Here was an interesting letter by Paul Killik:
It shows how all this was long in the making
It shows how all this was long in the making
I am writing to you at a time of considerable turbulence and uncertainty in financial markets. I will endeavour to explain how, in my judgement, we arrived at this point and where we might go from here.
Politicians and Journalists have been quick to blame bankers, but the events have been driven as much by a failure of regulation as a failure of the banks. Two decisions were critical - the first, in the US in 1999, was the decision by the Clinton administration to revoke the Glass-Steagall Act, which removed the 1933 firewall between commercial and investment banking. Alongside this, the same administration overtly encouraged the banks to lend to the disadvantaged, the so called sub-prime market. The second decision, in the UK, was taken by Gordon Brown in 1998, when he removed the responsibility for the regulation and supervision of the banking industry from the Bank of England, and handed it to the Financial Services Authority, an organisation with no experience in bank regulation.
That is not to exonerate the bankers, who were culpable of imprudence driven by a combination of ambition and greed, but in my opinion, had the events explained in the previous paragraph not transpired, the bankers would have found it difficult and in some cases impossible, to have behaved as imprudently as they did.
More recently, apart from the events of last week, politicians were either behind the curve in their response, with the crisis developing at a rate faster than they responded, or they made errors which simply served to aggravate the situation. An example of this was the dithering over Northern Rock, with decision making made more complex by the triumvirate approach.
However matters really deteriorated about four weeks ago when the US Treasury Secretary Henry Paulson, allowed Lehman Bros to go bust. I believe that this was a significant mistake and it was the systemic effects which followed that caused the complete dislocation of financial markets from which we are hopefully now just beginning to emerge. In truth, Lehman was too big to fail and it should not have been allowed to happen. Until that time, there was a financial crisis, but it was of manageable proportions. It went out of control on the back of Lehman.
If sufficient measures have now been taken, and I personally believe that the decision to re-capitalise the banks was the right one, then it allows us to look ahead further than the current week or even day to which our recent horizons have been limited.
On 1 September, only about 6 weeks ago, the market closed at 5602. It subsequently fell to an intraday low of 3884 last Friday, a decline of 31%. As I write this paper, we have recovered to around 4300, a rally off the bottom of over 11%, but still 23% below where we were on 1 September.
Interestingly, 10 years ago on 20 July 1998, before the emerging market crisis, the FTSE stood at 6179. By the 5 October it had fallen to 4649, a fall of 25% in about 10 weeks. However, by the 29 April 1999, six months later, it had recovered to 6599, a recovery off the bottom of 42%, which goes to demonstrate how strongly markets can recover after a sharp fall.
At our current level, the yield on the FTSE 100 Share Index is 5.3%. However, this is based on historic dividends, and whilst there will be some dividend increases this year they won't compensate for the loss of dividends on some of our major banks and other businesses suffering from the slowdown. Adjusting for this, I would expect the forward yield to be about 4.8%. This is still higher than the 4.7% yield on the 10-year gilt, which is generally defined as the "risk-free yield". However, whilst the income from such a gilt is as secure as you can get for 10 years, it offers no growth or compensation for inflation. By comparison, whilst the FTSE's price performance has been somewhat disappointing over the last 10 years, the income produced by a portfolio invested in the FTSE has grown by about 100%. It is for this reason that equities usually yield significantly less than long-term gilts.
I have always held that the relationship between the gilt yield and the equity yield is the most powerful valuation measure for the market, and by this measure it is very cheap today, offering a yield higher than a 10-year gilt. In my 40 years on the market equities have more commonly offered a yield only half that of the 10 year gilt. So to return to that level would require equities to double. In passing, I would mention that, in my judgement, the market would be 25% higher than it is today, at approaching 5400, utilising the same valuation tools, if Gordon Brown had not removed the tax credit on dividends 10 years ago.
Having explained why I consider equities to be cheap at current levels, I now have to turn to the prospects for the economy. Although interest rates are now falling, they rose strongly from 2004 through to the end of 2007 due to inflation caused by Asian expansion. We believe that this interest rate pattern is consistent with past recessions, although the inflation source was external – maybe similar to the 1970s OPEC shock.
However, I do not agree with the doomsayers who predict a major recession or even a depression. Interest rates have already declined significantly, and with the prospect of rapidly falling inflation over the coming year, combined with a slowing economy, we expect to see them decline significantly further still. In addition, we have to allow for the growth of the BRICs, the emerging economies of Brazil, Russia, India and China. The current consensus expectation is for economic growth from this group of about 8% in 2009 and 2010, notwithstanding the slowdown in the West. In light of these two factors it is difficult to foresee anything other than a relatively mild recession.
On balance therefore I believe that equities should be bought at around current levels. That is not to say that one should chase the market, but long term investors should look to feed money in selectively. However, I would be inclined to focus my selection on larger companies, with strong balance sheets, good cash flow and with a significant exposure to emerging markets or natural resources, which are linked to their growth. I doubt that we will see much growth from the Western economies over the next year or two, but as I have explained, I expect the emerging markets to grow strongly, as will businesses exposed to this growth.
