World debt stood at 160 per cent of GDP in 2001 and by 2013 was 215 per cent and continuing to rise. Not surprisingly this flow of central banks’ generosity has finally driven the FTSE 100 index above its December 1999 high.
It has also driven bond yields to historically unknown low levels, and even has some central bankers questioning their role as political ‘fixers’ for governments.
Cash not economics
Today’s markets are a good illustration of the paradox that market activity is determined by cash flow rather than economic or political realities. The 20th century had sufficient crises to destroy all but the strongest and most resilient of investors, and the same is true today.
Values do not reflect the demographic decline of the developed world, nor spreading deflation, the descent of parts of the Middle East into the mediaeval barbarism of ISIL, nor the return of war to Europe itself and the breakup of, if not the EU itself, then probably the eurozone.
How should prudent investors prepare themselves for this uncertain future? All securities markets are overvalued, and earnings growth has stuttered over the past few years. Demand for goods is falling, even for consumer staples.
While deflation is currently a threat, the inflationary dangers stored up by quantitative easing (QE) have not disappeared. One day, but no one knows when or why, that reality will lead to a panic, and a sharp fall in prices.
Investing in dangerous zones
There is much to be learned from the attitude of the single capacity stockbrokers, destroyed by the Big Bang of the 1980s, after a century of successfully protecting the capital of Britain’s upper middle classes. These advisers understood that, while possible to identify value in stock markets, it was simply impossible to predict prices.
So they concentrated on investing for income and found that the growing income of an equity portfolio produced the capital gains needed by their clients, helping to offset the depredations both of inflation and tax. They knew instinctively what professors Dimson and Marsh of London Business School later proved by research – over any reasonable period, 90 per cent or so of capital growth comes from reinvested dividends.
So until the 1980s the typical private investor portfolio was a 30 per cent mix of fixed interest securities (often not gilts but preference shares or corporate debentures) and 70 per cent blue chip equities. Fixed interest yields were generally some 50 per cent more than equity yields, and the combination of the two gave an income return of 2-3 per cent more than current inflation. A portfolio would consist of some 15 to 20 different securities, as was considered the optimum level of diversification.
But equally the analysts were concerned about the capital risk involved in the equity holdings, and especially
-Valuation risk – were the shares too expensive?;
- Financing risk – was the company over-geared with debt?; and
- Franchise risk – how solid was the business model?
It was this combination of yield, diversification and prudence that kept investors safe through a very dangerous century.