Investment tactics going forward 22/11/08

1. By Bruce Baker BSc MBA DFP Certified Financial Planner Director Puzzle Financial Advice Pty Ltd, AFS licence 230050 An independently-owned financial planning business http://www.puzzlefinancialadvice.com.au Investment tactics going forward22/11/08 Attempting to look into the future is fraught with difficulty. Failure to attempt to do so is reckless. Warren Buffett “It is better to be approximately right than precisely wrong.” www.puzzlefinancialadvice.com.au

2. Topics for today • What has happened in stock markets? • Have we seen the bottom? • What can guide us for the period ahead? • What happened after the past really big deflationary crashes? • What other sign-posts are there for the future? • Summary of the investment challenge • Our strategy to deal with these challenges www.puzzlefinancialadvice.com.au

3. Last 12 months – one of biggest crashes • 48.5% fall in real terms in Australia so far www.puzzlefinancialadvice.com.au

4. US real share prices • One of the big crashes in US history – history hints at further to go – reversion to mean. • US house prices may still to fall another 30% in real terms www.puzzlefinancialadvice.com.au

5. Have we seen the bottom? • Have we seen the bottom? • I suspect that at least for some stocks and some securities the answer is no. • Is the market good value from a long-term perspective? • Clear case in some individual securities • less clear for other stocks and other sectors • Some securities selling for less than cash backing the asset !!!! • Other securities are a long-way below NTA. • Why might some stocks and some sectors sell down more? • Deleveraging (gearing into shares) is being unwound because of losses • and hedge fund redemptions – and lenders are tightening lending rules • So there has been a lot of forced selling - perhaps more forced selling to come • Panic selling • A lot of investors are very nervous / shocked. • As are their advisers • Robert Prechter believes the real panic selling has yet to commence • He may well be right • We don’t seem to have seen a “final capitulation selling” phase • Which we probably need to see before we have seen the bottom • Many investors are short of cash – forced selling • Many investors have lost sight of (or faith in) the strategy that they were following – so selling • The economic pain is ahead – no-one knows how bad • Australian house prices have yet to crash – 50% • Australian banks have yet to be rescued • Banks are scrambling to raise capital at discount to market price – more capital raising to come • This damages mum & dad shares investors • House price crash plus failure of Credit Default Swaps likely to crush Aussie Banks • A lot more pain for Aussie Bank share investors probably lies ahead www.puzzlefinancialadvice.com.au

6. Has the US hit bottom? • Reversion to the mean – then overshoot is normal Alan Kohler 14/11/08 www.puzzlefinancialadvice.com.au

7. Have US shares hit the bottom? FAR From bottom – but it might take years to get to the bottom • What does Professor Robert Shiller’s data say? www.puzzlefinancialadvice.com.au

8. Robert Prechter Views. • Robert Prechter is thinking that in US, Dow Jones Industrial Index fall to 3000 • at 12/11/08 Dow Jones Industrial is 8282. Would need a further 64% fall. But may take 5 years. www.puzzlefinancialadvice.com.au

9. So have we hit the bottom? • To help answer that question, we must consider the question of “how did we get here?” US Debt Bubble – biggest in 200 years www.puzzlefinancialadvice.com.au

10. Australia’s debt bubble • Biggest debt bubble in Australia for 150 years • Biggest debt bubble in USA for 200 years www.puzzlefinancialadvice.com.au

