Paralysis and panic is behind us now.
How to invest in a bear market
The FTSE All Share Index lost 29pc in 12 months and there is more pain in store.
By David Stevenson, manager of the Ignis Cartesian UK Opportunities Fund
Published: 10:32PM BST 15 Jun 2009
UK equity investors have had a torrid time of it in the last year. The FTSE All Share Index lost 29pc in the 12 months to the end of March and there is more pain in store. Recent stock market rallies should be taken for what they were, short-term technical bounces rather than the market bottoming on improved fundamentals.
That said, for investors who are able to stomach the volatility and take a longer term view, there are positives. The UK stock market is at one of its lowest points in the last ten years.
In the coming 12 to 18 months, it is likely to fall further taking valuations to levels of 'cheapness' that only present themselves once or twice in a lifetime. Making the most of these opportunities, however, requires a suitable investment approach and there are key considerations for investors in a bear market.
Companies are under considerable pressure and investors need to look in detail at what they are potentially buying into.
This requires careful balance sheet analysis as heavily indebted businesses may not survive the coming years. This may seem extreme but is a reality of economic cyclicality. Companies with low or sustainable levels of borrowing, and which therefore have a degree of control over their future, are relatively attractive, especially when combined with a secure dividend yield.
Earnings provide a barometer of corporate health and are under pressure across the market. Investors can, however, mitigate that risk by targeting certain types of companies.
Defendable earnings are important and are typically generated by companies with big franchises, large market shares and leverage over competitors or suppliers, allowing them to eke out more market share or a better margin. Thinking big is generally a sensible approach.
Big brands have a footprint that will allow them to survive through a difficult environment. Companies like Vodafone, Centrica and Unilever are all likely to outperform, operating in areas where spending remains necessary. Food retailers and pharmaceutical companies are also attractive.
Investors should also focus on sectors that offer predictable growth, rather than those dependent on support from the economic cycle.
Secular trends currently include the long-term growth of outsourcing, both in the public and private sector, and the maintenance and operation of critical infrastructure, such as utility and telecommunication networks and transport links. Both of these should offer resilience in a downturn and will benefit if the government's stimulus plans come to fruition.
It pays for investors to be sceptical in all market conditions but particularly during a downturn. It is important to think independently and not be fooled by consensus views.
Fundamental analysis of balance sheets and earnings will give a clearer picture of companies' future prospects. This then allows a portfolio to be built 'bottom-up' without necessitating a 'top-down' view on overarching macroeconomic, consensus or benchmark themes.
For investors seeking exposure to the market via mutual funds it is important to analyse the investment approach of fund managers. There is a temptation for managers to alter their process when short-term performance numbers disappoint, as can happen in volatile markets.
This, however, tends to be detrimental. Proper analysis of a manager's track record is therefore important, paying particular attention to longevity, consistency of approach and performance during previous downturns.
Certain managers are suited to a rising market, others, typically those able to best identify potential balance sheet holes and signs of earnings weakness, fare better when business models come under increased pressure, as is currently the case.
Another point to consider is the level and type of trading in a fund. Fund managers are generally not good short-term traders. Investment views need to be made on at least a one year basis, and a bear market does not change that.
A sharp pickup in turnover within a portfolio may indicate panic trades or a fundamental shift in strategy. In a bear market the number of attractive stock ideas tends to fall.
This may justify holding a more concentrated portfolio, and then adding new positions when opportunities arise. The important point is to make sure a fund manager is not holding low conviction stocks for the sake of diversification.
Finally, it will pay to be patient. The UK stock market will recover, but not overnight. At the moment market conditions remain challenging and it would be foolish to invest expecting the market to bounce back straightaway.
Equities tend to move before economic data picks up but with the current levels of volatility it is prudent to wait for clear signs that leading indicators are improving and government stimulus packages have laid solid foundations for growth.
This is likely to be some way off but by reinforcing a portfolio based on the points above, and taking advantage of increasingly attractive valuations, long-term investment opportunities in the UK can be exploited.
http://www.telegraph.co.uk/finance/personalfinance/investing/5545094/How-to-invest-in-a-bear-market.html
Wednesday 17 June 2009
Tuesday 16 June 2009
Chartists are the astrologers of the markets
Charts are extremely popular.
Chartists believe that they can see patterns in charts which can predict future price movements.
Chartists believe that they can see patterns in charts which can predict future price movements.
- They like to superimpose straight lines over the charts, usually connecting a series of high or low points. Sometimes, they also have squiggly lines drawn on them as well.
- The chartists all have their own systems that they follow, normally based on the thoughts of a guru from a long time ago, or perhaps some strange pattern which exists in nature.
- And the jargon they use sounds very scientific. Expressions such as 'declining wedge' and 'fourth wave' suggest to outsiders that the systems are profound and well researched.
- The beauty for chartists is that they don't need to know anything about the market they're trading. They have no need to look at fundamentals.
You shouldn't get distracted by charts.
