How to claw back returns

By BRENT SHEATHER

If there is one thing that haunts stockbrokers' dreams above all else, even more perhaps than an insider trading investigation, it is a prolonged bear market where share prices fall month after month after month.

Such an environment is depressing not only for the psyche but for the general process of intermediating financial markets.

For one thing, stockbrokers and financial planners are perennially optimistic.

People who sell equities are generally remunerated in three ways: from a fee on the sale of some sort of equity-based security, promoting share floats or an ongoing fee to manage a portfolio.

A bear market makes the execution of any one of these processes much more difficult. Mum and Dad, after hearing the news that stock prices have fallen, decide to leave the money safely in the bank.

Share floats are less attractive for corporates because secondary market prices are low and, last, a sustained fall in stockmarkets can lead to clients wondering why they are paying the monthly monitoring fee.

Bonds are the obvious alternative asset class to shares and often tend to do well when shares are falling.

However, they are a far from satisfactory alternative to intermediaries because fees on quality bond issues are much lower than for shares.

A bear market is a bad time to be an equity salesperson and, consequently, many people leave the industry during such a period.

The three years ended March 2003 was a painful period for devotees of global equity investment, particularly their local cheerleaders who had championed international portfolios as being a safer alternative to New Zealand shares.

During that period, the S&P 500 fell 47 per cent.

A recent study of bear markets by Goldman Sachs US strategist Peter Oppenheimer shows that this millennium's first bear market has been a relatively tame affair so far.

After the Great Crash of 1929, it took 26 years for prices to recover fully from their 70 per cent plunge.

Oppenheimer suggests that by looking at previous bear markets one may be able to decide whether the rise in share prices is sustainable or just a bear market rally.

He divides bear markets into two types - cyclical and structural. Of the two, structural are much the worse - more severe and more difficult to shake off.

Cyclical bear markets are those that are caused by a rise in interest rates which, in turn, depresses economic activity.

They tend to end when interest rates begin to fall.

The really nasty ones, like the 1929 crash and, Oppenheimer suggests, the 2000- 2003 downturn, have more complex structural origins arising most commonly through a misallocation of resources.

Oppenheimer says: "Structural bear markets often co-exist with large current account or budget deficits compared with high levels of debt."

Sounds ominous, doesn't it.

But don't jump just yet.

Oppenheimer is optimistic the current pause in the sharemarket is normal and that it is three years after the low point is reached when medium-term direction tends to be determined by economic growth.

"Looking forward, the main risks are the US deficit and interest rates. Given high leverage in economies currently, a continuation of low inflation and interest rates is key.

"However, technology and globalisation should help to contain inflation.

"Structural opportunities lie with growing consumer markets in the emerging economies.

"On balance, we expect the next major move in equity markets to be upwards."

Great, but the Dow has fallen by almost 300 points since the start of August, so what if he is wrong? Can we insure our portfolios against another 1929 monster and, if we can, should we bother?

In New Zealand, indeed around the world, many investors were chastened by the 2000-2003 experience and have bought into an asset class which promises to be less risky than stockmarkets yet outperform bonds.

If you believe marketing brochures, that asset class is hedge funds.

However, some experts are raising questions about just how well a hedge strategy will protect assets in a nasty structural bear market and suggest that a combination of high returns and low risk sounds too good to be true.

Certainly, Warren Buffett doesn't buy the hedge fund story - he reportedly has US$40 billion ($60 billion) on deposit.

Some recent research raises other questions. The Financial Times says a study by Mercer Investment Consulting suggests hedge funds do almost as poorly as other risky investments when things go badly.

Are hedge funds like umbrellas which you can only use when it is not raining?

For the truly bearish, there is always gold, silver and cash - but it is worth noting that in the United States, in the worst bear market of all time, during the Depression, the best-performing asset class was long-term government bonds.

In times of moderate inflation and positive growth, it is easy to be convinced that bonds are for sissies, but if ever inflation goes sharply negative again anything with a government guarantee and a 6 per cent coupon will look pretty smart.

* Brent Sheather is a Whakatane-based investment adviser .