Sunday 23 July 2017

Fund manager warning on bubble may not be heeded

Leading asset management boss fears correction in the Australian property market. Photo: Bloomberg
Leading asset management boss fears correction in the Australian property market. Photo: Bloomberg

Paul Sommerville

Fund managers are not renowned for their altruism. They earn their fees from charging a percentage of funds under management and then a percentage of the profits. So it is very unusual for a manager to give back the funds and his source of income, especially if he has been performing well.

But that is just what Philip Parker has done. Parker, the chief executive of Altair Asset management, has decided to liquidate its Australian shares fund and return the money back to clients, citing a looming correction in the Australian property market. He has warned stock "valuations are stretched, property is massively overstretched".

Parker states that "mortgage fraud is endemic, it's systemic". "We think that there is too much risk in this market at the moment, we think it's crazy." He deems Australian equities to be "far too risky at this point". So he has disbanded his team and investment committee, which includes the former chief economist of both Morgan Stanley and UBS , and they are all heading to the beach to watch the impending property market "calamity" from the sidelines.

His decision may be well-timed. Weak signals are coming from the Australian economy. ANZ bank is now expecting just 0.1pc growth in first quarter of 2017.

Second quarter is also expected to be negatively impacted by the effects of cyclone Debbie. Some economists are even suggesting a recession is on the cards.

It is obvious there is a gigantic bubble in the Australian economy but it is mainly being fuelled by the extraordinary monetary easing by China. Any slowdown in China will be the catalyst.

Skippy the Kangaroo always knew there were problems before the silly humans. I wonder if the readers of the Sydney Morning Herald, where the story first broke, will heed the warnings or blissfully carry on until well after the music stops. The bets must be on the latter.

Time to give up cigarettes

There was a time when no long-term portfolio would be without tobacco stocks. The inelastic demand for cigarettes through good times and bad ensured these companies were a safe and steady investment.

Over the years, tobacco stocks have performed extraordinarily well. The revenues were always improving, the income and profits good and the dividend consistent and rewarding. So much so that many investors and fund managers now treat them as a bond substitute.

With yields on bonds no longer attractive 'bond-like' substitutes must be found and tobacco stocks fit the bill. It is another consequence of quantitative easing.

Tobacco stocks are now valued similarly to growth stocks in a normal market due to their consistent dividend payout. Investors will pay any price for that dividend income stream.

Bond yields have been falling for 30 years, so tobacco stocks have been going up for 30 years. But there is one problem - stocks are not bonds, there are risks .

Tobacco consumers are dying or giving up - not exactly a good recipe for a 'growth' stock. Philip Morris International (PMI) the world's largest publicly-traded tobacco company saw 11.5pc slump in cigarette shipment volume during the first quarter of 2017.

Revenue (excluding sales of new tobacco technology products) fell a whopping 6.6pc. But shares in the company continue to outperform due to bond yields and central bank alchemy. In Japan, Japan Tobacco the third-largest tobacco company in the world, faces an uphill battle when anti-smoking laws are likely to be introduced before the 2020 summer Olympics in Tokyo.

A recently-announced merger between British American Tobacco (BATS) and US rival Reynolds American will create the world's biggest tobacco firm and there is sure to be more M&A activity in the sector, further consolidation as the pie shrinks. BATS share price has also received a huge boost from the fall in sterling (they make their money in dollars but report earnings in sterling).

But all over the world rising taxes, awareness of health risks and stricter laws are eroding the demand for conventional cigarettes.

The manufacturers all see the e-cigarette industry as their saviour but while we would expect that segment to grow substantially it is unlikely to replace their primary product. Much more significant for their stock prices is the prospect for bond yields. While they remain low the share prices are supported but at extremely elevated levels.

Any acceleration in yields or interest rate rises will see these share prices re-rate considerably.

Older investors find it hard to discard shares that have done them so well over time but it is probably a good time to dump them, these shares are priced to perfection while their customers are literally dying.

To paraphrase: "Sell 'em if you got 'em."

Volatility and the VIX

World financial markets have been extraordinarily quiet for a very long time primarily due to Central Bank policies.

That was until two weeks ago on May 17 when we witnessed a "volatility explosion".

The VIX (volatility index) jumped 45pc for the seventh-largest one-day spike in history. The S+P 500 suffered the biggest one-day decline since Sept 9, 2016 and the Nasdaq the biggest fall since June 2016.

But then all went quiet again and equity indices marched back to make new all-time highs.

In fact the VIX fell for six days in a row, one of the largest declines in history over that period. The VIX then had its second-lowest weekly close in history .

So we travelled from the seventh-highest jump in volatility ever to the second lowest weekly close in history in the space of a few days - very unusual.

I want to draw your attention for educational purposes that the VIX is no longer a good tool to measure volatility (for the moment at least). Why?

The VIX index can actually be traded and is now used as a tool to "help" other asset classes by high-frequency traders. For example, if a spike occurs naturally in VIX on any particular day it usually denotes selling pressure in equities.

In order to cajole computer programmes to step in and buy shares it is very easy to sell a large amount of VIX which will automatically cause a buying of large quantity of equities. The computer algorithms are "fooled" into buying.

Secondly, traders are using VIX to earn extra returns on certain strategies especially bond portfolio managers'.

By selling VIX to those who believe it "must" go higher they are taking in extra income on a daily basis - basically betting that anybody taking out insurance will not have to call on that insurance policy and lose their premium.

In short, the VIX as a thermometer is broken.

Investors should not take any readings of it seriously. There are other much better indicators to focus on.

We cannot predict when this period of low volatility will end but it is clear, if history is any guide, periods of extreme low volatility are always followed by long periods of high volatility.

paul.sommerville@sam.ie

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