Chartists have no scientific basis
It is fine to look at the odd chart every now and then; it's the crazy theories that chartists use that you should be cautious on. Charts themselves are useful for a feeling of how far markets can move and how they react to news flow.
However, a few things are obvious about chartist theories.
- These ideas are not applied in the economics field which is always searching for theories on human behaviour.
- Nor do the theories have a true mathematical basis, and the chartists often do not have a mathematical background of any kind.
- How many chartists do you know who are successful? Probability would suggest that there are a few out there somewhere.
Chartists are the astrologers of the markets. They use a pseudo-science. At best, it is a clumsy way of following trends. Their methods are unsubstantiated, though extremely popular.
There is simply no reason, for example, why price moves should imitate the pattern of plant growth, star patterns or anything else.
Ref: 100 Secret Strategies for Successful Investing by Richard Farleigh
Property prices often lag stock prices
Strategy: Property prices often lag stock prices
---
What one investor did.
"In 1989, I shocked a lot of people in my dealing room when I suddenly sold my home in Sydney, and put my sale proceeds into Deutschmarks. It was viewed as rather bizzare. However, I was convinced that the property market would start to feel the effects of the share market crash some 18 months earlier.
I was also very keen to rent a stunning apartment overlooking Sydney Harbour. It was directly opposite the Opera House, and nearly as high as the Sydney Harbour Bridge. Despite having one of the best views in the world it wasn't exactly very expensive - amazingly only a few hundred Aussie dollars a week.
Anyway, as it turned out I was right about housing prices (and fortunately the Deutschmark, which went on to rise against the Australian dollar)."
---
In general, share prices have been a good leading indicator for property prices, which often follow the direction that the stock market took two or three years earlier. The economy pushes the shares and property in generally the same direction, but with property, the reaction takes longer.
1. There are always exception to rules
Recently in 2005, however, there may have been a decoupling of the two markets, and this strategy may not have been very effective.
A few years ago, stocks were dominated by weak global economies and the tech wreck. This was followed by a persistent recovery which started after the invasion of Iraq. Housing prices on the other hand, have until recently been surging, inspired by the massive drop in housing interest rates.
So housing has not shown any tendency to follow a lead set by the share market. Whither this strategy?
It is always valuable to be aware of patterns like this and when they don't work, to try and figure out the reason. On this occasion, dramatic events have dominated each of the markets and swamped any usual behaviour.
It is not too bad. We only need among all our strategies, to be right on most occasions or on our bigger positions, to have a comparative advantage.
Don't buy or sell property just because of the share market - always wait until property prices themselves started to move in the right direction, to give you further confidence before taking action.
Ref: 100 Secret Strategies for Successful Investing by Richard Farleigh
---
What one investor did.
"In 1989, I shocked a lot of people in my dealing room when I suddenly sold my home in Sydney, and put my sale proceeds into Deutschmarks. It was viewed as rather bizzare. However, I was convinced that the property market would start to feel the effects of the share market crash some 18 months earlier.
I was also very keen to rent a stunning apartment overlooking Sydney Harbour. It was directly opposite the Opera House, and nearly as high as the Sydney Harbour Bridge. Despite having one of the best views in the world it wasn't exactly very expensive - amazingly only a few hundred Aussie dollars a week.
Anyway, as it turned out I was right about housing prices (and fortunately the Deutschmark, which went on to rise against the Australian dollar)."
---
In general, share prices have been a good leading indicator for property prices, which often follow the direction that the stock market took two or three years earlier. The economy pushes the shares and property in generally the same direction, but with property, the reaction takes longer.
1. There are always exception to rules
Recently in 2005, however, there may have been a decoupling of the two markets, and this strategy may not have been very effective.
A few years ago, stocks were dominated by weak global economies and the tech wreck. This was followed by a persistent recovery which started after the invasion of Iraq. Housing prices on the other hand, have until recently been surging, inspired by the massive drop in housing interest rates.
So housing has not shown any tendency to follow a lead set by the share market. Whither this strategy?
It is always valuable to be aware of patterns like this and when they don't work, to try and figure out the reason. On this occasion, dramatic events have dominated each of the markets and swamped any usual behaviour.
It is not too bad. We only need among all our strategies, to be right on most occasions or on our bigger positions, to have a comparative advantage.
Don't buy or sell property just because of the share market - always wait until property prices themselves started to move in the right direction, to give you further confidence before taking action.
2. Property may be the easiest market
Despite a lot of talk about whether stocks, bonds or cash are the best investment, it may be the property market that is the easiest of the markets, for three reasons:
1. You can watch the stock market for a useful buy or sell indicator, and hve plenty of time to act in the property market.
2. There are not many false trends in property prices. The market is not a listed market where everyone can see the prices - deals are done privately and price trends develop slowly and surely. You can wait for the herd to start to move and then join them for a nice journey.
3. Just about everywhere, there is no tax on capital gains on people's own homes.
Ref: 100 Secret Strategies for Successful Investing by Richard Farleigh
Currencies trading are very difficult.
