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Peter Elston’s Investment Letter – Issue 4 August 2015

31 July 2015

We have introduced an explicit value-oriented approach to our investment process. We think multi-asset value investing is both new and original (a search of the term and variants of it on Google yields zero results). Value investing traditionally is associated with investing in equities, but we have applied it to the management of multi-asset portfolios and their associated components, namely tactical asset allocation, equities selection, fixed income selection and specialists selection. After all, the principle of value investing is to buy things cheaply, something that can be applied to anything, whether tactical asset allocation or grocery shopping. In practice, we apply a value approach by looking at current yields of various instruments (debt, equity, funds) and asset classes and asking the simple question, “are they materially higher than they should be?” in the context of various other factors such as future income growth, leverage, inflation and monetary policy. If the answer is “yes”, we will invest. (In the case of things that don’t yield anything such as commodities, we would look at valuation based on inflation-adjusted prices, but they’d have to be well below historic averages for us to be interested). We think this approach is one that is both simple and effective.

It is also an approach in which risk management is deeply embedded. We think the most important investment-related risk is the risk of permanent loss of capital, not price volatility. Important risk is thus much more closely related to solvency risk, something that can be more effectively avoided by assessing intrinsic value. Market risk on the other hand is something that much of the time we seek to be actively exposed to as a source of return. Unlike success, risk is about the destination not the journey. One should be able to tolerate and recover from the odd bit of bumpy road. It’s driving off a cliff one should avoid.


When will commodities prices recover?

Unlike equities, bonds or property, commodities cannot be valued on the basis of the income they generate. This makes it hard to feel comfortable investing in them, as without yield it is hard to predict future returns. In fact, when you invest in commodities, one way or another you have to pay for storage, which makes them even less attractive as investments. For this reason, our core allocation to commodities is zero for all our funds other than our Growth Fund where it is a low 2.5%, and this more for their diversification benefits than their return characteristics.

The only reasonable method I can think of to value commodities is to consider their inflation-adjusted prices then compare them with their long-term price trends. But this throws up another problem – what should the trend real price appreciation of a particular commodity be? Should the real price of a commodity be rising, falling or staying the same over the long term? Should nominal prices be rising in line with inflation, in which case trend growth is zero? Or falling, in which case trend growth is negative?

This question brings to mind an article written by the great Isaac Asimov. The piece in question was entitled The Dismal Science, and it somewhat obscurely constituted the editorial in his 1991 science fiction magazine (Asimov was a polymath and would write on any number of subjects).

Asimov began his editorial by saying that he could not understand economics. “People may say they understand it and economists even win Nobel Prizes, but I think it’s all a fake”, he wrote.

He then went on to note a New York Times article in which the story is told of a bet made by two economists, one who thought the prices of certain industrial metals would rise – because of rising populations – and one who thought they would fall – because of advancing technology. Asimov was staggered to learn that the pessimist had lost the bet.

If we look at a broad index of commodities over the last 15 years, we capture in that period the great bull market of the noughties. This means that trend growth over that period was substantially positive, +8.9% real in fact, and thus that current prices look very cheap relative to trend (see chart).

Real Price of Commodities*

*UBS Bloomberg CMCI Composite divided by US consumer price index
Source: Bloomberg as at 29/05/2015

Look further back however and you get a different picture. In the case of gold, oil, copper and lead, longer term trend growth in real prices has been 2-3% per annum (see charts below). In other words, Asimov was right! Trend growth over the longer time frames is nowhere near the 8% per cent or so registered in the last decade and a half, but it is nonetheless positive. I would guess that the explanation for the 2-3% growth lies in real prices tracking growth in real incomes (GDP) and thus the fact that the world can afford to pay a bit more each year for these raw materials in real terms.

Real Price of Gold*

*Gold Spot Price per Troy Ounce vs CPI Index

Real Price of Oil*

*Crude Oil Price vs CPI Index

Real Price of Copper*

*London Metals Exchange 3 month Copper Price vs CPI Index

Real Price of Lead*

*London Metals Exchange 3 month Lead Price vs CPI Index

Source for all graphs: Bloomberg as at 29/05/2015

Nevertheless, 2-3% real is still not particularly attractive given that commodities prices are very volatile and that as an investor in commodities you will a) be paying for a storage and b) not be using the commodities to manufacture things and make a profit. Looking at the charts, it would appear that a sensible approach to commodities investing would be to buy them when real prices are well below trend and to have a long-term – 5-10 years – investment time horizon, selling when real prices are well above trend.
So, where are prices currently in relation to their trends? While the oil price is still well below its trend, 26% in fact, the others are either close to it (copper and lead) or above it (gold), making them in my view unattractive.

