Listen to Buffett – this too will end

Chairman, Wilson Asset Management
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In recent months I have written about the developing bubble in (perceived) safe, high yield securities. Unfortunately this month I find my self more concerned than ever.

US interest rates have been at unprecedented lows for what is now a prolonged period of time, despite the US experiencing a gradual economic recovery, and investors are starting to herd. The flow of funds to relatively higher-yielding investments has become a torrent. Junk bonds in the US are trading at all time lows against government treasuries and the Dow Jones is at all time highs.

The Australian market is behaving in sync. Stocks that pay high dividend yields, and are perceived to have pricing power in their business model, are trading at, or close to, all time highs.

The bubble that brought on the GFC has now been replaced by a different bubble, but one that is equally dangerous. As Rene Rivkin used to say, every boom busts, we just don’t know when.

Wise words from Warren Buffett

My mate Nige has just returned from Omaha for the annual Berkshire Hathaway meeting, where investors from all over the world meet to listen to the wise words of Warren Buffett and Charlie Munger. They consistently reiterated their view, that we are in unchartered territory in regards to monetary policy, and they do not know how the US will ween itself off the QE drug or bring its budget into line.

They made it clear that finding good value was difficult and they are accumulating cash and waiting for the inevitable fall in asset prices, when they again will buy enthusiastically.

As Warren often says, the time to be fearful is when others are greedy and the time to be greedy is when others are fearful. In Australia we will see something like $500 billion in bank term deposits roll off this calendar year.

Those investors will probably be surprised at what they get offered (by their bank) to reinvest and many may go hunting elsewhere for more attractive returns. Even the ASIC Chairman, Greg Medcraft, is trying to get ahead of this bubble by warning investors to be sceptical of investment yields that appear to good to be true. With higher returns comes higher risk. The attitude that even blue chip stocks, such as our banks, Telstra and Woolworths, provide bond-like stability is just not right, so beware of treating them thus.

Trends tend to travel further in both directions than common sense and value suggest they should, but that’s the human component of markets and they won’t change. There is no telling how, or when, this rush for yield will end but end it will, and we will be doing our best to insulate our investors from the fallout by not being in the overpriced areas of the market.

Election gambit

The Australian Federal election, of course, is around the corner, and the political experts are suggesting the Coalition will win convincingly. Whichever party wins, they will find themselves with a very weak budget position and the odds suggest, to me, that higher taxes and lower spending are likely to be a signature of the next term.

Markets may stage a relief rally on a change of government or may indeed price it in before the event, given the likelihood of the outcome. Either way, it is not an issue we are too concerned about at this time.

While interest rates are the key driver of asset prices globally right now, ultimately, stock markets need earnings growth to really maintain rising share prices. In Australia, we are seeing little evidence of this. The risk of share prices moving ahead of earnings is becoming more acute with every step up in the market.

At this time, our market is in a very unusual environment where good economic news leads to a market sell-off, as happened on 9 May, when better than expected unemployment numbers were announced. The market is being fuelled by the expectation that interest rates are going lower and investors will continue to drive the high-yielding stocks ever higher.

Our bull market is leading to a bubble in high-yielding stocks, we have no way of knowing how and when it will end, indeed it appears to be moving higher before it ends, but end it will.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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