In the world of finance it has been a difficult Summer and a turbulent Autumn.
These types of volatile conditions often expose weaknesses that auditors and investors have missed, and this has proved to be so again.
Northern Rock investors discovered that the ‘borrow short’ (and in significant quantities!) and ‘lend long’ policy that they thought was the alchemy of their board’s business model, turned out to be no more than fool’s gold.
Leading international banks and credit rating organisations were embarrassed to discover that people with inadequate income, no assets and a poor credit history tend to default on their loans (something that any pawn broker could have told them).
So, Chuck Prince (head of Citigroup – the world’s largest bank), Stan O’Neal (head of Merrill Lynch) and Adam Applegarth (Northern Rock’s CEO and a lightweight by comparison) lost their jobs.
Outside the private sectors, politicians discovered that they too can be found-out by financial turbulence.
Our ex-Chancellor is no doubt wishing that he had stuck to the maxim “if it’s not broke, don’t fix it” and resisted the temptation to tinker with a UK regulatory system that had avoided a run on a major national bank for hundreds of years (the last one, 150 years ago, was minor compared to Northern Rock).
No doubt the new Chancellor understands the reality of the phrase “I promise to pay...” which is on all UK bank notes.
Someone once said to me that only a very wealthy man or a fool underwrites the debts of a bankrupt.
I am not sure where that places the new Chancellor, after all, it is our money (the tax payers) and not his that is propping up a business (Northern Rock) decimated by the largess and ignorance of its directors.
Why do I mention all this? Firstly, because it highlights the fact that markets can be ruthlessly effective in dealing with inefficiency, which is healthy for the global economy and, secondly, because it is at times like these, when everybody is worried about economic growth, sub-prime loans, declining house prices, bank solvency etc, that opportunities arise.
Remember, when equities decline in value it rarely “feels” like a buying opportunity, but that is when fund managers should earn their corn.
Throughout the Summer, bonds have proven attractive to investors who have become more risk averse. As a consequence, bond yields have declined and the return on UK 10-year Government bonds is now just 4.56% per annum.
Meanwhile, as equity prices have declined price earnings ratios (the number of times the company’s profits will go into its share value) have fallen. The inverse of the PER is the earnings yield (the amount of profit as a percentage of the stockmarket value of the company) and this has risen and is approaching 9%.
The difference between the earnings yield on FTSE 100 companies and the yield on 10 year bonds (over 4%) is the highest it has been for many years and is a strong indicator that equities are significantly better value than bonds.
For these reasons we continue to maintain the maximum allowable percentage allocation of our funds in equities whilst minimising the duration of the proportion of our funds allocated to bonds.
This takes a little nerve when all is doom and gloom, and I have to say I expect some volatility in markets for the foreseeable future. But for those who can accept the ups and downs of equities the potential rewards, over the next few years, are very attractive. The financial markets may, at present, look like a dark jungle, but there are certainly diamonds in there.
Gary Reynolds is director and chief investment officer at Courtiers
The views expressed in this article of those of its author and do not necessarily represent those of IFAonline or any other Incisive Media affiliated organisation.IFAonline
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