Investing when interest rates are low

Investing is like going to an amusement park. Providers of financial products and investments tempt the public with the prospect of "attractive returns" in glossy prospectuses. They often use clearly laid out model calculations to demonstrate the performance-to-date of the investment strategies offered and what can be expected in future. The answer to the questions of whether the trend in prices and values in the past was due to the success of the model used, or to chance, and whether it can be extrapolated at all, is another matter. In fact, for some time now prices on the financial markets have been influenced more by monetary policy stimulus measures by the major central banks on a massive scale than by other factors.

Perverse markets

In the last few days alone, an interest rate cut in China, the pronounced reluctance of the Federal Reserve to raise rates, and the aggressive monetary stance of the European Central Bank have led to a surge in equity prices, record-low yields in Europe, a softer euro, and stronger emerging market currencies. During phases such as this, there is a surge in investor risk appetite, which prompts investors to purchase assets with the greatest speculative leverage. The fundamentals of these assets, i.e. the operating quality of the respective companies' earnings, are often of secondary importance to these trading-oriented investors.

It comes as little surprise that investment veterans such as Paul Woolley bemoan the shortsightedness of the investment management industry. Woolley argues that this is the cause of the periodic emergence and bursting of price bubbles. He adds that theory does not explain these phenomena. And he continues to believe that markets are efficient and self-stabilizing. In Woolley's view, there is a diametric contradiction between short-lived investment strategies and long-term return targets. He advises investors to back carefully chosen value stocks, to avoid exotic investment instruments lacking in transparency, and to keep management fees and trading costs as low as possible. For Jeremy Grantham, co-founder of Boston-based investment management firm GMO, valuation is the primary consideration. He explains that there are no "terrific types of investment" per se, but instead only securities and asset classes that are available cheaply at a particular time in relation to their expected returns.

The experts at his company regularly analyze the valuation ratios of various asset classes and consider what the trend in prices might be over the next seven years on the basis of their experience. At present, they believe that most securities markets are overvalued, and only see opportunities for additional purchases at semi-reasonable prices in stocks of US groups with high-quality earnings, major international corporations, and carefully selected companies in the emerging markets.

Overvalued US stocks

Norbert Keimling of fund company StarCapital takes a similar view. He believes that the securities of US companies are heavily overvalued and should be avoided. His argument is based on the so-called Cape ratio, a ratio to evaluate stocks developed by Robert Shiller, winner of the Nobel Prize in economics. At around 23, the Cape is some 40% above its historical average, according to Keimling. He explains that in the last 130 years there have only been similar overvaluations in 1901, 1928, 1965, and post-1996. Keimling goes on to say that across all these periods the S&P 500 index reached significant highs, which were then followed by phases with weak or below-average stock price performance. Other informative ratios such as the price/book ratio or TobinsQ suggest that the US stock market is now overvalued by between 30% and 40%. He adds that this market has rarely been as expensive as it is now by comparison with other markets. According to Keimling, high valuations point to low returns in the future, with a high risk of losses.

Countercyclical opportunities

Instead, investors adopting a countercyclical approach should concentrate on markets and segments that are currently out of favor, such as China, commodities and value stocks, which offer interesting opportunities at present. In China, for example, Keimling argues that the price gains from the last bull market have now been fully digested, with the market trading at close to book value. He says that investors generally paid twice the price for these stocks. He also draws attention to the appeal of the commodity sector, and mining stocks in particular. Keimling points out that while prices on global equity markets have risen by almost 50% since 2010, mining company stocks have fallen by around 65% on average, with prices that are now below book value, making the stocks cheaper than at any time in the last 20 years.

He adds that value stocks are also attractive following their below-average performance over the past seven years. Keimling explains that there have only been six comparably dry spells since 1931, adding that in each case the stock prices of companies with strong revenues and earnings subsequently outperformed for an extended period. Keimling concludes by suggesting that it is advisable to invest on a global, broadly diversified basis, to underweight the US market and overweight European stocks, and to mix in emerging market and commodity stocks on a countercyclical basis, focusing on equities of corporations with a proven operating track record.

He explains that it is very difficult to replicate targeted strategies like this using passive investment products, adding that in any case – because of the composition of indices –exchange-traded funds (ETFs) contain too many stocks of weak companies that a value-oriented investor would wish to avoid. Furthermore, many global indices have an excessively one-sided focus on the major markets. According to Keimling, so-called style ETFs are not in a position to capture value premiums in the markets, and they dilute the potentially strong returns that appear possible with a careful selection of individual stocks.

Doubts over strategy papers

Meanwhile, as far as strategy funds and certificates are concerned – i.e. smart beta strategies – there is a question mark over whether they deliver what they promise. Some studies raise doubts over whether they generate any added value at all. The paper "How smart are smart beta ETFs?" by Denys Glushkov of the University of Pennsylvania backs this sobering assessment. In any case, it would come as no surprise to skeptics if many of the factor strategies that have been launched were geared more to the providers' economic interests than to investor performance.

At times when both growth and rising interest rates could be a source of concern, the investment strategists at UBS recommend that investors opt for broad diversification of asset classes, even if this is not always able to perform the customary stabilizing function. For a tactical investment horizon of six months, they consider high-yield European corporate bonds to be interesting on account of the European Central Bank's purchase program. In addition, they have overweighted the stocks of European and Japanese companies in the belief that monetary policy offers a great deal of support. In contrast, they have a rather skeptical view on emerging market investments.

All in all, in light of low interest rates and long-term performance, there does not appear to be any alternative to carefully chosen equity investments.

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