Home / Peter Elston’s Investment Letter – Issue 10 February 2016

Peter Elston’s Investment Letter – Issue 10 February 2016

It is possible that we are now in an environment in which the falls in markets since last summer, particularly those in early December and throughout most of January, begin to have an impact on aggregate demand (which anyway was already somewhat insipid what with on the one hand the US nearer the end than the beginning of its business cycle and on the other hand China slowing structurally). If people or companies feel more uncertain as a result of market declines, they may reduce their spending or investment patterns which could cause a recession.

How one judges whether this will happen and thus whether a protracted bear market looms is an almost impossible task. The global economy is an example of what is known as a non-linear complex adaptive system. Or to put it another way, it’s unpredictable. Fear can spread like wildfire, feeding on itself. And fear can be rational, as in bumping into a tiger, or it can be irrational, where one is fearful for no reason other than that others are fearful. Whether the crowd’s fear is itself rational is neither here nor there. Why wait to find out? It is human nature to run first and ask questions later. This reminds me of the conversation in Joseph Heller’s classic novel Catch 22 between Yossarian and Major Danby: “But, Yossarian, suppose everyone felt that way?” to which Yossarian replied, “Then I’d certainly be a damned fool to feel any other way.” You cannot argue with the logic.

You may think me barmy but below is my favourite chart (Chart 1). It depicts book values over the last 15 years of portfolios invested on 31 Dec 2000 in various MSCI indices, rebased to 1. In other words, no account is taken of subsequent movements in equity markets, only of dividends received. The series are calculated by simply dividing the total return indices by the respective capital only indices. Think of them as the accumulated value of dividends received (if you look carefully you can just about discern a slight flattening of the lines in 2009 when dividends fell, meaning that the rate at which dividends accumulated fell slightly).

Chart 1: Dividend indices – accumulated value of dividends derived by dividing total return indices by capital only indices

Source: Bloomberg Dec 2015

The point of the chart if you haven’t realised it is this: if dividends are so stable, why are markets so volatile? (I keep a copy of this chart pinned up on the wall near my desk to remind me to keep wondering about this question). The fact is that dividends in aggregate rarely fall and when they do they recover quickly. Why do markets sometimes behave as if dividends are going to dry up for good when the likelihood of this happening is so remote? Furthermore, why worry about this possibility when the circumstances that would cause it such as a nuclear holocaust or an asteroid hit would almost certainly cause you to worry about things other than the value of your portfolio. The answer to both of course is: human nature. Humans run first and ask questions later.

What this means of course is that if you step back and behave rationally, you can take advantage of the irrational behaviour of the crowd.

In 1981 Yale’s Bob Shiller wrote a paper titled “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?”

In the paper, Shiller noted that it had “often been claimed in popular discussions that stock price indexes seem too “volatile,” that is, that the movements in stock price indexes could not realistically be attributed to any objective new information [about dividends], since movements in the price indexes seem to be “too big” relative to actual subsequent events.”

To illustrate the point graphically, he plotted (see Chart 2 below) the S&P Composite index, P, against the present discounted value of the actual subsequent real dividends, P* (both series were de-trended so one could more clearly see the variations around the trend). What is clear from the chart is that the answer to the title of Shiller’s paper is ‘yes’, stock prices do indeed move too much to be justified by subsequent changes in dividends.

Chart 2: Actual S&P composite index and theoretical value based on discounted future dividends (both de-trended)

Source: Robert Shiller, 1981

Shiller’s paper dispels the notion that stock markets are efficient. Markets are simply too volatile to be justified by big changes in discount rates (real interest rates) or by people being rightly fearful of collapses in future dividends. Given that dividends haven’t collapsed in the past and that the sample size is large, it is highly unlikely that they will in the future. Companies have the ability to adapt to prevailing conditions. In the face of lower earnings, they can cut payout ratios in order to maintain dividends. They can cut capex, costs or prices. In the face of higher inflation, they can raise prices. All this means that companies in aggregate have a remarkable propensity to deal with and recover from recessions.