11. The problem with debt bubbles • The Austrian School of economics argues that debt bubbles lead to economic depression: cause and effect. Their argument is very compelling. Further they argue that there is nothing central banks can do to stop this effect. Yes, central banks can prolong the unfolding and they can exacerbate the eventual pain but they argue that central banks cannot prevent economic depression. • There have been 3 debt bubbles in the USA over the last 200 years. The current debt bubble is far and away the biggest. The previous two debt bubbles led to economic depression. • there have been 3 debt bubbles in Australia over the last 150 years. The current debt bubble is far and away the biggest. The previous two debt bubbles led to economic depression. • So the 2 key questions you need to consider are these: • WHY SHOULD THIS TIME BE DIFFERENT?If for the USA and Australia, the last 2 debt bubbles led to economic depression, why won't this debt bubble lead to economic depression? • Further, since this debt bubble is far and away the biggest of the 3 debt bubbles both USA & Australia have experienced, why won't this debt bubble lead to a bigger economic depression than the last 2? • These are both interesting questions that deserve the attention of investors at this point in time. • Is it absolutely certain that we will have economic depression? Very few things are absolutely certain in economics. • To try to counter this risk of economic depression, central banks and governments have never in history been as motivated to take extreme and decisive measures to counter this risk of economic depression. If nothing else this action will change the course of events ahead. I am sure not even the central banks are confident that their actions will prevent economic depression. • It is just possible that these central bank & government actions might just prolong or defer the problem - or make it worse (there is significant historical precedent for such intervention making things worse). • Alternatively, they might create extreme inflation. We live in interesting and very risky times and our global financial world is incredibly complex. • Personally, I suspect that at some point these extreme monetary stimulus measures by central banks and government will create very serious inflation – but I suspect this will be some years hence. • 13/11/08 “George Soros, chairman of Soros Fund Management, testified at a House Oversight and Government Reform Committee hearing on Thursday.” He said "a deep recession is now inevitable and the possibility of a depression cannot be ruled out.” • http://www.reuters.com/article/newsOne/idUSTRE4AC5IN20081113 www.puzzlefinancialadvice.com.au

12. Have we hit the bottom yet? • A perspective on house prices from Assoc Professor Steve Keen from University of Western Sydney • “How about the objective data, as recorded in the Demographia survey, that Australia’s median house price, at 6.3 times median income, is the most unaffordable in the OECD?” Steve Keen 12/11/08 http://www.debtdeflation.com/blogs/2008/11/12/always-look-on-the-bright-side-of-%E2%80%A6-economic-data/ http://www.debtdeflation.com/blogs/?s=debt http://news.sbs.com.au/insight/episode/index/id/42 SBS 9/9/08 Economist Steven Keen has claimed Australia is heading for the worst recession since the Great Depression, and predicts housing prices will drop by over 40 per cent. www.puzzlefinancialadvice.com.au

13. Australian Household debt • “Or the RBA’s own data that which shows that, relative to household disposable income, household debt in Australia is actually slightly larger than in the USA? Clearly our economic managers are torn between not wanting to spook the market, and wanting to present objective guidance—so much so that debating whether economic projections reflect scientific foresight, or politically inspired spin, has become the contest du jour in Question Time. “ Steve Keen 12/11/08 http://www.debtdeflation.com/blogs/2008/11/12/always-look-on-the-bright-side-of-%E2%80%A6-economic-data/ www.puzzlefinancialadvice.com.au

14. What is ahead for Australian house prices? • Best to look at historical experience. • http://www.debtdeflation.com/blogs/2008/08/04/how-much-worse-can-it-get/ www.puzzlefinancialadvice.com.au

15. Warren Buffett “Buy American. I Am.” • Warren Buffett is a value investor • 16/10/08 NY Times “So ... I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds.” • But even Warren Buffett has never invested in a market like this. Warren Buffett was born in 1930 in the middle of the Great Depression – the last market that was “somewhat similar” to this one. www.puzzlefinancialadvice.com.au

