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INVESTMENT SPECIAL: Anything but gilts

In search of the next ‘trade of the decade’

21 May 2011

12:00 AM

21 May 2011

12:00 AM

In search of the next ‘trade of the decade’

Imagine you were sitting in St Paul’s at the 1981 royal wedding, waiting for the mismatched bridal couple to arrive and idly speculating about the best way to save up for a wedding present for their first-born, a generation hence. The odds are you would not have given much thought to British government stock, or gilts, as the investment of choice.

At the time, gilts had become a pariah of the financial markets, shunned by anyone who had followed their calamitous decline in value over the postwar period. Inflation is the great enemy of bonds, and so great was the loss of faith in UK government debt as a store of value in the face of the country’s continued economic incontinence that in 1981 most issued gilts were trading at 40 per cent or less of their face value. One in-famous issue, undated 2.5 per cent Consols, which had once provided the fictional Forsytes (and many real-life Victorian families) with their income, had fallen so far that its price barely exceeded its yield, a hitherto unimaginable event.

With hindsight this turned out be one of the great bargains of the century. A combination of belated government resolve, technological change and a flood of cheap goods from emerging markets ushered in a sustained period of low inflation, which in turn drove down interest rates to levels last seen in the 1950s. These trends proved just as beneficial for government bonds as the inflationary, strike-bound, oil-oppressed conditions of the 1970s had been damaging.

Undated gilts such as the aforementioned Consols have risen more than three-and-a-half times in price in the 30 years since the Prince of Wales’s first wedding, producing an annualised return of more than 15 per cent, with the added benefit that the capital gains have been tax-free. The return is higher than anything gilts have ever produced in the past, and comfortably higher than shares over the same period. Gilts at their 1981 levels were a fine example of a ‘trade of the decade’, an investment which required just one simple decision but went on effortlessly to deliver exceptional results for ten, 20 or even 30 years.

In a world where investors increasingly focus on shorter-term outcomes, these rare beasts are worth looking for. For the past ten years, for example, a simple strategy of buying gold, holding gilts and avoiding shares would have produced terrific results. The gold price has risen steadily at 17 per cent per annum over the ten years to May 2011, without a single down year. FTSE 100 shares, meanwhile, have produced just 0.2 per cent per annum, even after taking dividends into account, though emerging markets have done rather better.

In the early 1970s, in contrast, a quite different strategy of buying oil and other commodities while avoiding bonds of all kinds would have made investors good returns in a generally unfriendly environment.

The perfect ‘trade of the decade’, on my definition, is an investment which not only produces enduring results and is simple to execute, but can be held for years without excessive cost or monitoring. Such decisions tend to fly in the face of conventional wisdom, which dictates that investors protect themselves through diversification — a sensible policy for anyone who is aware of their own ignorance, but one that tends to be taken to costly extremes, especially at big turning points in the market and the economic cycle. ‘Diversification becomes diworsification,’ as the celebrated US stockpicker Peter Lynch once put it.

By definition, trades of the decade will typically involve assets which are valued anomalously — being either very cheap after a long period of poor performance (a potential buy), or very expensive after a strong bull run (to be avoided). The investor needs patience and determination to buy or sell when most investors have been doing the opposite, for the paradox of good long-term trading strategies is that they would not work if anybody had a good word to say for them at the outset.

Where might the trades of the next decade be found? Of the assets to avoid on a ten-year view, two stand out. One is the US dollar and the other are government bonds of over-indebted countries which, after their spectacular run over the past 30 years, are about to enter a long period of poor-to-terrible returns as inflation (and sovereign debt default in some cases) returns to centre stage. While government bonds still have some diversification value, and would offer temporary protection if the world falls into a depression, this is not a scenario in which low-maintenance decade-long returns will be made.

On the buying side, Japanese equities are the most obvious candidate on valuation grounds, having not been as cheap as they are now since the 1970s. They meet all the criteria set out above, including the fact that there are scores of plausible arguments (poor demographics, unsustainable debt, and so on) against them.

There will also be more profit to be had from a long cyclical upswing in the price of natural resources, which began around 2000. That was a trade of the decade just gone, but it is not over yet. As Alex Brummer says in this issue, commodity prices tend to be volatile: the biggest risk here is being forced out of a winning long-term position by confidence-sapping temporary falls — one of which is quite likely this year. Gold is another trade of the decade candidate from the Noughties which has further to run.

In Aesop’s fable, he makes a distinction between the fox, who knows many things, and the hedgehog, who knows just one great thing. The biggest investment story today is that of the global debasement of money, as governments compete to trash their currencies and put off the evil day when the consequences of the unsustainable global debt binge of the past ten years have to be faced. That in turn tells us that the trade of the current decade will have at its heart protection against inflation, and protection also against governments as they try to bludgeon their way through the unappetising choices needed to bring the problem to a resolution.

Anything but gilts, in fact.

Jonathan Davis in the founder of Independent Investor.

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