Shiller’s key conclusion is that markets are not efficient. If markets were efficient, they would track much more closely the present value of future dividends, something that can be reasonably estimated and which is very stable. Thus when markets veer a long way from the present value of dividends as they have a tendency to do, they will naturally be drawn back towards it, also known as mean reversion. This means it is possible for tactical asset allocation to add value.

To illustrate further this tendency for markets to recover, I have investigated how the US equity market has behaved following instances when it has fallen by various amounts in relation to its all-time high. Specifically, I have calculated how long it has taken the S&P 500 index to recover its all-time high once it falls certain percentages from said all-time high and what the annualised return has been during these periods. As of 20 January 2016, the S&P 500 was 12.7% below its all-time high attained on 21 May last year. Thus, I have considered all other periods since 1955 when it has fallen by the same amount, as well as by 20%, 30% and 40%. The results are shown in Table 1 below.

Table 1: Evidence of mean reversion in US equities

Source: Bloomberg, 20 Jan 2015

On the 13 occasions since 1955 when the S&P 500 has fallen by 12.7% from its all-time high, it has taken an average of 581 days (roughly 2 years) to regain its high, during which time the annualised return has been 6.3%. This is in fact slightly lower than the long-term average of 6.6%. However, when the index falls by more than 20%, the annualised returns to get it back to its all-time high have been well above 6.3%.

What this means is that judging by the history of the last 60 years a decline in the order of what we have seen over the last 8 months should not prompt one to increase equity weightings. However, if the market falls further, one should begin to get excited. And one should continue to get more excited the further the market falls. Gamblers call this a Martingale strategy and it works when applied in markets where there is mean reversion as is the case in equity markets.

Although it is certainly possible that we have entered a protracted bear market in equities, I don’t believe this to be the case. Economies around the world still in general have scope to grow, as evidenced by negative output gaps, low inflation, and unemployment rates that can fall further. Monetary policy can remain supportive (as we go to print Japan has introduced negative interest rates). And there is also scope to boost fiscal policy if necessary, though this would more likely be a response to a recession rather than slower growth. As for equity valuations, dividend yields are well above historic averages, which in the absence of a nuclear holocaust or asteroid hit represent good value. Thus, I don’t think markets will continue to fall for much longer but if they do we will be ready.


Inflation watch

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


Table 2: Inflation data releases over past month

There are very tentative signs of improvement in inflation numbers around the world (improvement could mean it either rising if it is too low or falling if it is too high). Numbers in Japan and the UK, while still below desired levels, were higher than both prior month and survey. Among the BRICS countries, China and India saw a similar pattern, though inflation rates in Brazil, Russia and South Africa were still high and rising.

I remain of the view that although monetary policy is not a cure for all ills, it can certainly help to get inflation back to desired levels in the medium term. For further reading, I would recommend former Fed governor Ben Bernanke’s 2002 speech Deflation: Making Sure “It” Doesn’t Happen Here. Below is an extract:

By increasing the number of U.S. Dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in Dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

I do not believe as some do that QE has failed. Frankly, what choice did central banks have once short term rates hit the zero bound? To get out the white flag and give up? Although headline inflation rates across the developed world are very low and in some cases negative, this is largely the result of falling commodities prices, in particular the oil price. Taking out food and energy, inflation is not so worryingly low. Yes, it will likely be a long haul, but central banks have come a long way from the policy errors of the Great Depression. And even Germany now understands that in combination with sensible fiscal policy, QE does not have to lead to hyperinflation.



Employment watch

Most if not all central banks are tasked with maintaining price stability and full employment. This section looks at recent employment trends and what they might mean for monetary policy around the world.

Table 3: Employment data releases over past month

Source: Bloomberg

On the whole, labour markets in key global economies continued to improve. Brazil’s unemployment rate unexpectedly fell in December, though it is hard to conclude at this point that this is definitively good news in light of rising inflation and the nasty recession that Brazil is experiencing currently.