Currencies trading are very difficult. They are more difficult than stocks and certainly more difficult than interest rates.
You need to learn by looking at price behaviour in the past, but trying to understand what currencies have done even recently is tough. There have been some big moves.
Take the US dollar versus euro rate, for example. It has ranged over the last few years from around 85 to 130. How is it possible that the currencies of the world's two largest economies can change in relative value by over 50%?
These types of currency moves are intriguing.
1. Purchasing price parity (PPP) is not much use
This theory suggests that currencies should tend towards the level where a collection of goods and services costs the same amount in different countries. PPP would suggest that if they are too expensive in one country, then that country's currency should fall.
The famous McDonald's Big Mac index is sometimes published in the Economist magazine, and it applies this analysis, to the price of the burgers in various countries.
The problem is that in reality PPP does not seem to have much impact on currency level. Perhaps it is for the same reason that people living in tiny but very expensive apartments in Tokyo do not migrate to Sydney or LA and buy a huge house. If they did, perhaps currencies would be easier to evaluate.
2. Market sentiment has the most impact
Since there are no reliable benchmarks, market sentiment is the huge factor that dominates events.
In 2005, the US dollar has been out of favour, despite an improving US economy and rising US dollar interest rates. The market is more worried about the US current account deficit. But is that econmies or fashion? There's the difficulty.
Conclusion
You need not avoid currency trading completely.
There are occasional opportunities such as the big market moves that you have seen in the major currencies during the last few years.
You should only be involved when you have a very firm grip on what's driving the market. That doesn't happen too often for any of us!
You need to learn by looking at price behaviour in the past, but trying to understand what currencies have done even recently is tough. There have been some big moves.
Take the US dollar versus euro rate, for example. It has ranged over the last few years from around 85 to 130. How is it possible that the currencies of the world's two largest economies can change in relative value by over 50%?
These types of currency moves are intriguing.
- The first thing to be aware of, is that you are looking at two economies. With stocks and interest rates, youj basically have only one economy to figure out.
- However, the second and bigger challenge is that currencies are largely driven by market sentiment, and the reason is that there is absolutely no successful benchmark for the pricing of a currency.
1. Purchasing price parity (PPP) is not much use
This theory suggests that currencies should tend towards the level where a collection of goods and services costs the same amount in different countries. PPP would suggest that if they are too expensive in one country, then that country's currency should fall.
The famous McDonald's Big Mac index is sometimes published in the Economist magazine, and it applies this analysis, to the price of the burgers in various countries.
The problem is that in reality PPP does not seem to have much impact on currency level. Perhaps it is for the same reason that people living in tiny but very expensive apartments in Tokyo do not migrate to Sydney or LA and buy a huge house. If they did, perhaps currencies would be easier to evaluate.
2. Market sentiment has the most impact
Since there are no reliable benchmarks, market sentiment is the huge factor that dominates events.
In 2005, the US dollar has been out of favour, despite an improving US economy and rising US dollar interest rates. The market is more worried about the US current account deficit. But is that econmies or fashion? There's the difficulty.
Conclusion
You need not avoid currency trading completely.
There are occasional opportunities such as the big market moves that you have seen in the major currencies during the last few years.
You should only be involved when you have a very firm grip on what's driving the market. That doesn't happen too often for any of us!
Government bond markets for major economies are not prone to crash
Strategy: Government bond markets for the major economies are not prone to crashes
The characteristics of bonds:
1. The level of interest rates set by the government are somewhat predictable
2. They are not as risky as stocks.
Many people point out that stocks outperform bonds in the long run. Perhaps. However, one comfort you do have with high-grade bonds is that you are unlikely to wake up in the morning and find you have lost 25% of your investment, which of course does happen occasionally with stocks.
Most unexpected shocks to the economy are bad news:
In the 1987 October share crash, panic was everywhere. Those who were holding bonds did very well. The bad news for the economy was good news for interest rates.
There is also the interesting effect of government deficits on bond yields, especially in the United States.
As an investor in the stock market, bonds are alternatives. There have been dream runs in the share market. This article alerts you to the attractions of the bond market when your strategies steer you in that direction.
The characteristics of bonds:
1. The level of interest rates set by the government are somewhat predictable
2. They are not as risky as stocks.
Many people point out that stocks outperform bonds in the long run. Perhaps. However, one comfort you do have with high-grade bonds is that you are unlikely to wake up in the morning and find you have lost 25% of your investment, which of course does happen occasionally with stocks.
Most unexpected shocks to the economy are bad news:
- a crash in consumer or business confidence,
- a terrorist attack,
- a war,
- a SARS crisis, etc.
In the 1987 October share crash, panic was everywhere. Those who were holding bonds did very well. The bad news for the economy was good news for interest rates.
There is also the interesting effect of government deficits on bond yields, especially in the United States.
- One could argue that the government bond markets should work like all markets, so that if the government wants to borrow more and more, it has to pay a higher interest rate, and sell bonds at a lower price.