16. Jeremy Grantham is buying – deep value manager • 18/10/08 Gratham Newsletter • “Finally! On October 10th we can say that, with the S&P at 900, stocks are cheap in the U.S. and cheaper still overseas. We will therefore be steady buyers at these prices. Not necessarily rapid buyers, in fact probably not, but steady buyers. • But we have no illusions. Timing is difficult. We play the numbers. And we recognize the real possibilities of severe and typical overruns. • We also recognize that the current crisis comes with possibly unique dangers of a global meltdown. • We recognize, in short, that we are very probably buying too soon. • ----- • For an unparalleled 20 years, global equities, especially U.S. equities, have been overpriced. Now, finally, they are cheap and likely to get cheaper. Likely, I believe, to set up a once-in-a-lifetime investing opportunity (or maybe twice in a long career). • History says a 50%+ overrun has characterized the aftermath of the three important equity bubbles. • Our conclusion, though, that the S&P is likely to bottom out in the 600 to 800 range within the next two years can unfortunately be seen as not particularly pessimistic from a historical perspective. www.puzzlefinancialadvice.com.au

17. MMC Funds Management is buying - deep value investor • 30/9/08 newsletter • “In keeping with our contrarian philosophy we are now moving from holding cash and are buying as we can see value in the market. We also believe that the market is not much more than 10% -15% from the bottom. However as you know timing the market is nigh impossible and we may have in fact already reached the bottom, only hindsight will determine if we are correct. • There is strong anecdotal evidence that a number of professional investors are now making the call to re-enter the market. • As you can see we agree with Mr Buffet that there is now compelling value in the market. We have also moved the weighting of the funds in particular the MMC Contrarian Australian Share Fund to hold large cap value companies that have been purchased at solid discounts.” • Alex Hutchison, CEO, MMC Contrarian Limited • “September Update: Value is now compelling • Markets hit the bottom long before the economic news turns good • We remain cautious about the prospects for the global economy which we expect to slow sharply, however we are optimistic that the Australian economy is healthy enough to stay out of recession during this global slowdown. • We are growing increasingly optimistic that all the bad news is pretty much factored into the share market. • When the share market is working properly, it is a great discounting mechanism, in so far as it looks forward and factors in all the anticipated good or bad news into stock prices today. This is what seems to be happening now. Clearly the next year or two will be characterised by more difficult economic circumstances than the past, however the much lower level that shares are priced at largely reflects that reality. • While we may not have seen the very bottom in markets, our sense is that we are getting close. • Accordingly we are intending to progressively invest the remaining cash holding into the share market over the coming few months.” www.puzzlefinancialadvice.com.au

18. Have we hit the bottom? • A fair few people are calling a bottom – “the market has fallen ~50% so how can it not be reasonable value! At least that is how one version of the “logic” goes? • Alternately people (like deep value investors) are trying to apply some form of fundamental analysis to the market – a lot of guess work in these times. • Eg will there be a total melt-down? • When will markets return to some form of “normality”? • What will governments and central banks do? • What will happen to consumer confidence? • Will the US$60trillion market of Credit Default Swaps blow up? (when?) (implications?) • No-one really knows? • A lot of people are giving views. • Everyone is really guessing to a fair extent – because we are in a period of extreme risk by any historic standards. www.puzzlefinancialadvice.com.au

19. BB View: we won’t know the worst is behind us until • The debt bubbles will be behind us • The housing bubbles will be behind us • The credit crisis will be behind us • We will probably have completed a major capitulation selling phase. • Probably a new deal on global currency management – where Asian currencies (particularly or at least the Chinese YUAN) will float freely against US dollar & EURO. • i.e. major trade imbalances – particularly between the East and the West will be back to more sustainable levels. • We will know whether the US is bankrupt? • US budget deficits will have returned to some level of manageability • A “new Bretton Woods Agreement” will have been negotiated to help manage the international global financial system. • Banks will be more highly regulated so that they lend much more conservatively • Securitisation of debt will have been outlawed (though I note in the morning of 13/11/08 the US Secretary of the Treasury, Hank Paulsen described debt securitisation as “having frozen up and being a vital part of the US economy and so needed special support at this time” … clearly issues to work through here. • The problems with securitisation of debt • Causes loss of monetary control by central banks • Allows lenders to be more cavalier in lending because they can sell on debt. • Global currencies will have somewhat stabilised – probably • Cash rates will have bottomed (close to zero) and started to rise again • The investing herd has sworn off shares for a generation – and sustainable dividend yield well above cash & fixed interest rates • The investing herd will have sworn off gearing into property. • Reversion to the norm in the very long-term charts will have been completed • eg Shiller’s share price and house price charts etc www.puzzlefinancialadvice.com.au

