Investors switch focus

By KEVIN ARMSTRONG*

Where's the return? And where's the risk?

These are perhaps the most challenging - and certainly the most important - questions that investors ever have to face as it is only by attempting to thoroughly measure and understand the risk of an investment that the potential return can be seen as attractive or not.

Just because an investment offers a potential return of say 12 per cent, it is not automatically attractive.

Now, after almost three years of the most damaging bear market for shares that the world has witnessed for about 70 years, these questions are more important and more challenging than ever before.

What is most interesting is that over this three-year period, the chorus to investors from "experts" has changed from "buy and hold for the long term" to something along the lines of "expect modest returns at best going forward from investment".

This is a staggering about-face after a period of substantially less than modest returns from shares. In fact, most global investors would have been delighted with modest returns over the past three years rather than their actual losses of between 20 and 80 per cent.

The generally used explanations for why share market returns will be at best modest going forward include: shares are still expensive, even after three years of decline; earnings growth is uncertain and may still be untrustworthy; tension in the Middle East; the US and global economy may be on the brink of slipping back into recession; deflation is the biggest risk facing the world currently.

It is remarkable how views change with falling prices. A year or so ago, as the US Federal Reserve was cutting interest rates with almost unprecedented vigour, the major concern was that their action would reinflate the "bubble" and cause rampant inflation. Neither happened and now the rising belief is that the Fed is running out of ammunition and has lost control, leading to a devastating deflationary spiral not seen outside Japan since the Depression.

Many of the concerns or rationalisations listed above have been broadly discussed for some time and what has to be born in mind is that share markets are outstanding "discounting" mechanisms; in other words, they quickly price in rising optimism or fear.

Given that shares have been plunging for the best part of three years, and by anything up to 80 per cent or more, much of this changed outlook must already be priced in or reflected in the market's current level.

Unfortunately it is now, after these declines, that we are seeing changes in investors' and advisers' behaviour.

With the carnage in shares now obvious to everyone, and with the expectation of modest returns at best from shares, investors who were previously "long term holders" are now fleeing shares in their droves. Statistics on money flows into managed funds throughout the world show that whereas three years ago, at the peak in share prices, record amounts flooded into managed funds, now the reverse is occurring with record outflows.

It may not be exactly the same individuals who were "long-term investors" at the peak who have now panicked, having suffered enough, but it may well be.

Now, with experts calling for only modest returns, those same investors are comfortable about avoiding shares and settling for keeping their principal secure in bonds and cash funds.

It has been a truly remarkable turnaround in investor sentiment over the past few years. Perhaps the most troubling aspect of this turnaround is how investors' appreciation of risk has changed and, as noted earlier, the appreciation and understanding of risk are essential in any investment.

At the peak investors had little regard for risk and were focused only on the much-anticipated return that the "new era" promised. It turned out to be a huge bubble, as most "new eras" do.

After suffering huge losses, investors have decided to give up on the pursuit of return and focus only on risk avoidance, hence the tidal wave of money in the US into cash funds with negative real yields and into bond funds with yields at 40-year lows.

How much risk these investors are actually taking is best demonstrated by looking at the benchmark US 10-year Treasury bond.

At the recent sharemarket lows, this bond was yielding 3.6 per cent, the lowest yield seen since 1961, down from 5.5 per cent just six months earlier and 6.7 per cent at the sharemarket peak.

Investors pouring huge sums into these and similar bonds at such low yields shows how concerned they are over the security of their principal.

However, it is possible that those same investors have failed to appreciate all the risks they are taking on with these bonds.

It is safe to assume that US and New Zealand Government bonds are reasonably secure and that an investor holding these bonds to maturity will receive the yield they expect. However, this is only true so long as the investor really is a long-term investor and holds the investment to maturity.

In the meantime - and on a 10-year bond there is a lot of meantime - interest rates can change. This affects the value of all bonds.

With long-term interest rates at or near record lows, the possibility clearly exists for these rates to rise and the result of rate rises from such low levels can be quite damaging. An investor who purchased a 10-year US Treasury bond in early October at a yield of 3.6 per cent would suffer a loss in value of 15 per cent if rates rose over the next six months back to where they were six months earlier.

The loss would be an even more dramatic 17 per cent if, over the next two years, rates rose back to where they were two and a half years earlier. These are remarkable losses although they would be only paper losses if the investor held to maturity.

Remaining a long-term investor is more likely in bonds than shares but, as we have seen over the past three years, investors' intentions change as prices change. Movements in interest rates therefore pose as important a risk for bond investors as the quality of the bond they're buying.

Bonds are not equally attractive at all times, particularly when compared to shares. This can clearly be seen in the accompanying chart that shows the relative return of US shares versus US bonds over the last 40 years. It clearly shows that over the long term shares do perform better than bonds - however, this outperformance is in no way steady and there have clearly been times when bonds have been far more attractive than shares.

The most recent occasion when this was the case would have been at the end of 1999 and the beginning of 2000. For several years shares had been in a rampant bull market and bonds had been performing poorly; the result was that shares had outperformed bonds by about as much and for about as long as they ever had and what followed was a remarkable reversal.

For the past three years or so, bonds have outperformed shares in as dramatic fashion as they ever have and it would therefore seem sensible to ask the question: "Is now the time to aggressively buy bonds, or have international shares now become more attractive?"

The answer to this question naturally depends upon each investor's tolerance to risk. However, it is certainly possible that much of the highly publicised risk in shares has now been priced in and that the actual risk in buying long-term bonds at such low yields is perhaps higher than many believe.

Getting back to the original question, it may well be that shares will produce far greater returns than bonds over the next year or two with substantially less risk than most investors currently perceive.

* Kevin Armstrong is chief investment officer, Private Banking Division, at the National Bank of New Zealand. The views expressed in his article are his views/opinions and do not reflect the views of the bank.