Brent Sheather: Mixed signals make it tough for investors

As the 2008 financial crisis unfolded central banks around the world reacted calmly because the conventional wisdom was that the chairman of the US Federal Reserve, Ben Bernanke, had earned his PhD studying the Great Depression. Therefore he and all the other experts knew the big mistake that was made back then.

That mistake was glaringly obvious - monetary policy was tightened and interest rates raised when the opposite should have been done.

In other words, when faced with a crisis of confidence and the likelihood that falls in stock markets and house prices would make people feel less wealthy, more cautious and spend less, governments should offset lower private sector spending by increasing the public kind.

Increased taxation wasn't an option during the Depression so the government had to either borrow more or print money.

This time around the US has pursued the latter two options and consequently government debt has risen from US$5.4 trillion in 2008 to an estimated US$9.1 trillion ($11.77 trillion) today, according to the CIA World Fact Book.

More public debt to pre-empt the slump was the received wisdom back then but the sceptics are becoming more vocal as, unfortunately, the money has been spent but the economy has not bounced back anywhere near as strongly as the experts had expected.

So having fired all the bullets the $10 trillion question is - what next, Ben?

Critics of the "spend your way out of trouble" model argue that all of the Federal Reserve efforts so far have just made matters worse and put off the inevitable day of reckoning. Indeed very few rational individuals would accept that the solution for a household with too much debt was to borrow more. Common sense is that one should cut spending and try to pay back debt.

Furthermore even governments can't keep on borrowing forever - higher borrowings are associated with lower growth and money printing risks currency debasement and ultimately a loss of confidence in the currency. This is why gold is so popular at present.

Lurking in the background of the current uncertain environment is the suspicion that this whole financial crisis is because of the greed of the banking sector, hence the Occupy movement in various countries. The Archbishop of Canterbury, writing in the Financial Times, said that many people see the protests "as their expression of a widespread and deep exasperation with the financial establishment". Amen to that.

There is some truth to this line of thinking, as James Grant puts it in the latest Grants Interest Observer - "if ideas could file for bankruptcy protection the modern model of money in banking would have beaten MF Global Holdings to the courthouse".

He complains that the banking business is full of asymmetric options as, on the one hand, if Mr Banker takes a big risk and it pays off he gets a bonus in one year large enough to buy himself a nice house in the best area of London. If it turns to custard the government, and ultimately taxpayers with proper jobs, will bail him out.

Grant also traces the steady increase in leverage of the banks. In the mid-19th century banks would typically lend out $3 for every dollar's worth of shareholder funds. But by 2007 the average had expanded to $30 loaned per investor dollar.

Grant reckons that this increase in risk-taking has occurred because in the 19th century bank shareholders had unlimited liability. This means that if you were a shareholder in a bank and someone defaulted on a loan you were liable to pay back bank depositors.

Contrast that with the situation today where shareholders have limited liability and the big banks are too big to fail, thus they know that the government will bail them out if they get into trouble.

The finance sector needs to have greatly reduced profits forced upon it. I touched on this in July last year when I reviewed the work of Paul Woolley at the London School of Economics.

Kenneth Rogoff, co-author of 2009 book This Time is Different, Eight Centuries of Financial Folly, offered the view in an interview in CFA Magazine that the current crisis is remarkably similar to previous crises. He noted that banking crises were usually followed by sovereign crises a few years later.

As to the future, he reckons the good news is that, so far anyway, all financial crises have eventually ended. But the timeframe for recovery is usually six to 10 years.

He also notes that once government debt gets over 90 per cent, economies start to slow. This is significant because one way out for a government with high debt is to develop the economy and thus tax receipts.

The US debt to GDP ratio is around 100 per cent. When questioned on the European crisis, Rogoff's view was that the most likely outcome was defaults in Greece, Portugal and Ireland but Germany will draw a line at Spain and Italy.

So what should investors be doing in this environment? Some financial advisers and stockbrokers advocate buying shares on the basis that on short-term measures shares look cheap. Andrew Smithers of Smithers and Co London strongly disagrees, arguing that shares are actually expensive on the basis of the 10-year price earnings ratio, that profit margins are at a high and have a history of going back to the average, and that the deleveraging process from the government will mean less spending in the economy and thus lower profits.

Most advisers are warning against bonds, which is actually a good omen for that asset class on the basis that the majority are usually wrong. There are, however, less obvious pointers to the future - the efficient market hypothesis has been criticised of late as an outdated theory but it is interesting to note that despite that fact hardly anyone is beating the market.

So maybe we should look at the stock and bond markets for information. What are they telling us?

US bond yields haven't been as low as today since the war years, so the implication is that inflation and growth will be much lower than usual. Not a great environment for shares. Also, in the past, when dividend yields on shares were higher than those for bonds, this has been a reliable buy signal for shares. But historical data shows that it has only been "normal" for dividends from shares to be lower than the income from bonds since about 1956. Before then dividend yields were higher than bond yields.

Local bond yields are much higher than those of the US and almost as high as the forecast return on global equities before fees, so it may be that local bonds are good value. However, we also have to consider the possibility that bond yields are lower than they should be because of the actions of central banks. All a bit confusing.

In such an environment it is important for financial advisers to be modest, acknowledge the uncertainty and continue to diversify clients' portfolios. One of the biggest threats to Mum and Dad's retirement is the adviser who doesn't know that he or she doesn't know.

Brent Sheather is an Auckland-based authorised financial adviser and his adviser/disclosure statement is available on request and free of charge.