Today and in my next blog I’d like to look at why the stock market has been going up, why we think the parts of it that we’re in are likely to carry on going up, (this blog), when the party might end, and what signs we should be looking out for which might help us to know when the end is coming.( next one). The canary in the mine sings when toxic gas escapes, usually before the men have noticed. We need a canary on our desks.

PREDICTIONS REVISITED

My last blog (Stock Market Soars as Sterling Slumps, March 8^th) contained a number of predictions. These included

-Sterling won’t fall against the dollar in the short term and will probably stabilise in a range $ 1.50-1.55

-Gilt market is worrying, but could stabilise

-Stock market will go on rising

-Small companies likely to perform well relative to the overall market.

These predictions have been broadly right so far. (WARNING - this doesn’t mean that we’ll ever get any predictions right again.) Sterling has stabilised against the dollar, the market has gone on rising, and the smaller companies have risen faster. Since March 8^th, the FTSE-100 index (the largest 100 companies listed in the UK) is up 4.3%, while the average gain for the smaller company funds held in TB Wise Investment is 7.4% - not bad going in less than six weeks. Gilt prices are slightly higher than they were on March 8^th.

I also made a comment on the relative performance of higher and lower-yielding shares. Since the end of 2008, lower-yielding ‘growth stocks’ have beaten the higher yielders by a huge margin. This trend looked very mature, and ripe for a change of direction. But, as we have learned to our cost, the fact that something looks as if it ‘ought to’ happen, doesn’t mean that it will.

Since March 8^th, the lower yield index has continued to be the stronger one, up 5.2% against 4.3% for the higher yielders, but since Easter, i.e. just the last couple of weeks, there has been a reversal, with the high-yield index up 2.3% while the lower-yield index is down 0.2%. This matters because our portfolios are heavily skewed towards value and yield, and away from growth and momentum.

We have two overall biases in the stock market. We prefer smaller companies to larger ones, and we prefer cheap companies to expensive ones. When small and cheap are doing well, our portfolios tend to do well, and vice versa.  In early March, small was just starting to perform, so I predicted a good run for TB Wise Investment and TB Wise Income, which has happened (see below). Now it looks as if cheap’s time may be coming, too. If this turns out to be correct, the funds will be in the sweet spot for a while longer.

WHY IS THE STOCK MARKET GOING UP?

We all know why it shouldn’t be. UK households are carrying £1.2 trillion of debt and our government is borrowing money at an unsustainable rate. It will take a long time for this debt to be repaid, and the necessary adjustments will be a drag on economic activity for the foreseeable future. The political situation could best be described as unhelpful. However, despite all these and other factors, the stock market is going up. In order to understand why, and inspired by yesterday’s televised Prime Ministerial debate, we arranged  a head-to-head debate between a buy-to-let property and a Glaxo share, with each arguing its own merits as an investment. The share won the debate convincingly. The main points were

Liquidity

The share pointed out that it can be bought or sold any working day within about a minute, at virtually no cost, and at a known price. The property could take months to sell, at a price that could be a good deal lower than the asking price, and the costs of the transaction are much higher.

Valuation

In the decade since the beginning of 2000, the average house price has risen 103%, while the Glaxo share is 27% lower than it was then.

Dividend Yield

There are numerous obstacles between you and your income from a buy-to-let property. You may not be able to let the property all twelve months of the year. You may employ a letting agent, who will charge you a percentage of your rental income, typically 15%, and if you don’t, you have to do the work yourself. Out of your income you have to pay for repairs and renewals. There will always be a degree of uncertainty, but at best the net yield, the after-costs and after-tax income as a proportion of the property value, is likely to be below 3.0%. The share pays twice a year, without you having to do anything apart from having a bank account for the payment to drop into. The company’s balance sheet is strong, leading analysts to predict that the dividend will be maintained, if not increased. Glaxo pays 4.8% at the moment, net of tax.

At this point in the discussion, the buy-to-let property was heard to mumble ‘I agree with Glaxo’

At the end of this very one-sided debate, I’m sorry to say that the buy-to-let property stormed off the podium, not even staying to shake hands.

Conclusion - good shares are now an attractive alternative to buy-to-let, which has been so fashionable since the mid-90s. As a result, we may see more retail money finding its way into the stock market.

This last decade has been very difficult for companies with stock market listings. Many companies (but not all - one has only to think of the banks) have made strenuous efforts to become more attractive to shareholders. Dividend yield is just one example.

Big pensions and other institutional funds have been steadily reducing their exposure to the stock market over the last decade, replacing their shares with gilts and high-quality corporate bonds (company loans). Gilts have been a bad investment over the last year, and good quality corporate bonds aren’t cheap (Tesco’s paper with two years to maturity pays just 2.0%). A typical institutional fund has reduced its weighting in UK shares from around 50-55% at the beginning of 2000 to around 30-35% now. Institutions are likely to be net buyers of shares over the next few years.