Is it time to buy oil? I’d say not. In 2001, prices fell to 53% below trend, and in 1970, 54% below (that these are so similar is instructive!) In other words, prices can fall much further if history is any guide which it often is. True, there are forces that might drive the price up (a prolonged period of heightened political risk or the fact that the world is using up its fixed reserves) but there are also forces that might drive it down further (the shift to renewables and lowered political risk, the recent Iran deal being a good example of the latter). At $30 I might be interested.

Scientific Advance

I don’t know whether it’s me noticing them more, the media picking up on them to a greater extent, or the fact that there are more of them, but I have been captivated by the scientific advances I have read about recently, many on the Business Insider website.

I have always been intrigued by the stagnation versus growth debate and have tended to side with the latter. My recent reading has reinforced this position.

While our closest relatives would struggle to launch a banana more than 10 feet off the ground, we, the human race, have just done a flyby of the furthest planet from Earth in the solar system, at the same time sending back photos. And we just shrug as if it’s no big deal! The scientific advances that must have been required to do this must surely somehow be useful in helping make the world a better place.

I forget all of bits and pieces I came across relating to other scientific advances – there were simply too many – but here are two I do remember.

The first was Boeing having just had a patent application for a new jet engine design approved by the US Patent and Trademark Office. The proposed engine uses lasers and nuclear reactions to create vast amounts of energy that is projected out the back of the engine in the form of thrust. Wow! Substituting oil and its derivatives in relation to land transportation and electricity production is already well underway but I’ve often wondered how jet fuel would be replaced. Perhaps this is it.

The second related to biotechnology and what the MIT Technology Review described as “the biggest biotech discovery of the century.” Jennifer Doudna and Emmanuelle Charpentier have found a way to use bacteria to cut out particular sections of DNA and replace them with other sections. Double wow! If anyone was wondering how we would likely find cures for cancer and other diseases such as HIV, they need wonder no longer.

I don’t understand Boeing’s jet or the DNA cutting bacteria. I wish I did. But what I’m pretty sure of is that such scientific advances, along with the countless others, are likely to have a huge impact on economic growth and the quality of human life.

Tactical Asset Allocation Change

At the end of June we increased our European Equity exposure to a 4 percentage point overweight position relative to our core allocations. We had felt that there had been a reasonable correction over the prior two months, with the Euro Stoxx 50 index falling by around 10% from its April highs.

Furthermore, we remain optimistic that an economic recovery is underway in Europe but that it is still in its early stages. Unlike in the US, where unemployment started to fall more than five years ago, in the Eurozone the employment situation only began to improve in mid-2013. Thus while the unemployment rate has fallen, it is still high at 11.2%, meaning that monetary policy will remain likely very loose for at least the next couple of years.

We feel that this, combined with profit margins that provide scope for improvement and dividend yields that are reasonable, bodes well for European Equities.

It was the uncertainty in relation to the Greece situation that gave us the opportunity to increase our European equity exposure at lower levels. Now that there is more clarity with respect to whether or not Greece remains in the Euro, we would expect investors to refocus on Europe’s better fundamentals.

Inflation Watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

My core belief about the first interest rate rises here in the UK but also across the pond is that they’ll happen much later than many think. True, Mark Carney and Janet Yellen would dearly love to normalise monetary policy, but the reality is it’ll be a while before they’re able to and I think they know it. The reason they talk about it I believe is because it is the only tool they have to stop asset prices, whether financial or real, from rising too much and causing problems down the road. Their main job is promote stability in the price of goods and services and right now these need supporting not supressing (core inflation in the UK has fallen from 2% a year ago to 0.8% currently).

Furthermore, I think both Carney and Yellen are well aware of what happened when the Fed raised rates slightly in late 1936 following a few years of moderate growth: a severe economic contraction and a halving of the stock market. Rates were quickly reduced and did not rise above 1% until the late 40s, a good ten years later.

Mark Carney’s comments to the Treasury Select Committee last month were strong on rhetoric but light on substance, saying only that “The point at which interest rates may begin to rise is moving closer”. That doesn’t really commit him to very much.

The final point to note, and this is specifically about the Fed Funds rate, is that it may be hard, as a result of QE, to induce an increase in rates. The Fed Funds rate is the rate depositary institutions lend excess reserves to each other. When actual reserves are close to required reserves, this rate matters. However, actual reserves are currently 30 times required reserves, the result of quantitative easing, so banks do not need to borrow. If they don’t need to borrow, raising the Fed Funds rate won’t have any effect.

Talking of the Fed, Janet Yellen was also on parade last month, this time in front of Congress. In relation to inflation, she said that factors that had been holding it back such as higher joblessness would subside. She was a bit more specific than Carney on the timing of the first rate rise, saying that “economic conditions would make it appropriate at some point this year to raise the federal funds rate target.” My question to her would be, if the banks don’t need to borrow because you’ve stuffed them with reserves, what good would a rate rise do? Seems to me she’s trying to talk down asset prices.

