise that only a handful of media turned up to listen to what he had to say.

Being both bullish about the equity market and happily out of step with majority opinion, Mr Miller’s views will struggle to gain traction for a while yet. At one point he compared the equity markets today with 1982, the year that the great bull market of the late twentieth century began. His point was not that the market conditions were identical at the time, but that if you looked at what analysts were saying about prospects in 1983, the list of potential negatives would have been as long  and sounded just as horrible as that which prevails today.

Could the analysts be just as wrong this time round? Being out of favour is no obstacle to being right. Indeed it is a badge of honour for the contrarian investor. Having earlier drawn attention to his fund’s troubles in this column, I feel it only fair to report that Mr Miller’s fund has outperformed the S&P index by 10% to date this year, reversing some at least of the losses of his annus horribilis in 2008. What is more, I am beginning to suspect that his judgment on equity markets, which proved to be so wrong during the crisis, will be proved to be right now that it is receding.

What are the arguments for thinking that the outlook for the equity markets is much better than the prevailing consensus? Reading across from valuation measures such as Tobin’s q and cyclically adjusted p/es, the market currently appears to be trading somewhat above fair value. If you take them at face value, estimates for the earnings of the S&P 500 in relation to the market’s level look unexciting.

But how good are those earnings estimates? Estimates are poor at the best of times, and particularly unreliable at turning points. Just as it took a long time for analysts to catch up with the scale of the decline in earnings in the immediate aftermath of the crisis, so too they have been slow to catch up with the improving trend since the recession ended earlier this year. In the second quarter of 2009, more than 75% of companies in the US came in with earnings that were ahead of analyst expectations.

At the same time it looks in hindsight very much as if corporate America, in common with investors themselves, reacted too sharply to the post-Lehman global financial crisis. The scramble to cut jobs, slash inventories and reduce debt has left many companies struggling to fill orders as demand starts to return. (Tim Bond of Barclays Capital makes a similar argument, pointing out that delivery times are currently lengthening, not shortening).

Another metric that Mr Miller points to is the ratio of expected earnings growth to GDP growth, which at around eleven times a “new normal” GDP growth estimate for 2010 of 2.4% is well above its historical average of six times. Yet he is of the school that believes that the scale of recovery in the US economy after recessions is typically proportionate to the severity of the preceding decline in output. As the US recession has been the worst since the 1930s, the scale and speed of the recovery is more likely to surprise on the upside than the downside.

If the historical analogy turns out to be correct, the implication is either that current earnings expectations are too high, or that GDP projections are too low. Mr Miller’s money is firmly on the latter. He expects technology, financials and consumer stocks to lead the stock market higher in 2010. IBM, he points out, has 100 years of earnings data, and is well known for the reliability of its earnings guidance. It is looking to continue growing its earnings at an annualised rate of 15% through next year. Yet its shares trade at a discount to the market, at a lowly 11x earnings.

The reality is that the future direction of financial markets is never a one-way, predetermined street. In a year’s time, if Mr Miller turns out to be right about the scale of the recovery in the economy and equity markets, as I suspect he may, those who have been left behind will surely conclude that they have allowed their judgment to have been impaired for too long by the lingering trauma of last year’s crisis. To put it another way, given a choice between betting that analysts’ forecasts are precisely right or that investor psychology is roughly wrong, the smart money rarely errs by choosing the latter.

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The Bubble in Gold Still Lies Ahead

There are many reasons why sensible columnists prefer to steer clear of writing about gold. One is that you get the weirdest responses. Twenty years ago they would arrive in funny shaped envelopes, often in green ink, often from individuals with extraordinarily peculiar views about the world. These days the risk is that anything you say will be instantly picked up, recycled and commented on in a thousand online blogs. Not all of that community, shall we say, are interested in constructive dialogue. Gold retains its capacity to excite the most extreme polarised views.

A second reason for thinking better of writing about gold is what one might call the Warren Buffett problem. When asked for his views about gold, he typically replies with the same answer, along the lines that gold has never been a good store of value and is unlikely ever to interest him as a home for his money. Gold, he says, ” gets dug out of the ground in Africa or some place. Then we melt it down, dig another hole, transport it halfway round the world, then bury it again and pay people to stand around guarding it”. It has, he argues, “no utility". There will always be other things that he would rather own.

Although doing back-flips when circumstances change is one of Buffett’s greatest strengths, he appears to have been true to his word in never having made a significant investment in gold or gold shares. In the late 1990s, he did briefly place a large bet on the price of silver, based on a personal analysis of the supply and demand equation for the metal which turned out to be quite flawed. He has been known also to recycle Mark Twain’s famous description of a gold mine as a “hole in the ground with a liar at the top”.

If the world’s greatest investor doesn’t think gold deserves consideration, has he got a point? A serious criticism of gold is that it may not in the strictest sense be an investment, in the Ben Graham sense of generating returns that can be analysed and valued. It can be lent out, for sure, albeit for meagre returns, but that has to be set against storage and insurance costs. While physical supply and demand clearly play a part in determining the price of gold, its performance is increasingly influenced by fluctuations in demand from investors (which a Grahamite purist might label as speculative interest).

The arrival of liquid, freely tradeable exchange traded funds in precious metals, some but not all of which are backed by physical collateral, is further encouraging this trend. With the sharp run up in the dollar price of gold this year, coupled with a notable recovery in equity markets, new gold funds are emerging by the week. John Paulson, the hedge fund manager who did so well out of the credit crunch, is the latest to launch a gold fund. Such high profile launches can only heighten interest in gold and more highly geared gold shares, and might in normal times be seen as early evidence that gold is entering a speculative bubble and must therefore be heading for a nasty fall.

