Highlights in this issue:

*** When market start behaving out of character you get the chance to make BIG money …
*** Why you should short commodities before the bubble bursts...

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From the pen of Karin Iten…

Dear Investment Academy Reader,

Investment bubbles shouldn’t exist. If markets were truly efficient, then as soon as the price of an asset rose above “fair value”, investors would sell it. The same goes for bargains – any “cheap” shares would be snapped up, driving the price back to its rightful level.

Of course, this is nonsense. In the last ten years alone, the tech bubble and the credit bubble have disproved any notion that we can eliminate boom and bust. So bubbles are a simple fact of life when it comes to investing. But if you accept that, it becomes easier to exploit them in the early stages, and avoid getting caught in the inevitable bust. MoneyWeek strategist Tim Bennett reckons he knows how.

Look out for the strange

Watch out for “a period in which returns on a particular asset class appear to be somewhat strange,” says Michael Dicks of Barclays. More precisely, pay attention when an asset’s short-run returns seem to be above or below its long-term risk adjusted returns equilibrium (RARE). To put that into plain English – if an asset class has recently done really badly or really well compared to its usual performance, the trend probably won’t continue, and you should invest accordingly.

But how can you tell?

Different assets have different risk and return attributes. Some, such as US government bonds (or Treasuries), offer low long-term returns along with low volatility (the price doesn’t fluctuate much). Others, such as emerging-market equities, offer the reverse – high volatility but potentially much better long-term returns. In short, some assets are usually “boring”, while others tend to be “exciting”. It’s when they start behaving out of character that you get the chance to make money. Once an asset starts to outperform in the short-term, history suggests a “bust is around the corner”, says Dicks. And the reverse is true when an asset slides below its long-term RARE.

Dicks took 12 asset classes (including real estate and hedge funds), dating back to 1994, and ranked them by their long-term risk-adjusted returns. By checking the gap between an asset’s current ranking, based on its short-term returns, and this long-term ranking, you can gauge the size of the opportunity. Over the long-run, US property should rank eighth, whereas at the end of 2007 it was 12th. That suggested a sharp undervaluation and a buying opportunity. An undervalued asset may not return to its long-term ranking quickly, but they all do in the end, says Dicks.

Mean reversion

This take on “mean reversion” theory is neat. But there are a few flaws. One problem is choosing a period over which to calculate a long-term risk-adjusted average. Taking just 15 years from 1994 is rather a short timeframe. For example, Japan’s equity markets have under-performed for the last two decades.

The other problem is timing. Spotting that, say, emerging-market shares are mispriced, is easier than spotting when they will “mean revert”. While “profit margins and PE ratios always seem to pass through fair value”, you only profit “if, and it’s a big if, you can … be patient enough”. Plenty of pundits made early bearish calls on tech stocks, for example, including Alan Greenspan in 1996.

But anyone shorting the stocks at that point would have been wiped out.

What’s hot and what’s not

Right now, Dicks reckons commodities and emerging-market stocks are trading well above their RARE, and investors should trim their holdings accordingly. We’d certainly agree on most industrial commodities (such as base metals).

The reason is China. Recent GDP growth has largely been driven by Beijing’s government-led lending boom. So attempts to rein it in – banks have been ordered to raise their reserves (i.e. lend less) – could spell trouble for commodity demand. But given the problems with timing a crash, it may be better to focus on undervalued assets. Dicks likes government bonds and property.

But we’re not so sure. Both Britain and America are deeply indebted and neither nation’s bonds look attractive. In fact, MotleyFool.com suggests that yields on both could “double over the next decade”, which would be terrible for prices. Grantham, meanwhile, predicts seven-year real (after inflation) returns on US government bonds of between -0.6% and 1.1%, depending on duration. So we’d steer clear.

As for property, US house prices are now below their post-1968 average relative to incomes. So it’s fair to say that they’re no longer expensive. But as The Economist’s Buttonwood column points out, “the impact of foreclosures and the end of the tax credit may make a recovery hard to sustain”. And in Britain prices remain “far too high” relative to both British household incomes and US prices.

So what would we buy? Grantham suggests high quality (defensive) stocks. He expects these to deliver a 6.8% real annual return over seven years, while “risky stocks have already been driven to extreme overpricing”.

Happy investing,

Tim Bennett
for the Investment Academy