STOP PRESS: Following Yellen’s remarks about the likelihood of a rate rise this year, Carney came out and hinted during a speech at Lincoln Cathedral that the Bank of England may raise the base rate around the turn of the year. “The decision as to when to start such a process of adjustment will probably come into sharper relief around the turn of this year”, he said. This was more precise than his remarks two days earlier to the Treasury Select Committee, and suggests that he is taking a cue from Yellen. In some respects this is to be expected. If the Fed chair suggests the US economy is stronger than previously thought, that would indeed have implications for the global economy and thus the UK economy. But for him to change his tune so quickly, and for him not to have consulted colleagues, seems a tad brusque.

Captain Murphy’s Diary

Murphy’s Law says that what can wrong, will go wrong. It is thought to be named after Captain Ed Murphy, an aircraft engineer who, frustrated with the work of an incompetent colleague, is alleged to have remarked, “If there is any way to do it wrong, he will.” This section is dedicated to combing the financial markets for risks that are lurking out there, preparing to pounce.

The risk that I consider this month is the risk of growth in the US slowing significantly as a result of the ending of QE3. Although all the talk is of interest rates rising, it is possible that the tapering of asset purchases by the Federal Reserve that began in January 2014 constituted a significant tightening of monetary conditions, the impact of which is yet to be felt.

When interest rates hit the zero bound, central banks have only one option if they want to loosen policy further: QE. But can one measure the impact of QE in terms an equivalent level of short term interest rate? The answer is ‘yes’. In a paper entitled “A model for interest rates near the zero bound”, Leo Krippner of the Reserve Bank of New Zealand lays out a method for converting central bank asset purchases into an effective short-term interest rate, what he calls the “shadow rate”. The maths is complex but to put it as simply as possible, Krippner uses bond option pricing techniques to determine what the short term interest rate would be if physical currency did not exist (central banks cannot in reality lower interest rates below zero because people would instead hold physical currency).

The chart below shows the actual Fed Funds rate versus Krippner’s shadow rate. It is interesting to note that since 2012 the shadow rate has increased by nearly 5 percentage points. This is similar in size to the increase in the actual Fed Funds rate between 2003 and 2006, arguably the cause of the fall in property prices that precipitated the global financial crisis.

While it is by no means clear that the impact of a 1 percentage point rise in the shadow rate is equivalent to the impact of a 1 percentage point rise in the actual rate, one would be wise to note that interest rate increases tend to impact economic growth with a considerable time lag. Knowing about Krippner’s work should help keep one more wary about the outlook for growth and perhaps to better interpret any unexpected weakness.

Krippner’s Shadow Rate Versus Actual Fed Funds Rate

Source: A model for interest rates near the zero lower bound by Leo Krippner & Bloomberg as at 29/05/2015

Download this investment letter as a PDF

Important information

Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/99.



Peter Elston’s Investment Letter – Issue 3 July 2015

2 July 2015

For the Love of Charts…

I like charts.

This month I take a look at MSCI’s major global sectors and see if there is anything that can be learned from what has been going on the last 20 years with respect to accounts items and ratios relating to profitability, leverage and valuation.

I get all this from Bloomberg, which aggregates the data for MSCI’s sector indices: Energy, Materials, Health Care, Information Technology, Financials, Consumer Discretionary, Utilities, Consumer Staples, Industrials and Telecom Services.

I’ve also made comparisons between the sector index data and the data for the overall MSCI World Index. It should be noted that these indices are for developed markets only and thus exclude companies in emerging markets.

I’ve tried to focus in on data where a particular ratio is at or near its extreme, or where there is a strong trend that may or may not be turning.

Here goes!

Revenue per Share

The sector that has exhibited both the strongest and the most stable growth in revenues is Health Care. Since 1994, revenues per share have grown nearly six times, compared with just short of a doubling for the World index. Furthermore, growth has not only been strong but also stable. While revenues for the World index fell materially both following the tech burst and the GFC, Health Care companies’ revenues continued to rise. This is perhaps the best example of a secular trend which has been extremely clear and also shows no sign of ending. Indeed, given the ageing of the world’s population and the continued scientific breakthroughs, one would expect this trend to continue.

Revenue per Share

Chart 1

Operating Income per Share

With respect to operating income, it is interesting to note just how extraordinary the energy boom was in the years leading up to the GFC. Indexed to 1 in January 1995, operating income per share for the Energy sector rose by over ten times before collapsing in 2009. The driver of operating income of course has been the oil price but one should note that despite the decline over the last 12 months, the Energy sector’s operating income has still risen more than any other sector over the entire 20 year period.

As for Health Care, operating income has flattened out the last three or so years, despite revenues that have continued to rise. It is not clear why this is the case but it is certainly something to keep an eye on.

The IT sector’s operating income has been more volatile than that of the Health Care sector but it is now slightly ahead over the 20 years.

