Brent Sheather: Bearish on just about everything

The retail investment advisory industry is quiet at the moment. Not surprising really; globally worrying conflicts are raging, short-term interest rates offer an equity-like premium over inflation and the Government is about to institute a capital gains tax on shares.

Throw in rising inflation and the fact that leading indicators like car sales appear to be dropping like a stone and it's no wonder Mum and Dad are leaving the money in the bank.

But is this the right strategy? Historically, retail investment activity has been a reasonably inverse indicator of investment returns. When the sharemarket is popular and everyone is investing, subsequent returns are often poor. Conversely, when times are tough and everyone is sitting on the sidelines, the bargains are there to be had. Fund managers, stockbrokers and financial planners regularly assess the outlook but the reality is that their job is primarily to sell risky assets, even if they are mispriced.

No one is going to pay a 1 per cent monitoring fee to have their funds sitting in a call account. The last month has seen the publication of two strategy documents by leading UK analysts Andrew Smithers, of independent economics research company Smithers and Co, and Tim Bond, of institutional bank Barclays Capital, which try to make sense of the investment outlook.

Smithers' report looks at "Where Are We Now" and concludes financial assets are significantly overpriced. It says the period of ultra-low interest rates, which has just ended, has pushed up asset prices (shares, bonds and houses) so that they are out of line with the income they produce. "Bringing asset prices back into line with income requires either incomes to rise or the asset prices to fall." Smithers suggests the latter option is more likely and notes that it is difficult for central banks to manage economies with falling asset prices - so recession in the next two to three years is likely.

Similarly Smithers is bearish on just about everything - he points to the way that gold prices and the price of Government bonds have gone up dramatically since 2000 yet gold is an indicator of rising inflation whereas higher bond prices signal greater risks of deflation.

The simplest answer to this apparent anomaly is that low-interest rates have pushed up the prices of all speculative assets.

Sharemarket bulls point to the low valuations of world sharemarkets but Smithers, whose firm co-incidentally has no fund management or investment broking arm, is unconvinced. He writes: "Profit margins in mature economies are strongly mean reverting (when high or low they inevitably return to their long-term average). They are very high and a narrowing to trend would produce a large fall in profits." Nowhere is this trend more evident than in the banking sector. Bank shares are as cheap as they have ever been because the "market" thinks that their profits will fall as interest rates rise. If profits do fall and the world economy moves into recession, risky assets like shares, junk bonds and finance company debentures will fall in price. Smithers' advice: Sell into rallies.

Tim Bond is head of global asset allocation strategy at Barclays Capital and is a co-author of the annual Barclays Capital (Barcap) Equity Gilt Study. Barcap is the investment banking division of Barclays Bank and its clients are institutional investors and hedge funds. Its July publication, "Global Outlook", summarises the firm's view on where things are going in the next 12 months and where we should be invested. Their view is that short-term interest rates in the US will continue to rise on the back of higher inflation. The report finds a historic negative correlation between sharemarket valuations (PE ratios) and inflation. In other words, as inflation increases the multiple of profits by which the sharemarket values a business declines.

"History tells us that inflation pressures are associated with equity market de-rating and it is not a good bet to expect an upward re-rating in PE ratios until the markets are satisfied that central banks have done enough to return inflation to target. This phenomenon might well be irrational, as suggested by financial market theory, but it has been an enduring feature of investor behaviour for the past 50 years.

"History also teaches us that purchases of equities during an inflation-linked de-rating phase invariably produce abnormally high total returns over the ensuing five to 15 years." Accordingly, Barcap is recommending shorter-term bonds and a reduced weighting in international shares although it does see European shares as being cheap.

With economists telling us international shares are overpriced, it is difficult to get excited about global markets at present. There is, however, an alternative, one which also pays a decent dividend. In two weeks' time, we will look at the pros and cons of the local listed property market.Brent Sheather is a Whakatane-based investment adviser