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Weekly Report 20 March 2008 - A contrarian market view

It has been a week with profits to be made for both day traders and trend watchers with volatility in stock, currency and commodity markets. You would have thought that the financial world was about to end judging by the press comment in the last few days, so is it time for a contrarian call to buy equities. We think it just might be, so let's take a longer term view for a change.

There’s no point in droning on about the Federal Reserve and interest rates, sub-prime writeoffs, the decline of the dollar and the rise in oil and gold.  We know all that already, and the theme is now wearing a bit thin.  We have always thought that if there are derivative-based (not asset value) losses, somebody must be making a profit as it’s a zero-sum game, so we’ll ignore that area.  What we need to watch is share values, which rise and fall but reflect three immediate inputs – interest rates, inflation and the outlook for company earnings growth (prospective p/e’s if you wish).

If you’ve a spare wad of cash and a lot of time, it’s worth reading the exhaustive Barclays Equity/Gilt study which each year looks at UK equity and gilt returns over the last century or so.  Without going into detail, the FTSE 100 index (FT30 before 1984) has followed a simple path over time.  This revolves around a rising line which is the total of economic growth, dividend growth and inflation, and these relate to the three inputs above.  OK, there’s no mention here of taxation levels, the proportion of corporate profits measured against GDP, exchange rates, gilt yields and so on, but you get the basic long term picture.  If the economy grows at 3%, inflation averages 4% and dividend yields average 3% over time, then the index should rise on average about 10% each year, and it fact it has.  Everything else is sentiment, and the key for long term investors is to sell when we are way above the line (the years 1998 to early 2000 most recently), and buy when we are miles below it (late 2002 to early 2003).

The current state of the market and where you might look

FTSE is around 5500 as we write, and we are now just below the long term line again.  Whilst the index is nowhere near as close to being a screaming buy as five years ago when it went below 3500, astute investors are starting to see value in many shares.  We have mentioned in recent weeks that smart money in the US has been regularly buying into dips, and this applies equally in the UK.

We are not saying go out and snap up everything yielding over say 8%, (and there are plenty to choose from by the way), because that’s not the point, but it could be time for a multi-month equity rally.  Don’t for one moment think we might not be wrong, and of course the bear market could easily resume in a savage manner, but CFD traders might soon make a killing looking out for big trend changes with buying volume in certain shares.  The banks might just be one place to start looking, and in terms of relative performance, our pick to go long would be Lloyds TSB right now. 

The BBC starts to feature gold as a safe haven – is it time to sell this nugget?

You have probably read the stories and urban myths about shoeshine boys in the 1920s, dentists in 1987, the front covers of
Barron’s/Newsweek and so on giving hints when the last ‘greater fool’ is buying shares.  It can apply to many asset classes though, so here are a few examples.  Dotcom stocks – it was to be a new paradigm that would change the world in 1999.  Japanese warrant funds – the market was supposed to go up for another ten years in 1990.  Buy to let property –it was the only way to protect your future because pension funds had done so badly. 

Well, here’s another one.  After three years of a relentless and profitable bull market in gold, the good old BBC have given up ramping property and just put on their website a nice video entitled ‘Investors in gold rush’.  It says that people looking to protect their assets are investing in gold, as the price of the precious metal rises.  You know we have been bullish all the way up, and indeed there is a valid scenario for gold being significantly higher in coming years, but it could be that we are close to a short term top.  We have in fact seen sell signals on Newmont and Barrick, the two big players, so this could the BBC’s very own ‘shoeshine moment’ for CFD shorts

CONTRACTS FOR DIFFERENCE (CFD) TRADES TO WATCH NEXT WEEK