As for Utilities, cash flows are supposed to be very stable but the reality is that in recent years this has not been the case – 2011-2012 saw significant declines in profit.

Finally, a word on Financials which was the worst hit sector in 2009. Operating income for the sector has recovered and continues to recover but is still half what it was pre-GFC.

Operating Income per Share

Chart 2

Capital Expenditure

There are a couple of interesting things to note about the capital expenditure data.

The first relates to the Energy sector and how despite the sharp falls in operating income to 2005 levels, capital expenditures have hardly fallen. If the oil price does not rise from current levels, I think there is a strong possibility that capital expenditures could fall a lot further.

As for capital expenditures for the World index as a whole, it is noticeable that they have been flat for three years now. This must be of concern for central banks who via negative real interest rates are hoping to encourage companies to increase capex.

The Bank of Japan’s governor, Haruhiko Kuroda has been getting particularly exasperated with his country’s hoarding of cash by corporates, telling them last November that such behaviour would be costly for them.

Perhaps increasing capital stock does not make sense in a country where demographic headwinds are so strong. Indeed, the falling global population growth may explain the weak capex in other developed countries.

Capital Expenditure

Chart 3

Dividends per Share

I have picked out five of the eight sectors in relation to dividends per share.

Although it may be related to one company or a small number of companies in the sector, the dividends that the IT sector has been distributing have been growing at a remarkable pace. Along with Health Care, the IT sector is one where there is a strong secular trend in place, albeit one which includes the odd collapse in profits. The dividend performance of Consumer Staples and Health are are closely related, which is understandable: Health Care is after all in many ways a consumer staple. Dividends in the Energy sector have not yet fallen but if operating profits in the sector are anything to go by, cuts may be just around the corner.

Dividends per Share

Chart 4

Total Assets per Share

It is interesting to contrast the fortunes of the Financial sector which continues to de-leverage (as measured by total assets) with those of Health Care which goes from strength to strength.

Total assets of the Financial sector fell sharply in 2008 and 2009 but have since continued to fall, driven by tighter capital requirements and weak loan demand.

Total Assets per Share

Chart 5

Gross Profit Margin

Gross profit margins can vary from industry to industry (the highest are to be found in the Telecom service and Utilities sector where asset turnover is very low).

However, changes over time can be instructive and in this regard it is interesting to note that while gross margins for Health Care have been declining, those for IT have been on the up.

Indeed, in 2013, the IT sector’s gross profit margin surpassed that of the Health Care sector.

Gross Profit Margin

Chart 6

Return on Equity

It is remarkable just how stable return on equity has been for Health Care companies. While this measure of profitability has been very volatile for other sectors, with return on equity for the World index anywhere between 2% and 17% over the last 20 years, the Health Care sector has posted numbers consistently in the 15-20% range.

The chart below also illustrates well the extent to which profitability in the Energy sector has been cratering, with it now sitting close to 20 year lows.

Return on Equity

Chart 7

Net Debt per Share and Net Debt to EBITDA

One sector stood out with respect to net debt, namely Information Technology.

This is a sector which over the last 20 years has seen a progressive strengthening of balance sheets. While much of this strength can be attributed to Apple inc, the sector is well placed to move quickly in the event of scientific progress being made in areas such as quantum computing or artificial intelligence.

Net Debt per Share

Chart 8

Net Debt to EBITDA

Chart 9

Price to Book Ratio

Four sectors to pick up on with respect to price-to-book ratios as well as the World Index as a whole.

First, although Health Care and IT valuations have been on the rise, they are still far below the levels they reached in the late 90s. Price to book ratios of consumer staples on the other hand have risen in line with the aforementioned two sectors but are now quite close to 20 year highs attained back in 1998. One might expect a bit divergence from here, similar to what happened in the late 90s.

As for the Energy sector, valuations at 1.6 times book are now close to historic lows, suggesting that much of the challenge being faced currently by the sector may be discounted in share prices.

As for aggregate World Index valuations, they have risen from 1.3 times book at the depths of the GFC to around 2.2 times currently. This is well below the 4 times book reached in the late 90s so arguably still represents good value.

Price to Book Ratio

Chart 10

Dividend Yield

Finally, the most important number of all: dividend yield. Viewing nine lines in one chart would have been difficult so I have split them between the following two charts, with the first of them including the yield for the World Index.

Starting with latter, the dividend yield for the World index is currently 2.2%. This is bang in line with the 20 year average so not overstretched by any means. Indeed, in the context of real long term interest rates that are much lower than 20 year averages, the current 2.4% is arguably attractive. Furthermore, the lowest levels that yields reached in the 20 year period under review was 1.2%, in the late 90s, so there is still scope for yields to fall further.

