This week, the US Federal Reserve cut back official interest rates to 1%. This is the lowest that it has been since 1958. The US equity market was initially disappointed - investors expected a 0,5% cut to 0,75%. Except for the housing market, it appears as if the economy has generally ignored the previous 13 rate cuts since January 2001.
Investors in the US however continue to be afraid of losing out on upward moving share prices. For this reason, encouraged by the zero real interest rates on money market funds, investors have moved funds back into the equity market over the last six months. The rally from October 2002 lows in the US, and more specifically since March, has come at a time when sentiment has crept higher. Whether these values are justified is highly debatable, despite the low interest rate environment.
The Economist this week points out that shares are now more expensive than at March 2000, when prices peaked. They are currently trading on a price to earnings ratio of 33 times, as against 31 for the broader S&P 500 in March 2000. This has been the result of falling corporate profitability and boosted share prices.
It also pointed out that institutional investors such as pension funds and insurance companies have high fixed rate liabilities, which cannot be matched with the paltry yield from bonds (around 3,3% on the 10 year bonds). Both institutional and private investors therefore almost "have no choice" but to take on higher risk for potentially greater returns than that provided by low yielding cash and bonds.
No one can be expected to time markets exactly right, but my overriding comment continues to be that an investment into US equities makes very little sense. Lets see what an investor can possibly hope to generate from such an investment.
- Well firstly there is the dividend flow. On average US companies are throwing off dividends at around 1,75%. Not too great a return.
- Secondly, and more importantly in most investors minds, is the hope for future capital gains. Investors prefer not to place too much emphasis on the probability of this outcome, which, where very low, is best described by the word hope.
Given stretched values, a reversion to normalized values is just as, if not more, probable.
I have previously reported that the starting value, as best reflected by the dividend yield, is the best predictor of ensuing total investment return. An investor that ignores the cash flow thrown off from any investment and concentrates only on the hope of selling at some future date at a greater price is in fact investing according to the so-called "greater fool theory". Wonderful in a speculative bubble, but cannot be considered as a sound investment approach.
Robert Kiyosaki calls it the "Passive strategy of Buy, Hold and Pray ?praying that the stock market booms and does not bust."
Is your portfolio adequately and constructively diversified?
I was quoted in the latest Finance Week (27 June, page 47), as saying "Though there is a lot of merit in the diversification approach, where a certain asset class remain very expensive, I maintain that there is absolutely no point in incorporating it into a portfolio."
I am essentially talking about not including expensive US equities, even in a diversified portfolio, until such time as they reflect clear value.
Private investors and many advisors typically derive their asset allocation decisions from investment managers, who in turn tend to present a unified method with regard to asset allocation. Manager's ongoing argument is that shares should always constitute the greatest proportion in a portfolio (excluding near retired and retired investors) because of their history of out performance. This argument is often perpetuated despite the absence of value.
This philosophy obviously suits investment managers because they derive fees from this main asset class, and are really in the "business of investing" as opposed to investors themselves.
Unfortunately most advisors and private investors then follow the approach in herd like fashion.
If my approach is considered contrarian to the typical "buy and hold irrespective of value" approach, then so be it. I have a very clear investment strategy for each one of my clients, including reducing the risk of capital loss through active asset allocation.
The effect on the local market
I pointed out in my Investment Trends Report (please e-mail me on ian@sharenet.co.za for a copy), that the dollar is likely to continue to weaken steadily for some time. The rand is however displaying very strong tendencies. There are a number of plausible explanations for this, including the high rate of real interest, the recent elimination of the Reserve Bank's net open forward position and the steady upgrading to investment grade by most International rating agencies.
Its very difficult to predict how the rand will move from these levels, and despite the many positives, changes can and do occur very suddenly. Together with the ever-present political risk, we may see capital outflows pick up on the exchange control relaxations.
Nevertheless with global investors struggling to find reasonable real interest rates, there are many reasons for the rand to hold firm for longer than widely expected.
Unfortunately the simple fact remains that exporters make less profits. Most local listed companies have some exposure to exports, with the resource shares the largest beneficiaries of a weak rand. A persistently strong rand will put pressure on these large cap shares into the second half of the year.
There are some commentators that are concluding that the rand could trade as firmly as R6/dollar!
Amnesty
The Exchange Control Amnesty and Amendment of Taxation Laws Act, 2003 is now in place.
For many South Africans this is an important piece of new legislation and for those with "grey money" offshore, i.e. monies shifted in contravention of Exchange Controls, there is no doubt that one must take full advantage.
Not only are there exchange control breaches, but also ongoing Income Tax contraventions on undeclared income derived from illegal funds offshore. The ongoing tightening of the international legislative environment, as well as the introduction of the Financial Intelligence Centre Act, 2001 locally, mean that detection by the regulatory authorities is heightened.
Between 1 June and 30 November 2003, residents with assets held in contravention of these laws may apply for amnesty. For exchange control amnesty there is a levy of 5% of the amount exceeding that which may be legally held, if repatriated, or 10% if funds are left offshore. For tax amnesty there is no charge, unless the assets are part of the proceeds of a tax offence in South Africa, in which case the levy is 2%.
The Amnesty Act is complex. Firstly is a matter of determining eligibility to apply. Then its not simply a matter of reporting undeclared offshore funds, but also a process of analysing all the Income Tax implications on undeclared revenue. In such cases its important to determine exactly when and how funds were accumulated offshore.
If you are based in Cape Town, and would like to have an initial discussion as to how to proceed, please don't hesitate to give me a call (082 921 0220).
I have identified two specialists in this area, who are in a strong position to advise and take clients through the application process.
Over and above the amnesty itself, this will give you an opportunity to review your foreign investments and consider options which are most appropriate to your needs.
Conclusion:
US equities remain a dangerous place to be invested in. This also impacts on local equity allocation.
Please contact me if you have an existing offshore exposure, and are looking for specific advice in this regard.
Optimising your investment strategy in challenging times.
For clients with total investable assets in excess of R1,5m to R2m, I provide a fee based investment counsel service. This includes both an initial plan and ongoing advice. Have a look at www.exsequor.co.za for more information on this service.
If you have any questions, please feel free to contact me.
Sincerely
Ian de Lange CA (SA)
27th June 2003
021 710 5700
This investment newsletter is published for general information. While every effort has been taken in the production of it, Sharenet (Pty) Ltd and/or Ian de Lange bear/s no responsibility for any loss or damage that may be result from any person's reliance on the information contained in the newsletter.
Posted: 2003/06/27 13:24 View Archive