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What next for stock markets?

2010 has turned out to be a funny year so far for equity markets. It started strong, lost steam, picked up again and again lost steam in August. The YTD performance (up to Aug 27) of major indices have a story to tell: MSCI AC World -6.17 per cent; MSCI Asia Pac -3.02 per cent; Nikkei -14.75 per cent; ASX -10.28 per cent; S&P 500 -4.53 per cent; FTSE 100 -3.9 per cent; Spot Gold +12.87 per cent.

What does an investor do? Sell stocks and buy gold? Regular readers of this column would have benefited from the gold trade recommended years ago but one cannot and should not have all his/her money in gold alone. In this background, it is worthwhile examining what has happened to stock markets during the year so far and for this I have the Gray duo (Orbis funds — June 30 fund report) to thank.

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you have got to get up and dance. We are still dancing.” These were the words of the former Citigroup Chief Executive, Chuck Prince in 2007. This has become mantra of sorts for the global policy makers. Since 2008, global governments have pursued aggressive policies to ensure that the music does not stop, in fear that too many people will be left without a chair. Having achieved their initial mission to stabilise asset prices, politicians are finding it too difficult to turn off the music. Witness Bernanke’s statement on Friday (August 27) where he said that he did not rule out anything in the battle to combat deflation.

Stock investors had a good run in 2009 (after a torrid 2008) thanks to the sea of liquidity but we must all not forget that the returns, while providing immense relief to stock investors, have come at a great long term cost to future returns. At current share prices, the Gray duo feel that “there is a much higher than normal probability that investors will be unable to earn a satisfactory real rate of return. Whether this takes the form of disappointing future returns, higher future inflation, or both, investors must fight even harder than before to preserve the purchasing power of their capital.”

They go on to say “ Government intervention has not only inflated asset prices, but it has also brought politics into the realm of financial markets. This has been most apparent in efforts to rein in banks and financial service firms, but the politicisation of BP’s oil spill in the Gulf of Mexico, and Toyota’s recall before that, remind us that few sectors can escape the heavy hand of government intervention, particularly when driven by public sentiment.”

Short term, I expect stock markets round the world to do well thanks to Bernanke’s resolve to fight deflation. So what should investors do? The first step is to maintain exposure to gold stocks — several top class funds are available for retail investors to buy. Second, invest with good fund managers with exposure to resource stocks. The coming five years, will be the period for stock pickers who place contrarian bets. The third piece of advice will be to invest in good quality, deep value managers who are seasoned in the art of making contrarian bets. The last piece of advice will be to invest in good quality absolute return managers — look for managers who did not lose money in 2008, had half decent returns in 2009 and are doing well so far in 2010.

Happy investing.

Views expressed by the author are his own and do not reflect the newspaper’s policy.