As for sectors, it is interesting to note that IT has converged with Health Care. Which of these deserves to be the higher rated is up for debate but on the basis of past volatility it should be the latter. Energy’s yield of 3.6% may well reflect fear of dividend cuts, but even factoring material declines is still attractive. Elsewhere, given past performance, the fact that the yield of Consumer Discretionary is a lot lower than Consumer Staples appears anomalous.

Dividend Yield

Chart 11

Dividend Yield

Chart 12

Download this investment letter as a PDF

Important information

Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/86.



Peter Elston’s Investment Letter – Issue 2 June 2015

3 June 2015

Fear of Equities:

Every now and again I feel the need to wonder why people are so scared of equities, in light of how stable dividend distributions are over time. I’m not the first to wonder this. Thousands before me have written about the so-called “equity risk premium puzzle”, a reference to equities returning so much more than they should have, given their risk. Six years into a bull market in equities is perhaps a good time to revisit the question, particularly because I’ve been meeting a lot of customers recently who have been and continue to be nervous about investing in equities.

The chart below shows the rolling 12 month dividend per share for the S&P 500.
Question: what would you pay for that income stream? (I have used the S&P 500 because data goes back further but you’d see similar patterns in the UK.)

Here are the facts. First, dividend per share growth since 1970 has been 6.0% per annum. Second, volatility of dividend growth has been 6.7% per annum, meaning that two thirds of the time dividend growth has been between -0.7% per annum and 12.7% per annum.

I don’t know about you, but I wouldn’t demand more than a 7% return from that income stream. Over 30 years, that’s 527 percentage points more than you’ll get from the 30 year Treasury, which more than compensates you for the higher volatility of the income stream, yes? I think I am being extremely reasonable, although, perhaps a tad greedy..

Rolling 12 Month Dividend Per Share of S&P 500

Source: Bloomberg & Seneca Investment Managers as at 30/01/2015

Using the Gordon dividend discount model, a 7% return would suggest a current fair value for the S&P 500 index of 4,151. You’ll note of course that I have reversed engineered this result. But I have done so to make a point, namely that even if the S&P 500 index reached 4,151, your return would still be a respectable 7% per annum!

The next chart overlays the dividends per share (left hand scale) with the S&P 500 index itself (right hand scale). It also bands the seven equity bear markets we have had in the last 45 years. The only bear market that was remotely justified on the basis of what happened to dividends was the most recent one in 2008-9. All the others saw no corresponding decline in dividends. Indeed during the first five dividends continued to rise.

Rolling 12 Month Dividend Per Share of S&P 500 vs. S&P 500 Index

Source: Bloomberg & Seneca Investment Managers as at 30/01/2015

But the main point to note is how much more volatile the index is in relation to the underlying dividends. The volatility of the S&P 500 index is 16.7% per annum, 2.5 times that of dividends.

There is an illogical circularity here. Equity investors demand a high return because of equity market volatility, but it is their own behaviour, not that of the underlying dividends, that causes the volatility!

The point of all this of course is twofold. First, one should not be nearly as fearful of equities as is generally the case. Second, bear markets should be welcomed with open arms; they represent
opportunities to buy a fabulous income stream super-cheap.

These conclusions have widespread academic support, but a paper written in 1994 by William P. Bengen, Determining withdrawal rates using historical data, is particularly interesting. Bengen’s study considered historical returns from equities – and bonds – over the long term to determine optimal equity-bond asset allocation as well as the maximum one could withdraw from one’s fund every year – expressed as a percentage of the starting value – without running out of money within 30 years. This maximum percentage he calls Safemax.

Although conventional wisdom is that in retirement one should shift to a more defensive asset allocation strategy, Bengen’s study found the opposite was true. He writes, “An asset allocation as high as 75% in stocks during retirement seems to fly in the face of conventional wisdom…But the charts do not lie – they tell their story very plainly.” The charts he refers to are ones that clearly show portfolios with higher allocations to equities lasting a lot longer than those with lower allocations. He then goes on to consider how one should react to periods of poor equity market performance, concluding that increasing the equity weight to 100% is the optimal strategy. “This [increasing allocation to stocks following periods of poor performance] is a testament”, he says, “to the enormous recovery power of the stock market – and the need to avoid emotion when investing. The best time to invest is likely to be right after the worst time to invest! Admittedly, increasing stock allocation to 100% after a long period of miserable returns requires unusual foresight and fortitude on the part of the adviser, as well as the client. If you can convince your client just to maintain the 75% allocation under such conditions, you have won a major battle. However, the client is still faced with a shorter-than-average portfolio longevity, and with much less wealth to pass on to heirs than originally hoped for.”

I would add two points to Bengen’s study. First it was written when long-term real interest rates in the US were 4%. This represented good value so an allocation to them made sense. Nowadays, long-term real interest rates are now either close to zero or negative, depending on the country, which makes allocating anything to government bonds an absurd idea. Second, longevity has risen over the last 20 years so one has to make one’s portfolio last even longer than was previously the case.

