Uncertainty in markets is nothing new

A rising concern among South African investors is the growing tension between the members of the Eurozone, many of whom are major trading partners. The indebtedness of Greece, Ireland, Spain, Portugal and Italy – and their attendant solvency and liquidity problems – have highlighted the fragility of the common monetary alliance.

While all this has been going on in Europe, the USA and China have each been beset by their own problems. The US economy has slowed, pushing its government to raise the country’s maximum debt limit and Standard and Poor’s to downgrade its coveted AAA credit rating. Meanwhile, the Chinese government has continued to combat rising inflation by raising interest rates, reinforcing concerns about the rate of its future economic growth and consequent demand for commodities (mainly metals and minerals).

Given the parlous state of the above-mentioned economies, it’s perhaps unsurprising that the Rand has remained relatively strong against the currencies of our trading partners. This is despite it being over-valued on the basis of purchasing power parity, the Reserve Bank’s usual point of reference. Gold, the traditional bolt-hole in times of particular uncertainty, was sitting at 1766 dollars per ounce on 15 August 2011, an increase of 44% in USD from its level a year ago.

However that doesn’t mean that we should be stocking up on baked beans and taking to the bunkers. Economies and markets are always uncertain. There is absolutely nothing unusual about this state of affairs. Furthermore, there is demonstrably only a very weak relationship between economic growth (or any of a host of other economic data series) and the fortunes of the world’s investment markets.

For this reason, it is more important to focus on the valuations available in the various major asset classes from time to time, rather than in forecasts for the future of their associated economies. The chart below summarises and updates our view of what’s expensive and what’s cheap, based on prevailing asset class dividend or income yields.

On this simple but robust basis, the most attractive asset classes continue to be global developed and emerging market equities, in the aggregate. There are, of course, pockets of greater or lesser value within these broad categories. South African equities are significantly cheaper now than for the last year-and-a-half. And cash and bonds (both local and international) and local listed property are still the more expensive asset classes.

From this (and the ongoing strength of the rand) PPS Investments continues to hold fairly full exposures to local and international equities and under-weight exposures to local and international fixed interest assets. We have no deliberate exposure to local listed property as an asset class, and remain comfortable leaving the selection of individual listed property securities within the discretion of the underlying asset managers we have appointed, as and when enticing opportunities arise.

Given a full equity exposure, it is useful to have a closer look at the following chart of local equity market returns over different periods of time, for the 110 year period from 1900 to 2010.

The chart shows the best-to-worst ranges of realised equity returns for 1, 2, 3 etc. year returns over this long period. A few powerful observations stand out immediately.

The range of possible outcomes over any 1 year is very wide. The best has been over 90% and the worst about –30%. But as investment periods get longer, so the range of outcomes gets narrower, because the swings and roundabouts of positive and negative performance tend to cancel each other out. At the right hand side the ranges are narrowest of all, like the narrow end of a funnel (we actually call this the “funnel graph”) because periods of negative performance have been smoothed by offsetting positive periods.

Of course, even at the right hand (10 year) edge of the graph, there’s still a range between best and worst returns. But in investing, the longer your time horizon, the more certain you can be about the eventual outcome. So, having a longer-term and valuation-based view of the investment environment gives confidence in the merits of this approach.