20. Topics for today • What has happened in stock markets? • Have we seen the bottom? • What can guide us for the period ahead? • What happened after the past really big deflationary crashes? • What other sign-posts are there for the future? • Summary of the investment challenge • Our strategy to deal with these challenges www.puzzlefinancialadvice.com.au

21. What else can guide us? • We have seen very big crash by historical standards. • We cannot be sure that this crash is over or not. • What other clues are there regarding the future? www.puzzlefinancialadvice.com.au

22. What has happened in deflationary crashes? Puzzle Financial Advice www.puzzlefinancialadvice.com.au

23. The USA in the Great Depression • Big fall again in ’37 after Keynesian stimulus wore off Puzzle Financial Advice www.puzzlefinancialadvice.com.au

24. Remember: Big share crashes & real estate crashes happen together • Source: US Fed via Prechter • So the west should be largely expecting big real estate price falls across the board. www.puzzlefinancialadvice.com.au

25. Normally you should not expect achieving the peak again in real terms for decades. www.puzzlefinancialadvice.com.au

26. And the next 5-10-15-20 years – a roller coaster • That is – probably not a buy-and-hold market – but a traders market. • Possibly a very wild and scary ride for buy-and-hold investors www.puzzlefinancialadvice.com.au

27. What other warnings is history providing? • 100-year average returns is about 6%pa real for shares • But typically • 20 years of ~14%pa real followed by • 15 years of negative real returns eg -1%pa real • For the West, the last bull market started 1982 • For much of the West, the long bear has started Risk 2. Western share markets centred on USA to have poor returns. www.puzzlefinancialadvice.com.au

28. Topics for today • What has happened in stock markets? • Have we seen the bottom? • What can guide us for the period ahead? • What happened after the past really big deflationary crashes? • What other sign-posts are there for the future? • Summary of the investment challenge • Our strategy to deal with these challenges www.puzzlefinancialadvice.com.au

29. Asia non-Japan emergence Goldman Sachs Asia non-Japan currency & asset price appreciation set for decades ahead And is China & India to do to US, what US to Europe in the last half of 1800s. www.puzzlefinancialadvice.com.au

30. Asia-non-Japan drives resource super cycle for decades • The experience of emerging Japan & Korea points towards this • For example www.puzzlefinancialadvice.com.au

31. This resource boom vs last boom www.puzzlefinancialadvice.com.au

32. Commodities after the 1929 crash www.puzzlefinancialadvice.com.au

33. Japan is at a very different stage in cycle www.puzzlefinancialadvice.com.au

34. What role should precious metals play? Gold seems to have just begun its bull run in A$ - and maybe also an A$ hedge – but Gold is unlikely to run again until the deflationary pressure wane. Gold price in A$ www.puzzlefinancialadvice.com.au

35. China AFR article 10/7/08 • Chinese GDP • as large as US in PPP by 2020 • as large as US in $ terms by 2035 • double US GDP by 2050 • and by 2050 IMF, United Nations, World Bank etc will be based in and dominated by China www.puzzlefinancialadvice.com.au

36. 11/7/08 ABC News “Petrol tipped to hit $8 a litre by 2018” www.puzzlefinancialadvice.com.au

37. Can the East take up weakening demand from West? www.puzzlefinancialadvice.com.au

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42. “Washington is quietly repudiating its debts” WSJ 22/8/08 • “Washington is quietly repudiating its debts” below. BBaker theory on what is happening is that: • for the next period (I am not sure how long it lasts – 6 months or a few years) – we get some sort of deflationary crash – of indeterminant magnitude THEN • Because of the level of US debt, the US will try to inflate its debts away through deficit fiscal policies – and easy money policies. At this point, one of two things can happen: • The US might achieve serious consumer price inflation – just like they have achieved massive asset price inflation during the 13 years from 1995-2008, through easy money policies from the US Fed OR • The rest of the world might tire of funding the excess spending of the USA, and the US dollar may then crash OR • We could get a mixture of the above two effects. www.puzzlefinancialadvice.com.au