- This was a criticism of fiscal policy by one brand of economists - the monetarists. They argued that 'crowding out' would mean that higher deficits don't help a weak economy, because they simply push up borrowing costs for everyone.
- However, current interest rates in the US are normal even though the deficit is at an all time high, therefore such an argument is not convincing.
As an investor in the stock market, bonds are alternatives. There have been dream runs in the share market. This article alerts you to the attractions of the bond market when your strategies steer you in that direction.
Making sense of direction and level of Short term interest rates
Strategy: Short term interest rates will tend toward the inflation rate plus the economic growth rate
There is always a great deal of discussion about interest rates, particularly US rates. Short term rates are set by governments and this can be a fascinating process to watch. The rates affect the economy and many of the markets.
The benchmark strategy helps to make sense of discussions about their direction and their level. It is a rough guide which is often missed by many commentators. With this rough valuation target, interest rates are easier to understand than most markets, where it can be hard to have a clue what the prices should be. Equities, the market that most investors concentrate on, do not have this kind of benchmark.
An interest rate is made up of the inflation rate plus a 'real' rate. That is, the real interest rate is what is left after allowing for inflation.
Interest rate
= Inflation + 'Real interest rate'
The economic growth rate is the percentage expansion or contraction in the economy with inflation stripped out. It can be loosely considered as the dividend paid by the economy in general.
Economic Growth rate
= Rate of expansion or contraction in the economy - Inflation
Rate of expansion or contraction in the economy
= Inflation + Economic Growth rate
Over time, the real interest rate moves towards the economic growth rate. In that way, the return from interest rates and the return from the economy in general, are equal.
In 2005, the short term rates in the US are 1%. When they start to rise, how far could they go? In the US in 2005, you may wish to target 4% because inflation was around 2% and growth was also around 2%. Add them and you get the target.
Rates had started moving lower worldwide and the question was, how far they could fall? Using the rate of contraction in the economy and the inflation rate gives you an estimate of the economic growth rate. As over time, the real interest rate moves towards this economic growth rate, using this simple strategy, you can have an idea how much further interest rate could move and in which direction.
As the level of interest rates are somewhat predictable, this benchmark strategy helps you to invest intelligently in the bond market.
There is always a great deal of discussion about interest rates, particularly US rates. Short term rates are set by governments and this can be a fascinating process to watch. The rates affect the economy and many of the markets.
The benchmark strategy helps to make sense of discussions about their direction and their level. It is a rough guide which is often missed by many commentators. With this rough valuation target, interest rates are easier to understand than most markets, where it can be hard to have a clue what the prices should be. Equities, the market that most investors concentrate on, do not have this kind of benchmark.
An interest rate is made up of the inflation rate plus a 'real' rate. That is, the real interest rate is what is left after allowing for inflation.
Interest rate
= Inflation + 'Real interest rate'
The economic growth rate is the percentage expansion or contraction in the economy with inflation stripped out. It can be loosely considered as the dividend paid by the economy in general.
Economic Growth rate
= Rate of expansion or contraction in the economy - Inflation
Rate of expansion or contraction in the economy
= Inflation + Economic Growth rate
Over time, the real interest rate moves towards the economic growth rate. In that way, the return from interest rates and the return from the economy in general, are equal.
In 2005, the short term rates in the US are 1%. When they start to rise, how far could they go? In the US in 2005, you may wish to target 4% because inflation was around 2% and growth was also around 2%. Add them and you get the target.
Rates had started moving lower worldwide and the question was, how far they could fall? Using the rate of contraction in the economy and the inflation rate gives you an estimate of the economic growth rate. As over time, the real interest rate moves towards this economic growth rate, using this simple strategy, you can have an idea how much further interest rate could move and in which direction.
As the level of interest rates are somewhat predictable, this benchmark strategy helps you to invest intelligently in the bond market.
Be careful at the end of long trends
Another dangerous time in the markets is after the end of a long trend. The fundamentals that caused the trend may have been assessed and fully absorbed by the markets, and, until there are new strong influences, it is hard to have a view.
Choose the right markets
In many cases where you have a view on the economy, or the world in general, there will be different ways to position yourself in the markets.
As an example, if you were bullish about the Chinese economy because of the massive growth potential, some ways to invest would be:
When you have a way, and there are a number of ways to implement it, look at the following 4 criteria. Choose the market:
2. Where there is the least downside risk if you are wrong?
3. Where there is the least random influences to mess up your idea.
4. Where you have the best liquidity.
Very often, you cannot meet all the criteria and the different criteria steer you towards different markets. It will then be a matter of judgement.
The challenge is to always think about various opportunities and the risks they involve.
As an example, if you were bullish about the Chinese economy because of the massive growth potential, some ways to invest would be:
- buy Chinese stocks;
- buy into shipping stocks (prices are already much higher on increased Chinese usage for shipping of imports and exports!);
- buy the yuan (the Chinese currency);
- buy commodities (raw materials), looking for Chinese demand to push up prices;
- buy into a currency that exports commodities (e.g. Australia and Canada); or
- buy stocks in foreign companies who sell products to China, for example mobile phone companies such as Nokia.