Specialist investments

We have decided to stop using the term ‘alternative investments’ to describe our investments that are neither equities nor bonds, and instead will use ‘specialist investments’. We have found that the term ‘alternatives’ tends to be associated with potentially high risk vehicles such as structured products, hedge funds, art, wine, coins, and stamps, none of which as a matter of policy we would invest in. What we are looking for in this area are investments that genuinely offer something of value in relation to equities or bonds. For us, this means income streams that are more stable than those of equities and more real (index-linked) than those of bonds. It also means yields that are generally higher than equity market yields. And finally, most of our specialist investments are listed on the London Stock Exchange.

We have four sub asset classes within the broad ‘specialist investments’ segment: REITs, private equity, specialist financial and infrastructure. While we considered using the term ‘real assets’ which others are using, we felt that this term too was misleading, suggesting as it does investment in the aforementioned non-yielding art, wine, stamps etc. What links all four sub asset classes is that they are ‘specialist’ in some way or another. So, we have decided to use the term ‘specialist investments’.

Table 4 below provides data on seven of our ‘specialist’ investments. The message is a simple one: our specialist investments have been great ‘diversifiers’. The seven in question have all outperformed and been less volatile than the broader equity market since listing, and have all been lowly or in some cases negatively correlated with the broader equity market.

Table 4: What do our specialist investments bring to our portfolios?

Source: Bloomberg

On a related matter, we have now aligned the strategic asset allocation within LF Seneca Diversified Growth Fund’s specialist investment segment with those of our other two public funds. Previously, the growth fund had a small allocation to commodities and a lower allocation to REITs. We felt that in the case of commodities, since physical commodities do not yield anything they are hard to value and thus should not be part of our strategic asset allocation. As for REITs, we felt there was no good reason why the growth fund should be any different to the other two funds. REITs may not be as ‘growthy’ as equities, but they can provide a good alternative to bonds (in the credit space rather than safe haven space).

Table 5 below sets out the strategic asset allocation weights within our ‘specialist investments’ segment, showing that all three funds now have the same weightings in this area.

Table 5: Strategic asset allocation within ‘specialist investments’, as percentage of total (previous in brackets)

Source: Bloomberg



Current fund targets (as of 22 January 2016, end Nov ‘15 targets in brackets)

The targets in Table 6 below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example. Note that since we did not include the below table in the January letter which was dedicated to the 2016 outlook, we are using end November targets for comparison.

Table 6: Current and previous target weights of our three public funds

Source: Seneca Investment Managers, Dec 2015


  • We increased equities target across the funds in early to mid-January from 2 percentage point overweight to 4 percentage point overweight, funded out of a combination of cash, fixed income, and specialist investments
  • This increase was driven more by bottom up factors and was all in UK where our UK equity specialist was keen to introduce two names, Victrex and Royal Dutch Shell
  • Victrex is the world’s largest producer of polyether ether ketone, a high performance polymer for which new uses and users are continually being found by the company; 3.2% dividend yield to Sep 2016 which we think is attractive given growth prospects and balance sheet with net cash; special dividends also likely over next two years
  • As for oil major Royal Dutch Shell, this was very much a contrarian investment idea; the shares had fallen materially over 2014 and 2015 and we felt the 10% dividend yield was extremely attractive even if the dividend were to be halved as seems very likely
  • The notable holding level target reduction was in specialist investment Assura plc, the niche healthcare property vehicle; it had performed extremely well in 2015 and the yield had fallen to 4%, a level we considered unattractive in comparison with our other REITs
  • It is encouraging to note that the timing of our addition of Halfords to the target portfolios at the very end of November was very opportune; the stock is now trading above our average purchase price which given the performance of equity markets is an excellent result; early days yet of course but it is always nice to get the timing as well as the long term right


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Important Information

Past performance is not a guide to future returns. The information in this document is as at 31.01.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
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 and do not constitute investment advice. Whilst Seneca 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.
LF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Link Fund Solutions, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.
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