However these are far from normal times. While the seeds of a future bubble in gold are being sown, and the gold price will remain volatile, if only to relieve momentum-chasers of some of their money, on most measures we are a long way away from any kind of climax. Despite growing media attention, gold remains surprisingly underowned by private investors. More people talk about it than actually own it in volume. Every trend-following speculator who is buying gold today for bandwagon reasons is, I suspect, comfortably matched by seasoned wealthy and professional investors accumulating gold for traditional defensive reasons, not to mention central banks desperate to reduce their dollar dependency.

Whether or not you care to define it as an investment, gold offers protection against the devaluation of the dollar and the eventual re-emergence of inflation that Buffett himself has identified as the inevitable consequences of the financial crisis and governments’ response to it. While he may be right that buying the Burlington Northern railroad is a better way to profit from eventual recovery in the global economy, the rest of us mere mortals will not be easily convinced to dump our gold and other commodities for some while yet.

Putting your head above the parapet and admitting to owning the barbarous relic and inviting all the unwanted attention that comes with such a public confession of unorthodoxy is one of the costs of ownership. The point about gold is not to own it for some ineffable or intrinsic reason, as gold bugs do, but because today’s unprecedented economic conditions make it a sound and defensible two way bet on the future. If gold’s time is ever going to come, we are living through just such a time now. The real gold bubble still lies ahead.

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Jim Rogers Tackles Dr Doom

There has been an entertaining but important public spat between Jim Rogers, the global investor, and Nouriel Roubini, the ultra-bearish New York economist who wrote an article in the Financial Times last week arguing that we are facing a monster bear market and "the mother of all bubbles" as a result of policymakers’ cheap interest rate policy. Here are some extracts from an interview between Jim and Damien Hoffman. The full text can be found here.

You said on Bloomberg that Nouriel Roubini did not do his homework regarding the asset bubbles about which he is now warning. Can you explain what homework he did not do?

All of it. How can you talk about a bubble when assets such as silver are 70% below their all-time high? Same for coffee, sugar, cotton, natural gas, and many more. I have a problem talking about a bubble when assets are this depressed from their all-time highs.

A bubble is when assets are screaming to new highs everyday, everyone is talking about them, and everyone owns them. Right now, virtually no one owns commodities. So for Mr. Roubini to talk about a bubble in commodities defies comprehension. It proves he does not understand markets.

I am flabbergasted at Mr. Roubini’s comment about bubbles because there is not a single market in the world making all-time highs except gold, US government bonds, cocoa, and the Sri Lankan stock market. That’s hardly reason to call for a bubble. So, I am most perplexed about this alleged bubble which is out there.

If an asset rises 100% in one year, that’s a great year, but not necessarily a bubble. Look at oil. It’s up huge(ly) off the bottom, but nowhere near its old highs. Look at Citigroup. The stock is up 3 or so times off the bottom …And since Mr. Roubini thought oil would stay below $40 a barrel for all of 2009, I would love for him to tell me and the rest of the world exactly where are all the oil supplies because the International Energy Agency (IEA) — which has the best global data set on energy supplies — has no idea where is the oil. Mr. Roubini should tell us where this price suppressing oil supply is hidden. All the oil possessing countries in the world have declining reserves. All the oil companies have declining reserves. So Mr. Roubini must know something the rest of us don’t.

Gold

I hope you will keep Mr. Roubini’s statement where he said gold going to $2,000 an ounce by 2019 is “utter nonsense.” I think you’re going to get a chance to call him before 2019 to ask him what he thinks of gold at $2,000 and why he thought it was “utter nonsense.” Regarding variables, it’s very clear there is huge suspicion about paper money around the world. This suspicion is gathering steam. Governments are printing huge amounts of money. This has always led to higher prices. Maybe I am wrong and it’s different this time. But I doubt it.

Additionally, no new large gold mines have been opened in decades. Some of those mines are over 100-years old. They are all depleting. On the other hand, central banks have huge gold reserves above ground — and they are less interested in selling than in the past. If you adjust gold for inflation and go back to its former all-time high in 1980, gold should be over $2,000 an ounce right now if you want to say its reaching new inflation adjusted all-time highs.

That does not mean gold has to get back to a true all-time high. Nothing has to. However, I suspect that given all the money printing in the world, we will see much higher prices for hard assets. Despite gold’s potential, I think I will make more money in other commodities such as silver, cotton, or coffee — all of which are terribly depressed.

On US equities

This is one of the few times in my life I have not had shorts anywhere in the world. I have also not had a lot of longs in the stock market because I’ve chosen longs in commodities and currencies. I have kept away from shorts because there is a gigantic amount of money being printed and it has to go somewhere. I thought some of it would end up in the stock market, and it has.

How much higher can the equity markets go? I don’t know. There are a lot of problems in the economy, but I don’t know when those problems will cause a downdraft in the stock market. All we’ve done is paper over the problem, so I expect we’ll have to deal with those issues in the future. Printing and spending money we don’t have simply prolongs the problems and makes them worse in the long run.

If the world economy improves, commodities will lead the way due to demand and shortages. If the world economy does not get better, commodities are still a great place to be because governments are printing so much money. And, if the world economy doesn’t get better, they will print even more money!

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