When you have a way, and there are a number of ways to implement it, look at the following 4 criteria. Choose the market:
1. Where the price has not already adjusted, or has adjusted the least, to the events you expect.
- This could rule out shipping, because shipping prices have already moved substantially higher in line with greater Chinese activity.
2. Where there is the least downside risk if you are wrong?
- If you have more reasons for being bullish on Nokia than just Chinese demand, buying Nokia stock may provide some protection if it turns out that you are wrong about the Chinese.
3. Where there is the least random influences to mess up your idea.
- The announcement of a government election in Australia, for example, would probably dominate the movement of the A$ up or down, and the Chinese economy would have little short term impact. In the event, the Canadian dollar would be better suited as a currency play on China, until after the election.
4. Where you have the best liquidity.
- This is the ability to buy and sell easily and inexpensively. Some Chinese stocks may be too illiquid.
Very often, you cannot meet all the criteria and the different criteria steer you towards different markets. It will then be a matter of judgement.
The challenge is to always think about various opportunities and the risks they involve.
Looking for investing ideas
Where to look for investing and/or trading ideas? There are thousands of different stocks, bonds and commodities. How can an investor find anything?
You need to be inquisitive about the markets. You will probably be drawn to the markets that you find most interesting. As you get to know more, try to identify patterns and anomalies in the way they behave. These will be the basis of your investing and/or trading idea.
It can be rewarding:
1. To be inquisitive, especially in the financial markets
2. To watch crowd behaviour. Jump onto some great trends and jump off when this turn more neutral. Trade with a consensus, rather than against it.
3. To think for yourself. Always apply your own reasoning.
4. To keep an open mind. Think about crazy things. Test them by asking challenging questions. The answers are less important than the thought processes they revealed.
You need to be inquisitive about the markets. You will probably be drawn to the markets that you find most interesting. As you get to know more, try to identify patterns and anomalies in the way they behave. These will be the basis of your investing and/or trading idea.
It can be rewarding:
1. To be inquisitive, especially in the financial markets
2. To watch crowd behaviour. Jump onto some great trends and jump off when this turn more neutral. Trade with a consensus, rather than against it.
3. To think for yourself. Always apply your own reasoning.
4. To keep an open mind. Think about crazy things. Test them by asking challenging questions. The answers are less important than the thought processes they revealed.
Monday 15 June 2009
Warning: Watch out for US dollar exposure in commodities trading
One word of warning on commodities. Since they are usually priced in US dollars, price moves can sometimes have more to do with dollar strength or weakness than with commodities.
In periods of dollar weakness, for example, commodity prices may rise just to keep their European and Japanese price relatively stable.
This is always an important consideration if you do not want to accidentally speculate on currencies.
Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading
In periods of dollar weakness, for example, commodity prices may rise just to keep their European and Japanese price relatively stable.
This is always an important consideration if you do not want to accidentally speculate on currencies.
Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading
The recent commodity story has been all about China
A new period has emerged over the last few years. Growing economies, particularly China, have experienced strong growth and inflation simultaneously. They have tolerated inflation, and let growth rage on. Commodities have had a renaissance. There has been debate about whether China will try to cool inflation, but in the meantime, commodity prices have soared as the hungry dragon searches the world for raw materials.
----
For instance, you could have bought Australian dollars in 2003 as a kind of commodity play.
Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading
----
For instance, you could have bought Australian dollars in 2003 as a kind of commodity play.
- The widespread view then was that Chinese demand for commodities would drive prices higher, and that Australia was well placed to benefit as a supplier.
- There were other things in favour of the Aussie dollar, such as strong growth and relatively high interest rates, which gave added confidence.
Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading
Long periods of high growth and high inflation are rare
To invest into commodities, you can choose to buy:
Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading
- individual commodity
- existing commodity index (basketo of several commodities)
- companies, such as steel or oil companies, which will benefit from higher prices of their products, or,
- the currencies of countries which have a lot of natural resources
The best time to do so is when inflation and economic growth are both strong.
In practice, though, there have not been many periods where growth and inflation are able to rise at the same time.
- Authorities normally respond to higher inflation by raising interest rates. They only have difficulty keeping a lid on inflation if raising rates weakens the economy too much.
- When there is strong growth, the authorities have a lot of room to move without causing a recession, and so they are able to stamp down on the inflation if necessary.
- Therefore, it has been rare to find long periods of high growth and high inflation.
- (This helps to explain why commodities have seen a 50 year or so price decline in real terms.)
CRB Index since 1950:
In the 1970s:
- there was high inflation, largely caused by OPEC, without strong economic growth.
- Commodities has their best run for a long time but prices still barely rose in real terms, because inflation caused a tripling of average price levels.
In the 1980s and 1990s:
- saw the opposite experience, with falling inflation and many periods of good growth.
- This was miserable for commodity prices in real terms. The economic growth was not enough.
