Market View - April 2011

The last quarter's events unfolding in North Africa and the Middle East, together with the tragic natural disaster in North Eastern Japan remind us only too well that we live in a world of known knowns, known unknowns, and most worryingly unknown unknowns (a phrase introduced to the world stage by Donald Rumsfeld in 2002)!

As Nassim Taleb reminds us in his book (The Black Swan: The Impact of the Highly Improbable) "unknown unknowns" have a nasty habit of totally upsetting our otherwise rational investment models when they occur out of the blue. Understandably recent events have unsettled global markets, increased volatility and make many investors re-evaluate their risk tolerance.

A pivotal theme of Taleb's book is that humans are constantly having to wrestle with the "ludic fallacy", namely that predictive mathematical models are useless when it comes to predicting the future. As an example he poses the scenario of a coin flipping exercise that results in heads winning the first ninety nine times, and asks what are the odds of the outcome being tails on the hundredth flip?

Naturally the logical and mathematical answer is 50%, but in such a scenario who would not be tempted to wager 1% instead? Similarly in markets and economics we have in recent decades witnessed all too often how our Gaussian bell curve models etc. have failed to predict probability outcomes, due to the black swan phenomenon.

The terrible tragedy following the earthquake and subsequent tsunami in Japan has understandably dominated financial markets this past month, with the continuing struggle to contain three overheating nuclear reactors in Fukushima depressing equity markets concerned whether the nuclear industry may be too dangerous to continue with as a viable source of energy generation! It could however be argued that the current position provides a potentially attractive investment opportunity for courageous investors believing that the local stock market is likely to emulate the Kobe earthquake in January 1995 (when the Nikkei 225 index fell almost 25% over the next few months before rising more than 30% by year end), and additionally for the more adventurous who may view the set back in the price of plutonium (down around 15%) and related commodity stocks as temporary!

Meanwhile, as commentators debate the outcome for US Treasury yields when QE2 ends in June (assuming of course that official denials about QE3 hold true), Bill Gross of PIMCO who personally manages more than a quarter trillion dollars in bonds has voted with his feet, selling all of his American government debt holdings after severely criticising the strategy adopted by the Treasury and Federal Reserve Bank. Legendary investor Warren Buffet is also negative saying recently, "I would recommend against buying long term fixed dollar investments, and would much rather own businesses".

With the US budget deficit currently running at £14 trillion ( by the way, if you were to start counting today and continued at a rate of a $1 a second, it would take more than 443,937 years to reach this number!) and total US debt standing at more than $55 trillion (i.e. more than three and a half times America's GDP when you include the future cost of unfunded liabilities such as social security and Medicare etc), combined with continuing concerns surrounding future Japanese and Chinese funding,  there is understandably a great deal of negative sentiment surrounding both US Treasuries and the world's reserve currency which has lost 35% of its purchasing power in the last decade. Over the same time the price of gold (which many perceive as the reserve currency in waiting) has increased fivefold!

Having fallen sharply in March, share markets did stage a partial recovery by month end. Overall the FTSE 100 in the UK ended down 1.5%, the S&P 500 in the US finished unchanged, in Europe the FTSE EuroTop fell more than 4% and in Japan the Nikkei 225 lost more than 8%. The only positive equity market returns came from emerging markets, where India was the star as the Mumbai stock market (as measured by MSCI) climbed almost 9.5%!

Looking forward we at Ash-Ridge continue to favor equities and especially like the combination of developed world high yielding stocks together with the more growth oriented emerging market opportunities. The long term value of dividends can not be emphasised enough and can be illustrated in the recently published annual Equity Gilt study from Barclays Capital showing that £100 invested into a representative index of UK stocks in 1899 without reinvesting the income would have grown to £12,655 by the end of 2010 (in real inflation adjusted terms £180), compared to £1,697,204 (or £24,133 in real terms) with income reinvested!