October 2011 Review Comments
Written by Tony Gray   
Wednesday, 01 February 2012 00:00
Volatility in global sharemarkets, commodity markets, bond markets and currency markets continues, keeping many investors on the sidelines. It appears global human and computerised trading is dominating markets. Prices run up on plans to make a plan and then fall back - usually for the flimsiest of reasons. This is not to say that there are not real problems with government debts and deficits, just that the day-to-day price moves are excessive. We have set out below our view on the various asset classes and generally remain cautious at the present time – acknowledging the ‘risk’ that growth assets rally and we are under-invested relative to normal positioning.

I think back to university days and one lecturer, experienced in US financial markets, who painted a chart similar to the one below. This sets out the timing of the economic, interest rate and sharemarket cycles. I couldn’t locate quite the right chart on the net – so I drew the following:

The chart illustrates that share markets lead the economy and interest rates lag. Right now market participants are pessimistic, but I’m not sure that they are depressed enough! Furthermore, we are not in recession and whilst bond market interest rates are lower, official rates are yet to be cut. This suggests to me that, while shares are at the low end of the range, more time needs to pass before we see a sustained rise.

One lagging indicator I am keeping a close eye on is unemployment – a rising trend will confirm the move to slow growth/recessionary type conditions and is the most likely trigger for the
Reserve Bank to cut official interest rates. That’s how the theory goes. In practice various sectors of the market might form a base anything up to 18 months apart in my experience. Our focus is on limiting exposure to the ‘at risk’ sectors until the margin of safety is large enough to justify some risk money.

Cash & Fixed Interest 

Banks have lowered fixed term loans to below variable rates and bond rates sit below the official cash rate through the full Commonwealth Government bond cycle (for example a 10 year bond is yielding 4.24% against the RBA Overnight cash rate of 4.75%). Bond markets are telling us that the economy is weakening and interest rates will be lower in future. This is also reflected in reduced term deposit rates.

We recommend a rolling term deposit strategy be maintained, with maturing deposits invested further out in time to reduce portfolio interest rate volatility. What might appear to be poor
rates today may well prove to be very attractive in 6 months time? Should rates in fact move higher (we doubt a significant upward move will occur any time soon), then other maturing deposits can take advantage of improved rates.

We also recommend maintaining a higher than normal cash reserve - to add to growth assets if/when markets next panic and/or when compelling opportunities arise. The government guarantee on deposits is now limited to $250,000 per institution and needs to be kept in mind as we review where to invest maturing deposits.

International Shares/Investment 

The risk/return from investing funds in this asset class remains unclear at present. The falling $A is a benefit, but offset by weaker share prices. We expect further falls will be accompanied by a lower $A and in that instance we would look to use a currency hedged fund or exchange traded fund to gain exposure - but not accept the ‘cost’ of a rising $A (which in previous cycles has robbed investors of the gains on the underlying stocks). 


We remain positive on the income yield and inflation hedging benefits of non-residential listed property. Whilst property trusts are not immune to the economic cycle, lower interest rates
would be a positive on interest costs and, with generally low gearing levels, I do not expect refinancing to be an issue.

Australian Shares 

As time passes the positioning of the local banking sector strengthens, with rising levels of collateral and reduced reliance on short-term money markets (especially overseas money). The negative is weak demand for credit and risks of rising bad debt levels if the housing sector continues to weaken. We recommend not holding an overweight exposure to the banks but would now add some exposure for underweight portfolios on the next market sell-off.

The mining sector has also weakened appreciably in the last few months and the margin of safety is improving for a number of key stocks. We favour Rio Tinto over BHP due to lower debt levels, but would be aiming for a share price in the low to mid $50 range before introducing. At this level earnings could halve and the stock would still be reasonable fundamental value. The dividend yield is lousy, although we expect a buy-back or increased dividend at some point.

Alumina Corp remains a takeover opportunity and also has a low level of debt, is a low cost operator (via the AWAC joint venture with Alcoa) and is yielding better than fixed interest when the franking credit is included. There remain a large number of potential additions to portfolios – in some cases to stocks we have not held for some years. Given the potential for individual stocks to fall more than 10% in a matter of days, I welcome any phone calls or emails to set alerts and review existing holdings.


The negative correlation of the gold price and share markets has broken down – with both falling during September. I recommend selling remaining GOLD exchange traded fund holdings. I am not yet moving to exit Newcrest Mining, but consider taking gains on junior gold stocks.
Last Updated on Thursday, 26 April 2012 10:18

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