43. Topics for today • What has happened in stock markets? • Have we seen the bottom? • What can guide us for the period ahead? • What happened after the past really big deflationary crashes? • What other sign-posts are there for the future? • Summary of the challenge • Our strategy to deal with these challenges? www.puzzlefinancialadvice.com.au

44. Next 5-15 years a big uncertain rollercoaster!! • Case for this has been made in the earlier slides. • Necessarily a very widely-diversified traditional long-term buy-and-hold strategy focused on Western markets • is likely to deliver very poor to negative returns • with a lot of volatility mixed in • (because of the cycle of 20 years good, 15 years bad) • So what is your alternative? • Winners need to have one or both of two key elements: • To be a trader (necessarily technically driven) • OR/AND • To invest in the themes where there is no 10-year bear ahead. www.puzzlefinancialadvice.com.au

45. BIG PROBLEM • The vast bulk of today’s managed funds • Have been designed for the long-bull market • Basically index trackers, index huggers. • not designed to handle the type of market we are likely to see over the next 10 years. • WHERE managers have products targeted at segments of interest where • They have low costs AND/OR • They add stock-picking and/or currency mgt value • THEY HAVE A ROLE • Most don’t have a useful role in our portfolios www.puzzlefinancialadvice.com.au

46. Topics for today • What has happened in stock markets? • Have we seen the bottom? • What can guide us for the period ahead? • What happened after the past really big deflationary crashes? • What other sign-posts are there for the future? • Summary of the challenge • Our strategy to deal with these challenges www.puzzlefinancialadvice.com.au

47. Puzzle’s strategy for next 5 years • Refocus to deal with the new market realities • No point pretending the long bull market about to resume (burying head in sand) • Focus on business processes & strategies to • Trade client portfolios • Efficiently • Compliantly (Need to comply with Corporations Law) • Cost-effectively for clients • For ALL our key long-term clients, need to be on • Limited Managed Discretionary Account (LMDA) • Through Assetlink (badged BTWrap) • Using Buy/Sell tools now in place • My commitment (as always) to you • The highest level of accountability reasonably possible • Keeping you informed of the logic of the strategy • Keeping you informed of what is happening in your portfolio • Keeping you informed of what is happening in the market • Calling a spade a spade • Putting your interests FIRST above all else • This strategy is far and away the best option I can see • based on my reading of investment history, current markets, economics www.puzzlefinancialadvice.com.au

48. What is Puzzle’s active portfolios strategy? • Our 10-year winners will remain our dominant themes • Though above approach does broaden our investment menu • The dimensions to the strategy • Buy/sell timing on individual securities • Portfolio construction disciplines to blend securities • Putting my money where my mouth is: • The Baker Family investments are going be entirely driven by this process from now on. www.puzzlefinancialadvice.com.au

49. Buy/sell timing on individual securities • Basically a momentum strategy • For a sector or security • Primary BUY signal will be Coppock Indicator • http://en.wikipedia.org/wiki/Coppock_curve • But supporting indicators help • Need to minimise the number of FALSE BUYS • Transaction volume low • Eg don’t typically want a buy & a sell on same security within 12 months • but there will be exceptions • A range of indicators for sell discipline • Ponder the question • Will it ever be “the right time” to switch back to long-term buy-and-hold? • My gut feel is that with this added to our tool-kit, • we will never want to let this timing over-lay go • But there will come a time again, • when long-term buy-and-hold will become more attractive again. www.puzzlefinancialadvice.com.au

50. XMM – to illustrate www.puzzlefinancialadvice.com.au