Six years into a bull market it is very hard to move from a defensive to a moderately aggressive stance (if you’ve been decently weighted in equities the last six years, well done and stick with it!) Bull markets only tend to last eight years, I hear you say, so surely the next bear market is just round the corner. It is possible that the next bear market is indeed about to begin, but it is also possible, probable even, that this is not the case. The current bull market is to a large extent a function of the bear market that preceded it. Since the last one was so damaging, the recovery may well be longer. This suggestion is supported by dividend yields that are, on the whole, still above historic averages so have further to fall. Furthermore, bear markets don’t tend to begin until unemployment rates start rising (as this is when central banks start to tighten monetary conditions). Since we’re still some way off from this happening, the likelihood is that the bull market has further to run.

But there is a chance that I’m wrong, or that some shock causes markets to fall, so if you are persuaded – as I hope you will be – to increase your equity exposure at these levels, you must also be ready to increase it even further. Contingency plans are after all an important part of any strategy.

Asset Allocation and Unemployment

I am a big believer in keeping tactical asset allocation simple. The more complicated you make it – either by considering too many factors or time frames that are too short – the less effective it tends to be. To support this view I cite work done in 1979 by Richards J. Heuer Jr. involving a study of horse handicappers. The study found that as one increased the number of pieces of information available to the handicappers from one to five, accuracy of predictions increased. However, beyond five pieces, accuracy decreased. Furthermore, while accuracy levelled off beyond five pieces of information, handicappers’ confidence in their predictions continued to increase!

My approach to tactical asset allocation focuses, simply, on the business cycle and how different asset classes perform at certain times. This means having a longer term time horizon, because business cycles average around six years.

To gauge the business cycle I use one indicator: the unemployment rate. There is nothing more fundamental to an economy than the percentage of the workforce that it is not, for whatever reason, able to put to work. Employment is closely linked with economic activity, a major determinant of bond and equity markets, hence my use of it in tactical asset allocation. This of course makes complete sense. Why? Because the unemployment rate is a good measure of inflation pressures and inflation pressures are a good leading indicator of monetary policy, the key driver of financial asset prices.

Of course if one is using the unemployment rate to predict the future path of asset prices, one must first establish that the unemployment rate is itself predictable. A simple way to do this is to determine if there is a sufficiently high correlation between the change in the unemployment rate over one period and the change over the next period. If there were no correlation, this would indicate that the unemployment rate follows a random walk and is thus unpredictable.

It turns out that, at least in the case of the US, changes over four months have the greatest predictive ability (three and five months changes are less correlated than four months). The correlation coefficient between four month changes and subsequent four month changes is 0.54, which indicates a fairly high degree of correlation. If I’ve lost you, just look at the chart below showing the unemployment rate in the US over the last 70 years and ask yourself whether it looks random or whether it contains some sort of pattern.

US Unemployment Rate

Source: Bloomberg & Seneca Investment Managers as at 30/01/2015

The relationship between the unemployment rate and long-term interest rates is a simple one: inflation. If the unemployment rate is above a certain level, inflation pressures will be low or falling and thus bond prices rising. Similarly, if the labour market is tight, inflation pressures will tend to be high or rising, a not-so-good environment for bonds.

Equities tend to perfom poorly when unemployment is rising, as rising unemployment is a feature of recessions and thus weak corporate profits.

Thus, much of the time, equity and bond markets will be out of sync (negatively correlated). Safe haven bond markets like rising unemployment. Equities do not.

Unemployment Rate, The Yield Curve & The Stock Market

Source: Bloomberg & Seneca Investment Managers as at 30/01/2015

So, what are unemployment rates around the world at the moment saying about the outlook for bonds and equities?

In the case of developed markets, unemployment has fallen pretty much everywhere, the reason for the good performance of equities generally. However, rates remain above levels that would be considered inflationary, so bonds have also been performing well. Looking ahead, the US and the UK are closer to the point at which inflation will start to rise than is the case in Europe and Japan, where unemployment rates remain closer to their peaks than their troughs. So, although equity markets in all four still look well supported, they look best supported in Europe and Japan.

As for bonds, there appears to be very little value in developed sovereign markets, but since inflation pressures are likely to remain most subdued in Europe and Japan, their bonds would be the relatively more attractive, if unappealing in absolute terms.

Of course there will always be noise that causes short-term volatility, but one would be advised to ignore this and look for the pattern. Simple.

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Important information

Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/67.



Peter Elston’s Investment Letter – Issue 1 May 2015

1 May 2015


A warm welcome to this, my first monthly investment letter. The intention is for it to be thought-provoking. Simple as that.