- The increased demand by the growing world economy was generally offset by falls in the costs of production and extraction due to dramatic improvements in technology.
- Technology also helped economies reduce their dependence on the more expensive commodities, such as oil.
- Social changes also reduced the growth in demand for commodities, as economies became more service oriented, and less reliant on manufacturing.
Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading
CRB Index
While you can choose your own selection of commodities, it is probably easier to use an existing index. The most watched indicator index is known as the CRB index.
Future and options on the CRB index are traded on the New York Board of Trade. It is made up of different categories of commodities:
Because it covers such a diverse range of materials, its movements will mask moves in the individual components, and smooth out the supply problems. Obviously, there are many other commodities which are not included int he CRB index.
Alternative methods
As an alternative to trading an index on an exchange, there are a number of different ways to trade commodities - apart from keeping silos full of corn in your backyard.
Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading
Future and options on the CRB index are traded on the New York Board of Trade. It is made up of different categories of commodities:
- Energy: crude oil, heating oil, natural gas
- Grains: corn, soybean, wheat
- Industrials: cotton, copper
- Livestock: cattle, hogs
- Precious metals: gold, platinum, silver
- Softs: cocoa, coffee, orange juice, sugar
Because it covers such a diverse range of materials, its movements will mask moves in the individual components, and smooth out the supply problems. Obviously, there are many other commodities which are not included int he CRB index.
Alternative methods
As an alternative to trading an index on an exchange, there are a number of different ways to trade commodities - apart from keeping silos full of corn in your backyard.
- You can also invest in companies, such as steel companies or oil companies, which you feel will benefit from higher prices of their products.
- Or you can even go a step bigger, and buy into the currencies of countries which have a lot of natural resources.
Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading
Trade in a basket of commodities
The strategy to adopt will probably be to trade a basket of several commodities, rather than any specific item. This is because to get the net effect of growth and inflation, you will need to remove a lot of the randomness in the price caused by supply factors.
These supply driven commodity markets can present extra difficulties. These markets are often turbulent.
Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading
These supply driven commodity markets can present extra difficulties. These markets are often turbulent.
- They can be influenced by events in remote countries, many of which can be unstable and corrupt.
- They can also be influenced by the random effects of the weather. You don't want your view that higher inflation will cause higher commodity prices to be upset by good weather causing a bumper crop in bananas.
Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading
Buying commodities. When?
Buying commodities when inflation and economic growth are both strong
Commodities are raw materials. Economic growths is good for commodity prices because a growing economy needs more inputs. Inflation is also good for commodity prices because commodities are tangible assets rising in price as the value of paper money declines.
Like all markets, the commodity markets have some large moves driven by a consensus on the fundamentals, which drive the price further than generally expected. So the idea here is to identify those periods where growth and inflation are strong, and then to take a long term view with a trading position.
Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading
Commodities are raw materials. Economic growths is good for commodity prices because a growing economy needs more inputs. Inflation is also good for commodity prices because commodities are tangible assets rising in price as the value of paper money declines.
Like all markets, the commodity markets have some large moves driven by a consensus on the fundamentals, which drive the price further than generally expected. So the idea here is to identify those periods where growth and inflation are strong, and then to take a long term view with a trading position.
Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading
Few assets benefit in stagflation
A combination of inflation and slow growth rarely helps any asset class. We had almost a decade of this in the 1970s, and stock and bonds suffered miserably. Even commodities struggled to rise in real terms.
1970s - a miserable decade
OPEC hit the world with two oil price increases. In 1973, the price per barrel went from a few dollars to over ten dollars, and in 1979 from the low teens to over 30 dollars. The west was far more dependent on oil than today.
The oil price fed into just about all prices, and inflation went out of control. By 1980, it was around 10%. People were accustomed to cycles in the economy. Normally, inflation would only rise when the economy was doing nicely and it was the excess demand that pushed up prices. However, in the 70s, jobs were scarce as unemployment also headed towards 10% and so there was plenty of unused capacity in the economy. This was inflation plus stagnation, and they had a nice word for it: stagflation.
No one knew what to do about stagflation. Australia tried wage freezes. Unions were more powerful then, and tried to ensure their members' wages were maintained. In the UK, they had 'the winter of discontent' and things became so bad that they were ready for the dose of medicine called Thatcherism.
No easy answer to stagflation
However, what could the authorities have done? A rise in the price of oil is like a tax on the entire country. Just about everyone is going to be worse off.
Unfortunately, there is no easy policy the authorities can adopt to fight stagflation. The economic theory has done a lot for economic management in normal conditions. The greatest economist ever, John Maynard Keynes, told us what to do: increase and decrease the government budget to smooth out the economic cycles. When people are not spending, governments should do the spending for them, and borrow the money. How insane were governments to reduce, rather than increase, government spending in the Great Depression! On the other hand, if people are spending too much and the economy is overheating, governments should cut back.
