Stock Valuations and Kevin Rudd’s $1M Bank Deposit Guarantee

Hello Everyone,

Pardon the sparseness of my posts in the last fortnight. I have been reading and thinking very hard. For me, it is important to try and say something meaningful rather than contribute to the endless media waffle concerning the current financial crisis that does nothing more than waste time and confuse people further.

As first glance, many ASX stocks look incredibly cheap based on historic valuations. There are now heaps of shares that have P/E ratios less than 10, and offer fully-franked dividend yields greater than 10%. These are not just the battered property trusts who have high debt – many of these companies are in other sectors and are still reporting record earnings growth. So why aren’t these companies’ share prices going up?

The reason is that sentiment is very very poor. The market is anticipating future drops in earnings over the next few years as the financial crisis runs its course. People lack accurate, trustworthy information, so they are expecting the worst.

I personally see reasons to be positive. Emerging markets like Brazil, China and India are still growing strongly, and many Australian companies have exposure to these economies. There will still be demand for cheap consumer goods. Plenty of money will still be made in biotechnology and agriculture.

My share portfolio has been battered heavily – I have many small cap stocks which naturally are more volatile and lack liquidity, but they’ve all been paying their dividends like clockwork and most of these dividends are higher than last year. I do not buy shares that do not pay a good dividend – I see the dividend as a mark of business stability and compensation for periods of stagnation.

Right now, I expect the market to see-saw up and down for a prolonged period. I am looking at ways to take advantage of this. One area I am reading up on is the investment technique known as Value Averaging. Most people are familiar with Dollar Cost Averaging, in which one regularly invests a fixed amount of money into a share or managed fund, regardless of the price.

With Value Averaging you vary the contributed amount depending on the value of your portfolio at the end of each time period, in order to reach a pre-defined target. The end effect is to buy more shares when prices are lower and buy fewer shares when prices are higher. Research has shown Value Averaging to outperform Dollat Cost Averaging about 95% of the time. I plan to write a post on this in the near future. If you can’t wait, click on the above link.

In other news, on the 12th of October, Prime Minister Kevin Rudd surprised everyone by announcing a package to provide an unlimited guarantee on bank deposits. The financial markets reacted like an agitated grizzly bear hit with a tranquiliser dart – there was a day of temporary euphoria, followed by a swift return to instinctive behaviour.

A week later, Kevin realised that the package may have been overly generous and he announced that the bank deposit guarantee would be limited to $1 million. Beyond this amount, bank account holders would have to pay for insurance.

I question the wisdom of this scheme. Although this may have allayed consumer fears about the solvency of banks, it may have had the unintended side effect of further fuelling an exodus from shares and other asset classes into this newly created ‘perfect safe haven’.

Furthermore, in the event that the financial crisis worsens and a bank does become insolvent, where is the Government going to get the money to meet their guarantee obligations? Probably by printing more money! This will cause increased inflation and devalue everyones’ wealth. Nonetheless, this is probably far more emotionally palatable than going to your bank and being told that your money is gone.

Speaking of inflation, the Australian Bureau of Statistics stated that the Consumer Price Index (CPI) will reach a 13-year high of 5% this year. The current interest rate on Australian bank deposits is around 6%-6.5% per annum, so people who have their money in cash will be treading water.

In contrast, corporate earnings are more resistant to inflation. Assuming that demand remains constant, corporate revenue rises with inflation. For this reason, I see better value in making defensive investments in defensive low-debt stocks than blindly putting money in the bank, unless you need to access your money in the short-term.

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