Brent Sheather: Deflation requires an entirely different strategy

Opinion

It is August 1929, the very top of the bull market, and lucky Aunt Daisy has just retired. Taking the advice of her certified financial planner, she has invested all her hard-earned $50,000 in the stock market.

Fasten your safety belt, Daisy! Whereas in last fortnight's column Uncle Sam was interested in total return - capital gain plus dividend income - Daisy is primarily interested in cash dividends, because she intends to live off her capital and reluctantly leave the residual to her three useless children, who apparently spend all day sleeping and all night dancing. Apart from the stock market crash, 1929 doesn't sound like a bad time to be alive. In fact, if my memory serves me right, which is questionable, it sounds a bit like the 1970s.

But I digress - the scary thing about the 1929 sharemarket crash (as opposed to the 87 crash) was that it was followed by a really bad depression in the real world, where growth and inflation went into reverse and millions of people became unemployed. J.K. Galbraith writes in The Great Crash, 1929: "A common feature of earlier stock market crashes was that having happened they were over. The worst was reasonably recognisable as such. The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning."

Needless to say, when the economy turned down, company profits plummeted, so Daisy's dividend income fell precipitously also. But if you owned the market portfolio - every listed company weighted according to its size, as index funds do, and Daisy did - dividends didn't disappear completely.

The graph shows Daisy's income from a widely diversified portfolio of US stocks and the capital value of the portfolio. Also shown for comparison is the cash income that Daisy would have earned if she put the money into short-term bank deposits or 10-year government stock.

The shocking thing from the graph is that if Daisy had invested all her $50,000 in the bank, her annual income from 1933 to 1942 would have averaged less than $100 - and in some years was actually zero as bank deposit rates got down to nothing.

Could it happen in New Zealand? Who knows, but in America and Japan it is happening now and my guess is many people wished they had bought some long-term government bonds to protect their income. Anecdotal evidence in New Zealand suggests that if bank interest rates fall dramatically here, a large number of retired investors are going to see their income plummet. People like saying that "cash is king" but, as we can see in a depression, cash is anything but king. Not only does it not diversify portfolios as well as bonds, it potentially produces no income either.

Analysis of the actual historic dividends paid for the period shows that Aunt Daisy's income from stocks did not dry up completely. Sure, it halved in 1932 and, as the graph illustrates, it was very volatile. But over the 15.5 years, it was about equal to the income from a government bond portfolio and more than three times that from short-term treasury bills (a proxy for bank interest rates).

The dividend yield on US stocks stayed reasonably constant over the period at 4-7 per cent. However, this yield was on a rapidly diminishing capital base. In fact, Daisy's children received less than half, in nominal terms, of the amount that Daisy originally invested some 15 years earlier. Most people would consider 15 years as being "long term", but even 15 years wasn't enough for Aunt Daisy to get her initial capital back.

One of the most extraordinary things about the Depression era was that short-term government stock rates - a close proxy for bank rates at the time - plummeted after 1929 and averaged less than 0.5 per cent a year in the period 1932 to 1947.

If the history of the 1930 to 1940 period has one fundamental lesson, it is the attraction of long-dated government stock in a depression. Many banks went bust in the 30s, so there are no prizes for guessing what happened to finance companies lending to the entrepreneurs. Sensibly constructed investment portfolios must be robust enough to cope with all economic conditions, ranging from inflation to deflation.

The risk of this latter phenomenon, a fall in the general level of consumer prices, presents investment advisers with an overwhelming case for including some long-term, low-risk bonds in every client's investment portfolio, no matter how young and "aggressive" they are.

In 1932 in the UK, consumer prices fell by 18 per cent. Even with government bonds yielding just 3 per cent, this was a real interest rate of 21 per cent. Deflation, if sustained, would put highly geared companies under huge pressure as the real value of contracts fixed in money terms would be increased, just as inflation reduces them.

Over the past 20 years or so, the biggest threat to most New Zealanders' wealth has come from inflation, so investors have been conditioned to concentrate on the risk of increasing rather than falling prices. In an environment of high inflation, high tax rates and low real interest rates, the most appropriate investment response has been to borrow heavily and invest in assets with a proven inflation-proofing ability - that is, residential property.

Deflation requires an entirely different investment strategy where security of cashflow is paramount and debt is minimised.

Some lessons from the 1929 crash which are especially relevant today:

* Hold a diversified portfolio including lots of medium- and longer-term safe bonds.

* If possible, eliminate debt and choose a floating rate.

* Avoid companies with high levels of long-term fixed-rate debt.

* Diversify your equity portfolio widely. Holding only 10 stocks is asking for trouble.

* Gearing either via options or margin trading is a very risky strategy.

* Don't panic, things eventually will (probably) get better. But if you must panic, make sure you are the first one to panic.

Another piece of advice on sharemarket panics I read recently - "If you keep your head when all around you are losing theirs, you obviously don't appreciate the seriousness of the situation."

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