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Danger in the safety bubble

Twelve years ago, there was a bubble in internet stocks. The bursting of that bubble, like the flag fall in a post-war taxi, set the meter ticking on the next one – an uproarious boom in government bonds.
Nanjing Night Net

In a way, one could not exist without the other. The rush to risk in dotcom stocks and the current flight to safety are the bookend events to a crazy-weird period, utterly opposed but connected by herd behaviour.

If you were seduced by the dotcom boom, or even the resources supercycle, there’s a reasonable chance you’re now in term deposits, bank hybrids or bonds.

Investors who piled thoughtlessly into stocks are now in “safe” assets, with a similar measure of thoughtlessness, crowd-sourcing their investment strategy instead of thinking for themselves.

The upshot is that from June 2008 to June 2010, the money being withdrawn from US equity funds totalled $US232 billion ($220 billion). According to The Investment Company Institute, over the same period inflows into the bond market hit $US559 billion. The same thing is happening here.

US 10-year Treasury bonds currently pay a pitiful 1.65 per cent. In July, the annualised US inflation rate was 1.40 per cent, making the real return from 10-year Treasuries 0.25 per cent — and that’s before tax. After tax interest receipts for most investors will be zero.

Only capital gains can save these investors. And that can only occur if bond prices move lower still. Should they move higher, capital losses will make already woeful returns absolutely abysmal.

The last time we saw investment propositions of this ilk was in 1999. Speculative stocks can go to zero very quickly. Bonds get you there so slowly you won’t even notice how much you’ve lost.

That’s led to a fascinating reversal of an old market truism. Where once bonds offered a risk-free return, now they’re loaded with a return-free risk.

If the first rule of investing is to preserve capital, investors seeking out “safety” are breaking it everywhere, en masse.

Of course, there’s plenty to worry about but as the latest reporting season showed, the corporate sector — Twiggy excepted — is hardly stressed. And still the ASX All Ordinaries Index remains about 36 per cent below the pre-GFC peak.

Thus begins the argument for stocks

As I discussed recently in this column, The Case for Infrastructure, published by Intelligent Investor in July 2009, made a compelling argument for four stocks — Spark Infrastructure, Sydney Airport, Australian Infrastructure Fund and Challenger Infrastructure.

Since then these stocks are up almost 90 per cent on average (including dividends), while over the same period the ASX All Ordinaries Accumulation Index has returned around 30 per cent.

It is the flight to safety of bonds, cash and hybrids that permits returns of this ilk. To see in the safety bubble confirmation that everything is about to get worse might be to draw exactly the wrong conclusion.

Of course, that doesn’t mean there are buys aplenty. So far this year Intelligent Investor has upgraded just 12 companies, one of which — Sonic — was only on the list for just over a month.

But recommendations aren’t London buses, which all turn up at once. Nor are they Sydney buses, which don’t turn up at all. There is no timetable for the arrival of cheap stocks.

Indeed, the prices of high-quality and high-yielding stocks have increased sharply of late. But that need not induce despondency.

I recommend that, if you can’t find the right opportunities, wait for the next fat pitch and hold on to your core holdings. Stocks such as Woolworths, Sydney Airport, Cochlear, CSL, Coca-Cola Amatil, ASX, Wesfarmers and Origin Energy should suit most conservative investors.

More risk-tolerant investors might appreciate QBE Insurance and ARB Corporation, for example.

There are enough opportunities in good-quality companies without needing to fish more treacherous waters.

The key is not to make easily avoidable mistakes. Don’t ignore pygmy portfolio limits for speculative stocks, avoid reaching for yield, be patient and act decisively when opportunities present themselves.

And don’t go boots ‘n’ all into hybrid income securities. Instead, consider shuffling a small part of your portfolio up the risk curve and into high-quality businesses, which should increase expected returns and, perhaps ironically, also lower real risk.

If that doesn’t tempt you, stick to the genuine safety of cash and term deposits over the recent batch of hybrid offers.

Nathan Bell is Research Director at Intelligent Investor. BusinessDay readers can enjoy a free trial offer. For more Intelligent Investor articles click here.

This story Administrator ready to work first appeared on Nanjing Night Net.