Keynes did not really trust interest rates as an economic tool. One reason was that in a recession, an interest rate cut may not be enough to encourage overly pessimistic consumers and businesses to borrow and spend. You can only lead a horse to water. But again, in normal conditions, interest rates can be used very effectively. When inflation rises, a little tightening up of interest rates slows things down a little, and the inflation eases off. This method of controlling the economy has become even more important as politicians have hijacked the fiscal budget for politics, rather than economics.
The trouble with stagflation is that the authorities don't know whether to boost the economy or to slow it down. Trying to create jobs risks even higher inflation, and trying to solve the inflation problem makes the job situation even worse. So it is not clear what to do with the budget balance or with interest rates.
These problems for the economy and the policy makers are reflected in the markets, and there is nothing attractive to investors. All you can do is to stay in cash, and to sell the other markets.
The stagflation of the 1970s only really ended when the US Federal Reserve gave the economy a sharp dose of very high interest rates in the early 1980s, and allowed a recession. Hopefully, we will not get another decade like the 70s for a long time.
1970s - a miserable decade
OPEC hit the world with two oil price increases. In 1973, the price per barrel went from a few dollars to over ten dollars, and in 1979 from the low teens to over 30 dollars. The west was far more dependent on oil than today.
The oil price fed into just about all prices, and inflation went out of control. By 1980, it was around 10%. People were accustomed to cycles in the economy. Normally, inflation would only rise when the economy was doing nicely and it was the excess demand that pushed up prices. However, in the 70s, jobs were scarce as unemployment also headed towards 10% and so there was plenty of unused capacity in the economy. This was inflation plus stagnation, and they had a nice word for it: stagflation.
No one knew what to do about stagflation. Australia tried wage freezes. Unions were more powerful then, and tried to ensure their members' wages were maintained. In the UK, they had 'the winter of discontent' and things became so bad that they were ready for the dose of medicine called Thatcherism.
No easy answer to stagflation
However, what could the authorities have done? A rise in the price of oil is like a tax on the entire country. Just about everyone is going to be worse off.
Unfortunately, there is no easy policy the authorities can adopt to fight stagflation. The economic theory has done a lot for economic management in normal conditions. The greatest economist ever, John Maynard Keynes, told us what to do: increase and decrease the government budget to smooth out the economic cycles. When people are not spending, governments should do the spending for them, and borrow the money. How insane were governments to reduce, rather than increase, government spending in the Great Depression! On the other hand, if people are spending too much and the economy is overheating, governments should cut back.
Keynes did not really trust interest rates as an economic tool. One reason was that in a recession, an interest rate cut may not be enough to encourage overly pessimistic consumers and businesses to borrow and spend. You can only lead a horse to water. But again, in normal conditions, interest rates can be used very effectively. When inflation rises, a little tightening up of interest rates slows things down a little, and the inflation eases off. This method of controlling the economy has become even more important as politicians have hijacked the fiscal budget for politics, rather than economics.
The trouble with stagflation is that the authorities don't know whether to boost the economy or to slow it down. Trying to create jobs risks even higher inflation, and trying to solve the inflation problem makes the job situation even worse. So it is not clear what to do with the budget balance or with interest rates.
These problems for the economy and the policy makers are reflected in the markets, and there is nothing attractive to investors. All you can do is to stay in cash, and to sell the other markets.
The stagflation of the 1970s only really ended when the US Federal Reserve gave the economy a sharp dose of very high interest rates in the early 1980s, and allowed a recession. Hopefully, we will not get another decade like the 70s for a long time.
Quality of company's management in determining its success
The quality of a company's management is by far the most crucial factor in determining its success
You have seen bad management mess up the most amazing opportunities where companies have failed despite having everything else going for them.
Often, the investor made many mistakes by focusing too much on the product, and not enough on the management. Good management will find a way to make their product work, while poor management can mess up good products.
Even big companies can make mistakes. Xerox had a fantastic product in photocopiers in the 1970s. They had a fantastic platform to expand into the technology market, by developing printers and similar devices, yet a few years ago, the company was struggling for survival. They've had a very tough time after never really grabbing the opportunity. It does seem to have been a management problem.
On the other hand, good management can often build something out of almost nothing. They are good at developing the business in the right direction. They spot opportunities, and have creative solutions. If their products are not selling, they may find ways to improve the product by research and development, or by buying or merging with other companies. They can weed out the wrong people and they face up to difficulties early.
It is easier to assess the management of smaller companies than larger ones.
There is a much greater variation in the level of talent within smaller companies. Just about all managers of big companies are very talented, even those who fail. Unfortunately, for smaller companies that is not always the case.
During the tech wreck, many small tech companies fall while others somehow survive. The survivors generally had good management. They weren't necessarily those with the best product, but they were those that cut expenditure when times were getting tough, and made plans for keeping the business alive for three or four years until the market recovered.
The track record of the managers is also very useful. Sometimes the managers are very appealing because previously they have taken a company all the way from nothing to good valuation. They may have built up a good reputation and made money for themselves in the process, and you know that they have choices apart from working for the company in which you're potentially investing.
