They have been called the four most dangerous words in investing.  Beware whenever you see the words “its going to be different this time” used to justify why it is worthwhile to join in the latest investment mania.  The mania will probably last longer than you think it will but it always ends in the same way – by not being different this time.

Professional traders who are very disciplined and accustomed to using stop-losses are the ones who truly profit from speculative bubbles & manias because they are the ones who hang onto their winnings and do not end up by giving all their winnings back again cometh the downturn.  The true professionals follow the trend up, get out & then switch to the bear tack and profit on the way back down too.

From a practical investing standpoint and no matter how compelling the argument du jour used to justify why it is going to be different this time, just don’t fall for it.  The market may sustain the latest investment mania for longer than speculators betting against it can stay solvent but, rest assured, it won’t be different this time.  As an investor you don’t have to bet against the mania, you can simply choose to protect your capital by not participating in it.

Secular bull & bear markets last an average of 17 years and the bear variety usually end with very low p/e ratios close to 10x average earnings over last 10 years.  The last secular bear market lasted from 1966 (Dow 969) to 1982 (Dow 784) with the 10-year average p/e ratio declining from 23x at the start to 8x at its end (source : crestmontresearch).

But secular bear markets do not necessarily end with the absolute price low in the indices.  This is a very important but subtle difference because the perma-bears will continually point out that the market’s p/e is not low enough for a new bull market to start and, by implication, this must be a bear market rally and indices will eventually fall back below their March 2009 lows.  However history shows us that investors can make money during secular bear markets in the period between the nominal price low of the indices and the ultimate valuation low point from which a new secular bull market commences.  Furthermore, there is no way of telling in advance whether the next secular bull market will start from a p/e of 12, 10, 8 or even whether it will be different this time (!).  So from a practical standpoint, long-term investors may be best served by staying invested in a diversified portfolio of quality stocks on low p/e ratios and banking some profits (top-slicing) every time the market nears an old high point in terms of the nominal price level of the index.  Each time the rally proves to be a false dawn and the market falls back to a support level, the long-term investor can re-invest the cash raised from their previous top-slicing exercise.  Eventually the market will sustain a break-out to new highs and a new secular bull market will be underway.

c.f. 1974 to 1982.  Dow went from a high of 1,067 in Jan 1973 to a low of 570 in Dec 1974.  The Dow rallied back to 1,000 in Feb 1976 but the market’s p/e ratio declined throughout the rest of the 1970s and reached a low around 8 times in 1982, when the Dow traded in a 784 to 887 range before the bull market really kicked off in August 1982.  So the market actually went up in terms of the nominal price level of the Dow but it got cheaper (derated) as corporate earnings rebounded during the 8 years from 1974 to 1982.  There was plenty of money to be made during this period as there were many Dow rallies and declines in the order of 10% to 20% during these years. 

The FTSE topped out at 6,950 in Dec 1999, hit a low of 3,278 in March 2003 and then more than doubled to 6754 in July 2007, and has since fallen to 3461 in March 2009.  There was plenty of money to be made in the rally of 2003 to 2007, even though it turned out to be a rally within a secular bear market which has so far lasted 10 years.

In the last month, stocks have, in general, rallied after the publication of Q1 earnings which suggests that the market had over-discounted poor earnings.  The bears argue that this cannot be a new bull market because the rally is being led by financials.  They may well have a point but just because financials have bounced back from extremely over-sold levels does not mean that the next market decline will take out the March 2009 lows. 

 So the answer is that the bear market may well be over in terms of the Dow not breaching its 6 March 2009 low of 6,470 but investors can expect the market to steadily derate in p/e terms over the next few years.  Hence we are now set for the market to find a trading range as earnings slowly recover over the coming years.

