Happier returns come with a warning

By BRENT SHEATHER

Investor sentiment staged a major turnaround in the three months to the end of September, as the markets bought the idea that economic recovery was imminent.

Accordingly, many investors sold their low-risk government bonds, a favoured investment among those who don't expect a return to good times.

What is bad for bonds is usually good for shares, and global stockmarkets recorded a solid gain of 2.8 per cent over the quarter, measured in New Zealand dollars.

While US shares were up by 0.4 per cent, other major markets performed strongly, with Australia and Europe up 4.2 per cent and 1.7 per cent respectively.

But the standout performer in the quarter was the Japanese sharemarket, returning 19.3 per cent. Before anyone gets too excited, Japan's long-term record is dismal, the market has a record of rallying only to fall to ever-lower lows and there is nodividend yield to rely on if the party stops.

While not matching the 14.7 per cent gain of the previous three months, the New Zealand market also performed well, returning a very respectable 3.3 per cent in the three months to the end of September.

So far this year shares have sharply outperformed bonds; in the nine months to the end of September, international shares rose 3.4 per cent while global government bonds fell 3.6 per cent. Over three years, however, bonds are still ahead of shares - by almost 12 per cent a year.

The many New Zealanders who contribute to superannuation schemes and savings plans will be encouraged to know that a balanced portfolio, like the one typically held by a pension plan or balanced unit trust, returned an estimated 6 per cent before tax and fees in the nine months, well ahead of the 4.2 per cent they would have earned in the bank.

For many investors the rise in world sharemarkets is being taken as a sign that it is now safe to buy international shares.

This behaviour is a little perverse, since the literature tells us that the art of profitable share investment is to buy when markets are low and sell when they are high. However such contrarian behaviour is notoriously difficult, as one can usually find 100 reasons not to buy when shares are low, and the opposite when conditions improve.

Despite improving fundamentals and the recent upward trend, there is a danger that a large part of the world's stockmarkets - particularly the US - are now so expensive that the return on those shares will be no better than the return on bonds over the medium term.

In the US, share prices as a multiple of profits are historically high, and dividends are low.

Depending on what method you use, prices on Wall St suggest future returns in the region of 5.6 to 6.6 per cent a year - not flash compared to lower-risk bonds, and expensive against New Zealand and Australian shares.

The New Zealand Superannuation Fund will apparently be investing internationally via an index fund which will presumably have about half its shares in the US. If the fund's high share component is based on history - with shares outperforming bonds - its strategy may be flawed.

Today's relatively low dividend yield on US shares suggests we should expect returns on those shares to be lower than they have been in the past.

On the same basis, the 4 per cent yield offered by local shares looks compelling, especially since it grosses up to 6 per cent to local investors with imputation credits. While not convincing the Guardians of the Super Fund, this factor gives local investors a good reason to have more New Zealand shares in their portfolios than the 7.5 per cent favoured by the experts.

* Brent Sheather is a Whakatane investment adviser.