Secrets Of Success: For market wisdom, follow the bears

By chance, this week two of the more bearish professional investors I know both gave their views on the outlook for markets this year. As they have (on my calculation) some 80 years of experience between them, and track records commanding respect, it seems unwise to overlook their arguments.

By chance, this week two of the more bearish professional investors I know both gave their views on the outlook for markets this year. As they have (on my calculation) some 80 years of experience between them, and track records commanding respect, it seems unwise to overlook their arguments.

Their views are based on taking a longer-term perspective on current market conditions than you will hear from anybody in the City, where short-termism still rules. There are, however, important differences between the two men.

The first bear is Ian Rushbrook, the managing director of Personal Assets, the Edinburgh-based investment trust, whose views I have more than once referred to. Personal Assets, unlike many generalist investment trusts, is run solely for the benefit of individual private investors.

In the 15 years since Rushbrook took it out of the Ivory & Sime stable, he has demonstrated, among other things, that it is perfectly possible for an investment-trust board to manage its share price so that the discount is eliminated.

Personal Assets has been run in defensive mode for five years, with something like a third of its assets in cash. But it cleverly uses futures contracts to retain some exposure to bear market rallies of the kind Rushbrook thinks we have seen in the past two years. His verdict in this year's annual report is unambiguous: "We believe equities to be overvalued, with ever-increasing risks of a correction, coupled with returns that in the short to medium term cannot be expected to be other than modest."

He also believes that Alan Greenspan, the chairman of the Federal Reserve, is largely responsible for the distortions in financial markets that have produced, Rushbrook says, some extraordinary shifts in investors' attitudes to risk in the past two-and-a-half years. Yields on high-yield US corporate bonds, for example, have halved from 14 to 7 per cent in that time, and the spread of emerging-market bond yields over government bonds has fallen from over 10 per cent to under 4 per cent.

These moves have largely been driven by investment banks and hedge funds taking advantage of Greenspan's low short-term interest rates to make easy profits from short-term trades in higher yielding assets (the so-called "carry trade"). Nice for them, but not without adverse effects. One is that investors now "seem to be falling over each other to settle for much, much lower returns than they did before, in exchange for taking on higher risks".

What's more, Rushbrook says, the misvaluation of bonds means that equities as an asset class appear "significantly more attractive than they actually are". This is clearly not a prudent or a sustainable process, although, as he also concedes, it is not obvious when the present overstretched valuations of financial securities will come to an end.

The implicit message is: sensible investors should not be lulled into taking more risk in this febrile climate than they can afford.

David Kauders, the second bearish professional whose views were aired, comes at the investment climate from a rather different angle. He's one of the few financial advisers who can justifiably lay claim to the title "independent", as he rarely speaks with one mind with the rest of the IFA community and deals only in government bonds, eschewing all those commissions on funds.

In a presentation in London, he argued that the world is heading for a global economic slowdown. He warned that the disinflation we have seen in the past 25 years will soon turn into deflation, as it has in Japan since their markets peaked in 1989. He also thinks (as I do) that the property market is a bubble inflated by cheap money that must burst in due course.

On equities, his take hasn't changed much over the past five years. He too argues that the rise in share prices since March 2003 is nothing more than a typical bear-market rally of the kind seen at least four times in Japan since 1989.

Having fallen from 6,900 at its peak to 3,400 at the low point in 2003, the FTSE All-Share index has rebounded by about 50 per cent, which is typical of bear-market rallies. The bottom of the bear market may not come for 10 years, in his view, and will be driven mainly by waves of enforced pension-fund selling.

More importantly, from his perspective, he thinks that investors are still failing to see the real attraction of government bonds, even at today's puny-looking yields. He compares the situation today with the time when gilts were yielding 12 per cent and you could get cash returns of 15 per cent.

Sure, he says, you would make a bigger short-term turn by switching into cash, but longer-term that was a dumb move. Quite apart from the capital gains that accrued as yields fell, those who bought gilts back then are today still getting fat cash returns each year that far outstrip returns on cash.

His argument is that the prudent investor, faced with an uncertain climate and the prospect of deflation, should lock in government bond yields at 4.5 per cent while they can. In two to three years' time, that will look a pretty shrewd move if, as he expects, inflation takes a further step back and we are heading towards minuscule interest rates. The great feature of all bubbles in financial markets, he says, is that those inside them never realise the fact.

What to make of these two warnings? The only sensible answer is: be careful, be aware, and remember that getting the big picture right is far more important than catching short-term market moves. My own feeling remains that the risks in today's financial markets are real. Equities are due a big correction, although maybe not until next year. As a pragmatist, I prefer to wait for the markets to tell me that the bear market has begun again, or that economic growth is slowing, before reducing my limited exposure to them as a class.

Meantime, it looks like the small-cap boom has run its course, and prudent investors will look more carefully at large-cap stocks in portfolios. As for bonds, the riskier types (corporate bonds, emerging markets) look full of hazard for medium-term investors.

jd@intelligent-investor.co.uk