At Seneca, we are value investors. I hate to give him even more publicity than he already has, but Woodford Patient Capital Trust’s Neil Woodford puts it well: “Valuation”, he says, “is the best form of capital protection.” I wholeheartedly agree.

Important risk, is the risk of permanent loss of capital, not volatility which measures temporary losses (and gains) of capital. In markets, what goes down more often than not goes up again: volatility should be thought of as the cost of good long term performance, not a risk to be concerned about (mine, not Woodford’s).

What is important to me, to my colleagues, to our customers, is to avoid investing in things that go down, but not up again. In other words, permanent loss of capital. How does one do this? By buying things well below their intrinsic value. In other words, by value investing. Indeed, put like that it’s difficult to understand why anyone would be anything other than a value investor!

In fact, it’s not difficult to understand: being a value investor is hard. It requires you to be contrarian, which human beings are not built for (we like to conform, to be part of a crowd). It requires you to be very analytical and objective, assessing numbers and facts rather than listening to the mass emanation of nonsense. It requires you to accept periods of underperformance: there can be periods of up to 2-3 years when the expensive outperforms. It requires you to be a bit dull – talking about discount to intrinsic value is, let’s face it, not as sexy as talking about the latest fad. But the hard work is all worth it. Funds managed by value investors generally have very good long-term track records.

Now, value investing is most commonly associated with equity investing. At Seneca we’re applying it to multi-asset investing.

Take government bonds as an example. Right now, the yield of the 30 year inflation-linked Gilt is -0.9% which means that buying and holding it to maturity will lose you 24% of your real capital. If you measure risk in terms of volatility, be my guest and invest – these things ‘look’ really safe. If you measure risk in terms of potential for permanent loss of capital, step away from the table, leaving the crumbs that may be left on it for someone else.

So, at Seneca, we apply a value investing ethos to everything we do: tactical asset allocation (the above case of government bonds being a good example), stock selection (where Graham and Dodd began), fund selection (we like managers who themselves have a value investing ethos), and sector/trend research (the value investing articulated by Graham and Dodd was as much about looking for quality and reliability, similar to that which can be found in some long-term trends, as it was about valuation measures).

The Big Picture

Looking back, the biggest events over the last 18 months have been the substantial falls in G7 bond yields and the oil price as well as the sharp rise of the US Dollar.

To be clear, what has been happening in bond markets is almost without precedent. Bond markets are thus a source of uncertainty and potential instability. Excellent real returns since the early 1980s have been driven by three things: the high level of the yield itself in real terms, falling inflation, and falling real interest rates. We are now at a point where neither inflation nor real interest rates can fall much further, so predicting poor returns from bonds has never been easier surely. But then that’s what most were doing – us included – at the back end of 2013 and look where that got them. 2014 saw US and European sovereign long bonds return 24.9% and 12.8% respectively, hardly poor.

Although one can be absolutely sure that the bond bull market will end, timing it is hard. Bond yields in the US stayed low throughout the 1930s, 40s and 50s, only rising sustainably above 4% in the mid-60s (see chart) though real returns would have been negative for some of this time as a result of high inflation during the war years.

In a debt soaked world it is very hard to get growth going. Classical economics text books ignore debt as a factor of growth, arguing that on a net basis it sums to zero. Instead, they present economic growth as a function of workforce growth plus productivity growth. I’m not trained as an economist – a good thing, I keep telling myself – but it seems to me that an underleveraged economy has the potential to grow faster as credit spreads throughout an economy (imagine how much more activity can place if a product can be exchanged for a promise rather than another product!) This is a good thing – credit, what is essentially an IOU, is one of man’s greatest inventions – but it does mean that the same must from time to time happen in reverse. The deleveraging of Japan’s private sector over the last twenty or so years stands as testament to this.

In June 2013, then Fed governor Bernanke commented that US growth forecasts were being revised up and that the Fed would soon begin tapering its bond buying program, causing bond yields to rise sharply. After hitting 3% at the end of 2013, the ten year yield has since slipped back to below 2%, defying pretty much everyone’s expectations. Despite the Fed’s optimism, it gradually became apparent that the economy would not be strong enough to absorb the ending of QE. The falling oil price only served to increase the downward pressure on inflation and thus bond yields.

It seems extraordinary that six years after the crisis we are none the wiser as to how economies will be weaned off “unconventional monetary policy”. One thing that is clear however is that central bank money printing has not led to the runaway inflation that many feared. Indeed, the opposite is the case: inflation is running below central banks’ targets for much of the developed world, and in fact is now negative in Europe. How can this be, given all the stimulus?

Economists such as Larry Summers and Robert Gordon argue that global growth is stagnating as a result of weak demographic trends and the absence of some game changing technology such as the steam engine, internal combustion engine or the silicon chip. It is also possible that workers have so much competition nowadays from robots, other labour-substituting technology as well as workers elsewhere in the world that a rise in real wages quickly results in a shift to specialists, particularly when the cost of capital is so low.