The UK composite insurers (notably PRU & AV) have a business model which combines life assurance, asset management & general insurance. One way of looking at them is to consider them as investment funds with an operating business attached. Their investment funds are stuffed full of government & corporate bonds and have a much smaller percentage of equities than they used to prior to 2000.
As such, given that the BoE is determined to force the price of Gilts higher and corporate credit spreads are still very wide, they are a high-yielding version of a corporate bond fund, selling at a discount to NAV.
Their dividend yields are covered by their largely stable earnings from the existing life assurance book & their earnings from general insurance (rates are hardening in this market due to a scarcity of capital caused by the credit crunch/bear market).
They offer a recovery story with considerable upside and double-digit dividend yields whilst you wait for the recession to play out. Corporate credit spreads will normalise at some point in the future, equities will recover and PRU & AV will once again trade near to their embedded values (which will themselves rise as markets recover).
Solvency and worries about insurers having to raise capital via rights issues (which would lower those NAVs due to new shares being created) are the bear points but in their recent results announcements PRU said they had an IGD solvency surplus of £1.7 bln (and their new CEO is presumably less keen on buying large chunks of AIG than their recently-ousted old CEO Mark Tucker), which would fall by £350 mln if equity markets drop 40% from end-2008 levels.  AV said they had an IGD solvency surplus of £2.0 bln which would be reduced by £800 mln if equity markets fall 40% from end-2008 levels.

Composite insurers are high beta stocks and their share prices will always move faster than the FTSE, however the market has become too bearish on the sustainability of their capital positions.  Although share prices never move in a straight line, their discount to NAV will unwind as confidence returns to financial markets.

Money (notes & coins in circulation) can be thought of as the longest duration, lowest coupon government debt which can ever be issued. The central bank does not pay interest on the notes it prints (although it is possible to pay interest on commercial bank reserves held at the central bank) and the central bank never has to redeem them. That legend on the ten pound note in your pocket that says “The Bank of England promises to pay the Bearer on demand the sum of Ten Pounds” will only result in the BoE giving you another, newer, crisper, ten pound note in payment for the one you attempt to redeem.

A recession can be viewed as too little demand for goods & services (nominal GDP). One way for a country to bring itself out of recession is to depreciate its currency (which effectively moves GDP, via exports, to the country in recession from other countries, boosting the former’s GDP). However the problem with the current global recession is that this is not an option as there is too little demand for goods & services across the globe. A country cannot just devalue itself out of a global recession. Japan has just given us an excellent example of what happens when a country is too reliant on exports, as demand has contracted globally, Japanese exports have just fallen off a cliff (down nearly 50%) and Japanese GDP has contracted as a result (when the world finally recovers from this global recession both Germany & Japan are likely to try to grow the size of their domestic economies so as not to fall into this trap again). What is needed is for the global pie of nominal GDP to be expanded.
Welcome to Worldwide Quantitative Easing. If every major economy stimulates its own nominal GDP by convincing their independent central banks to print money and spend it by purchasing government bonds (the governments then spend the borrowed money on goods & services) then the result will be the desired expansion of the global pie of nominal GDP. The side effect is a round of currency devaluations which show up most noticeably against any country which doesn’t engage in QE (the Euro is leading this particular pack and the usually-conservative Swiss recently decided they did not want their currency to appreciate alongside the Euro so they intervened to lower the Swiss Franc against the Euro and embarked upon Quantitative Easing of their own to boost their GDP and underline to the FX market that they meant business). Also, as mentioned in Race to the Bottom (27 March 2009), real assets increase in value (as measured in fiat currencies) - admittedly real estate & equities are currently in bear markets but they won’t last forever, especially at this rate.
The question of whether the world’s central banks are capable creating just enough inflation but not too much can be left for a while.  The central banks will have to err on the side of creating too much inflation in order to be on the safe side – then they can rein inflation back in again by slowly taking the punch bowl away so as not to undermine the recovery.

Most people think of inflation as a rise in the price of goods and services.  The published measures of inflation (RPI and CPI) measure the rise in the price of a basket of goods and services.

However economists define inflation as an increase in the amount of money in circulation (literally inflating the stock of notes & coins in circulation).  Some people deny there is a link between an increase in the money supply and RPI/CPI.  The Bundesbank firmly believe that a link exists and have passed this belief on to the ECB which manages its policy by keeping one eye on the growth in the money supply.

A simple explanation of why the money supply does in fact affect the price of goods & services runs as follows:

Strictly inflation is defined as an increase in the money supply. Assume that increasing the money supply (by printing money) does not cause cause a rise in the price of goods & services. Then a government could print as much money as it likes and use the money to acquire ever-increasing amounts of goods, services & assets. Plainly this could not last for ever and therefore there is a tipping point beyond which printing more money will cause the price of goods & services to rise.

The problem for central banks is that nobody knows precisely where the tipping point is – which is part of the reason why central banks have such a tricky job in meeting their inflation targets.