For specific investment ideas please speak to your Broker.
Paul Killik
15 October 2008
Politicians and Journalists have been quick to blame bankers, but the events have been driven as much by a failure of regulation as a failure of the banks. Two decisions were critical - the first, in the US in 1999, was the decision by the Clinton administration to revoke the Glass-Steagall Act, which removed the 1933 firewall between commercial and investment banking. Alongside this, the same administration overtly encouraged the banks to lend to the disadvantaged, the so called sub-prime market. The second decision, in the UK, was taken by Gordon Brown in 1998, when he removed the responsibility for the regulation and supervision of the banking industry from the Bank of England, and handed it to the Financial Services Authority, an organisation with no experience in bank regulation.
That is not to exonerate the bankers, who were culpable of imprudence driven by a combination of ambition and greed, but in my opinion, had the events explained in the previous paragraph not transpired, the bankers would have found it difficult and in some cases impossible, to have behaved as imprudently as they did.
More recently, apart from the events of last week, politicians were either behind the curve in their response, with the crisis developing at a rate faster than they responded, or they made errors which simply served to aggravate the situation. An example of this was the dithering over Northern Rock, with decision making made more complex by the triumvirate approach.
However matters really deteriorated about four weeks ago when the US Treasury Secretary Henry Paulson, allowed Lehman Bros to go bust. I believe that this was a significant mistake and it was the systemic effects which followed that caused the complete dislocation of financial markets from which we are hopefully now just beginning to emerge. In truth, Lehman was too big to fail and it should not have been allowed to happen. Until that time, there was a financial crisis, but it was of manageable proportions. It went out of control on the back of Lehman.
If sufficient measures have now been taken, and I personally believe that the decision to re-capitalise the banks was the right one, then it allows us to look ahead further than the current week or even day to which our recent horizons have been limited.
On 1 September, only about 6 weeks ago, the market closed at 5602. It subsequently fell to an intraday low of 3884 last Friday, a decline of 31%. As I write this paper, we have recovered to around 4300, a rally off the bottom of over 11%, but still 23% below where we were on 1 September.
Interestingly, 10 years ago on 20 July 1998, before the emerging market crisis, the FTSE stood at 6179. By the 5 October it had fallen to 4649, a fall of 25% in about 10 weeks. However, by the 29 April 1999, six months later, it had recovered to 6599, a recovery off the bottom of 42%, which goes to demonstrate how strongly markets can recover after a sharp fall.
At our current level, the yield on the FTSE 100 Share Index is 5.3%. However, this is based on historic dividends, and whilst there will be some dividend increases this year they won't compensate for the loss of dividends on some of our major banks and other businesses suffering from the slowdown. Adjusting for this, I would expect the forward yield to be about 4.8%. This is still higher than the 4.7% yield on the 10-year gilt, which is generally defined as the "risk-free yield". However, whilst the income from such a gilt is as secure as you can get for 10 years, it offers no growth or compensation for inflation. By comparison, whilst the FTSE's price performance has been somewhat disappointing over the last 10 years, the income produced by a portfolio invested in the FTSE has grown by about 100%. It is for this reason that equities usually yield significantly less than long-term gilts.
I have always held that the relationship between the gilt yield and the equity yield is the most powerful valuation measure for the market, and by this measure it is very cheap today, offering a yield higher than a 10-year gilt. In my 40 years on the market equities have more commonly offered a yield only half that of the 10 year gilt. So to return to that level would require equities to double. In passing, I would mention that, in my judgement, the market would be 25% higher than it is today, at approaching 5400, utilising the same valuation tools, if Gordon Brown had not removed the tax credit on dividends 10 years ago.
Having explained why I consider equities to be cheap at current levels, I now have to turn to the prospects for the economy. Although interest rates are now falling, they rose strongly from 2004 through to the end of 2007 due to inflation caused by Asian expansion. We believe that this interest rate pattern is consistent with past recessions, although the inflation source was external – maybe similar to the 1970s OPEC shock.
However, I do not agree with the doomsayers who predict a major recession or even a depression. Interest rates have already declined significantly, and with the prospect of rapidly falling inflation over the coming year, combined with a slowing economy, we expect to see them decline significantly further still. In addition, we have to allow for the growth of the BRICs, the emerging economies of Brazil, Russia, India and China. The current consensus expectation is for economic growth from this group of about 8% in 2009 and 2010, notwithstanding the slowdown in the West. In light of these two factors it is difficult to foresee anything other than a relatively mild recession.
On balance therefore I believe that equities should be bought at around current levels. That is not to say that one should chase the market, but long term investors should look to feed money in selectively. However, I would be inclined to focus my selection on larger companies, with strong balance sheets, good cash flow and with a significant exposure to emerging markets or natural resources, which are linked to their growth. I doubt that we will see much growth from the Western economies over the next year or two, but as I have explained, I expect the emerging markets to grow strongly, as will businesses exposed to this growth.
For specific investment ideas please speak to your Broker.
Paul Killik
15 October 2008