It seems therefore that one can view currently low bond yields in two ways. The pessimist would argue that they reflect a flight to safety and fears of yet-to-surface instabilities within economies and financial systems. The optimistic view would be that they reflect low inflation which is a good thing, as well as the aforementioned structural issue surrounding labour costs. In such a world, the owners of capital are the winners. You don’t get rewarded for investing in government bonds because there is no or little risk with respect to credit or interest rates.

I tend to side with the optimists, though that doesn’t mean I think bonds are a good investment. Although there may not be a new game changing technology about to burst onto the scene in the way that the steam engine and the internet did, there is certainly technological progress that does not get celebrated widely in the media. As economists Brian Wesbury and Robert Stein of First Trust Advisors note, “tablets and phones that cost a few hundred Dollars today have capabilities that cost millions just 20 years ago. Shale oil drillers are successful on most of the wells they drill versus much lower percentages of success in the days of wildcatters. 3-D printing reduces prices, while increasing flexibility in production. Low cost apps, websites, and the cloud undermine the need for brick and mortar investment.” Furthermore, although technological progress may often be linear, its effects can most certainly be non-linear. For example, photovoltaic cell efficiency may well be closing in on a tipping point at which usage takes off.

US Experience Graph Image2


Despite some proclaiming that the price fall was a sign of a weakening global economy, I suspect that increased supply has been mostly to blame. Since 2009, global supply of crude oil has increased from around 84 million barrels per day to around 94 million bpd. At the same time there has been a huge increase in the supply of energy from renewable sources. True, renewable energy still only accounts for a small percentage of total, but it is at the margin where its effects are felt.

The changing supply/demand dynamics in the energy industry represent a paradigm shift, something that the Saudis appear to have recognised. They know that the global economy can tolerate a price of $100 per barrel – after all, one barrel contains the energy equivalent of roughly twelve years of human work (based on 40hrs per week, 48 week working year) which would be valued much more highly – but also feel that they alone should not bear the responsibility for keeping it there, particularly in a world that is being weaned off the substance.

So, OPEC – for which read ‘the Saudis’ – has decided that if no one else is going to cut production, it won’t either. The resulting price fall has been forcing production cuts on the less efficient producers, rather than them being offered voluntarily. This is ultimately how a well-functioning market should operate, and demonstrates that the process of creative destruction is alive and well.

What perhaps is slightly unusual is that, unlike in most other industries, in the case of energy it is likely to be the most recent entrants – shale oil and renewable energy suppliers – who will get weeded out first, rather than the veteran incumbents in the Middle East. This is a shame, at least in the case of renewable energy, but should ultimately be seen as a good thing; the lower oil price will boost aggregate demand as well as increase pressure on renewable energy companies to improve efficiency further.

That said, I cannot see the oil price falling much below $50, despite Saudi oil minister Naimi’s unusually blunt comment that OPEC will not cut production even if the oil price falls to $20. This is game theory at its purest, with OPEC apparently attempting to engineer swift production cuts by higher cost operators so that the market can return to a more balanced state and prices back to normal, even if this is still well below $100.

The falling oil price was one of the factors behind the strength in the US Dollar but by no means the only one. Changes in expectations with respect to monetary policy are, as usual, the key factors. The reality is that by ending its bond buying program the Fed has been tightening policy. Furthermore, expectations are that the Fed will raise interest rates within the next year or so. In Europe and Japan on the other hand, expectations are for policy either to remain loose or to be loosened further. The rise in the Dollar has been exacerbated because of its status as a funding currency; as it starts to rise, many who have borrowed in US Dollars seek to pay them back, thereby adding to the strength.

Looking Ahead

The critical question I think has to be whether or not the global economy is at risk of sliding into recession. If the risk of this is low or negligible, as I think is the case given that central banks and governments generally remain very supportive, then the outlook for stocks should still be reasonable – after all, dividend yields are still decent while profitability of companies as measured by return on equity is not stretched.

In this regard, I think we still need to watch very closely for signs that the rise in the Dollar or the fall in the oil price is impacting growth in the US, the latter through closures of shale oil developments which have provided a boost to the economy is recent years. As of now, the yield curve is still steep, albeit it less so than a year ago, suggesting that a recession is not looming.

Yield Curve Graph Image

Coincident Index: shows the current state of economic activity within a particular area. Compiled using employment, real earnings, average weekly hours worked in manufacturing and the unemployment rate.

Indicators can be classified into three groups based on the time period that is being measured. Lagging indicators change after the economy as a whole changes, coincident indicators show the current state of the economy and leading indicators show where the economy is going. Coincident indicators are often used in conjunction with leading and trailing indicators to get a full view of where the economy has been and how it is expected to change in the future.

Download this investment letter as a PDF

Important information

Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP15/50.


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