Management strategy can also reveal a lot about their quality. Many investors focus too much on current revenue and profits while ignoring strategy. It's this that can be vital to a company's future, particularly with smaller companies that have fewer resources to recover from mistakes.
You have seen bad management mess up the most amazing opportunities where companies have failed despite having everything else going for them.
Often, the investor made many mistakes by focusing too much on the product, and not enough on the management. Good management will find a way to make their product work, while poor management can mess up good products.
Even big companies can make mistakes. Xerox had a fantastic product in photocopiers in the 1970s. They had a fantastic platform to expand into the technology market, by developing printers and similar devices, yet a few years ago, the company was struggling for survival. They've had a very tough time after never really grabbing the opportunity. It does seem to have been a management problem.
On the other hand, good management can often build something out of almost nothing. They are good at developing the business in the right direction. They spot opportunities, and have creative solutions. If their products are not selling, they may find ways to improve the product by research and development, or by buying or merging with other companies. They can weed out the wrong people and they face up to difficulties early.
It is easier to assess the management of smaller companies than larger ones.
There is a much greater variation in the level of talent within smaller companies. Just about all managers of big companies are very talented, even those who fail. Unfortunately, for smaller companies that is not always the case.
During the tech wreck, many small tech companies fall while others somehow survive. The survivors generally had good management. They weren't necessarily those with the best product, but they were those that cut expenditure when times were getting tough, and made plans for keeping the business alive for three or four years until the market recovered.
The track record of the managers is also very useful. Sometimes the managers are very appealing because previously they have taken a company all the way from nothing to good valuation. They may have built up a good reputation and made money for themselves in the process, and you know that they have choices apart from working for the company in which you're potentially investing.
Management strategy can also reveal a lot about their quality. Many investors focus too much on current revenue and profits while ignoring strategy. It's this that can be vital to a company's future, particularly with smaller companies that have fewer resources to recover from mistakes.
The fundamentals had changed and the trend may not be your friend
"I didn't invest in this or just about any other tech company in the final twelve months of the boom, and I tried where I could to sell my tech investments. I had been investing in tech since 1995, but, to me, the fundamentals of the tech sector had changed. The quality of new tech companies had dropped tremendously and they were being funded with a lot of cheap money from naive investors."
The above investor made his decision despite the fact that share prices in the tech sector were trending straight upwards and that decision saved him a hell of alot of money when the crash came.
The tech crash is a great example of where fundamentals are the most important consideration, and where the trend may not be your friend. The strategy here is to monitor the fundamentals and to cut positions accordingly, even if the trend is still in your favour.
If the fundamentals have changed, adjust the position accordingly.
The above investor made his decision despite the fact that share prices in the tech sector were trending straight upwards and that decision saved him a hell of alot of money when the crash came.
The tech crash is a great example of where fundamentals are the most important consideration, and where the trend may not be your friend. The strategy here is to monitor the fundamentals and to cut positions accordingly, even if the trend is still in your favour.
If the fundamentals have changed, adjust the position accordingly.
The 3% rule for wealth preservation
If you want to maintain your wealth in real terms, you can probably spend no more than 3% of your capital each year.
The idea is that real interest rates are generally around the 3% level. At the moment for instance, five year rates are roughly 5%, inflation is roughly 2%, and that leaves you 3%.
Now you may think that you can earn more than the 5% offered by interest rates. Investing in the share market for example, has outperformed interwst rates over the long term, so that could help. But by trying to do better than interest rates you will also risk losses. The share market can be volatile with long bleak periods for investors who move away from low risk investing. The other problem of course is tax.
The fellow who won the lottery could probably have counted on earning $30,000 per year in real terms if he had invested the entire $1 million. That is probably less than his job was paying. So even though he feels rich, and all his friends want a loan, he may struggle to live off his capital. He would need to be frugal; perhaps the cars and the studio weren't such a good idea.
The task of just maintaining wealth is a challenge for many people, not just those lucky in the lottery. The era of low risk, high returns of over 10% is over for the moment. Those days are gone and wealth preservation is more difficult.
The idea is that real interest rates are generally around the 3% level. At the moment for instance, five year rates are roughly 5%, inflation is roughly 2%, and that leaves you 3%.
Now you may think that you can earn more than the 5% offered by interest rates. Investing in the share market for example, has outperformed interwst rates over the long term, so that could help. But by trying to do better than interest rates you will also risk losses. The share market can be volatile with long bleak periods for investors who move away from low risk investing. The other problem of course is tax.
The fellow who won the lottery could probably have counted on earning $30,000 per year in real terms if he had invested the entire $1 million. That is probably less than his job was paying. So even though he feels rich, and all his friends want a loan, he may struggle to live off his capital. He would need to be frugal; perhaps the cars and the studio weren't such a good idea.
The task of just maintaining wealth is a challenge for many people, not just those lucky in the lottery. The era of low risk, high returns of over 10% is over for the moment. Those days are gone and wealth preservation is more difficult.
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