For overseas investors - sovereign wealth funds have grown hugely over the last few years with high petrol prices - UK shares have got much cheaper as sterling has fallen. It costs them less to buy Glaxo shares in their local currency than before, but most of Glaxo’s income arises outside the UK, meaning that, all other things being equal, the company will benefit from the weak pound.

Finally, it is beginning to look as if the world’s economic recovery is turning out stronger than most analysts expected.

Watching share prices over the last few months, it has been clear that there are far more buyers than sellers in almost all markets. While this situation persists the market will continue to rise. If investors decide to buy the cheap shares, which haven’t risen much, rather than the expensive ones which have, then Wise Investors will do well.

THE ELECTION

Only three weeks to go - thank goodness!

It’s impossible to predict how the markets could react to the outcome - there are simply too many variables in the equation. However, it appears that the market is being moved by forces which are more long-term and global in nature, so the election result may have little effect in more than the very short term.

Sometimes, election results do affect markets. In 1992, investors were expecting the weak Conservative government of John Major to lose to Labour, who had promised a big ‘windfall’ tax on the privatised utilities ( water, gas and electricity companies). The Tories won, and the utility company shares bounced massively. I don’t see anything quite similar in the offing this time.  So -‘no surprises expected’-famous last words.

The only prediction I’d be tempted to make is that if we get a hung Parliament, there will probably be a second General Election this year.

SOME MORE PREDICTIONS

Normally, before the end of big stock market up-trends, the price action tends to become more volatile and erratic. That hasn’t started to happen yet, which makes us feel that there is still some way to go. Also the balance of the market is still heavily skewed towards buyers - that’s unlikely to change overnight.

On the other hand, markets have run on a long way, and we have been adding sectors and funds to the ‘too expensive’ list, mainly in the area of technology. A period of consolidation would be helpful at this point. On FTSE-100, the 5500 level is important. If that is breached, we would be less confident for the market overall, but we don’t expect to see it below that level again in this rally, because of the strength of demand. A consolidation phase which ended above 5500 would be a strong positive signal.

It wouldn’t surprise us if the renewed interest in ‘value’ and ‘income’ turns into a bigger trend, but it’s too soon to be certain.

An increasing number of commentators have expressed doubts about the sustainability of Chinese economic growth, which is still around at 10% per annum. As China has been growing at this rate for around a decade and a half, it would be foolish to attempt to predict what might cause this trend to end, or when, or how other asset classes might be affected, but it’s something else to be aware of. (China was discussed in my January 4^th blog ‘China, next time round’)

THE CANARY IN THE MINE

One of the fund managers I visit recently described managing investment funds in the current environment as being a bit like farming on the side of a volcano. It’s less than 18 months since the world’s financial system came close to implosion - huge banks and insurance companies were failing every day, Japan’s car exports halved, and many things happened that none of us had ever seen before.

Nearly all the debt that caused the near-meltdown is still there, and a whole lot more, when you factor in government borrowing. The extraordinary measures introduced to keep the system functioning will have to be unwound in the next couple of years.

The volcano beneath us is still bubbling away - the Greek government has become insolvent and is being bailed out at the moment by the EU.

Our job is to manage money. We want at all costs to avoid a recurrence of the huge losses that happened in 2007-8. Should there be another major dysfunction (which isn’t a foregone conclusion), there will certainly be warning signs. These will be discussed in detail in my next blog.

Recent market conditions have been favourable for the funds. Since the date of my last blog, March 8^th, the FTSE 100 is up 4.29%, and the IMA Active Managed sector which contains both funds is up 3.61%. Against this positive background, TB Wise Income is up 4.62%, while TB Wise Investment is up 5.93%. TB Wise Income has been particularly strong over the last couple of weeks.

Since the rally began (March 10^th ’09), the FTSE-100 has risen 63.8%, and the IMA Active Managed sector average is up 50.7%. During this period, TB Wise Income is up 65.7%, and TB Wise Investment is up 67.8%. These figures are pleasing in a market environment which on the whole hasn’t suited our fund management style.

TB Wise Income still yields nearly 6.0% per annum, net of basic rate tax. Our belief that in due course investors would take more interest in higher-yielding assets may be starting to bear fruit. If not, we are being paid to wait.

TB Wise Investment has benefitted from renewed interest in UK smaller companies and private equity. Our holding in Graphite Enterprise Trust (private equity fund-of-funds, and a 5.0% holding in TB Wise) is up by 27% since March 23^rd - but is still at a 24% discount to the value of its assets, which haven’t been updated for several months. Also, investors are beginning to take more interest in investment trusts, as a result of which discounts have started to narrow. We have started to take profits in some areas, mainly technology.

As ever, please contact me if you have any specific questions or comments. I am most easily reached by e-mail on tony@wiseinvestment.co.uk

This blog represents Tony Yarrow's views as at 15th April, and does not constitute financial advice.

Tony manages TB Wise Income and TB Wise Investment