Don't Invest in an Stock Index Tracker, Stick with Defensive Stocks

By: MoneyWeek

July was a very good month for the UK stock market – the best in more than six years, in fact.

The FTSE 100 rose by 8.5% during the month, as more and more investors flip from bearish to bullish, scared of being left behind by the rally. And with the banks set to report a rebound in profits (however artificial) this week, the cheer may well continue. Barclays has already set the scene this morning with a pre-tax profit of nearly £3bn for the first half of this year.

So what happens now – and what should you be doing about it?

One of the pundits who has called this particular phase of the financial crisis most accurately so far is Jeremy Grantham, a widely respected US fund manager based at GMO.

Many of Grantham's views will be familiar to MoneyWeek readers. Before the bust, he regularly condemned the "easy money" interest rate policies of Alan Greenspan, and highlighted the rampant property bubbles on both sides of the Atlantic. He's also a believer in the long-term merits of commodities as an investment. His regular investment letters are well worth reading at www.gmo.com.

In mid-March, Grantham wrote a piece entitled "Reinvesting when terrified", in which he basically said that the market was cheap and it was time to buy. His argument was that, despite the miserable long-term fundamentals, the market is being driven higher by "extreme stimulus and moral hazard of recent quarters". In other words, all that money pumping, and letting investment banks off the hook for their stupidity had to have some effect.

And it seems it has. But with the S&P 500 well above Grantham's "fair value" target of 880, what does he reckon will happen now?

Avoid trackers, even if the market rally continues

With lots of institutional investors still left on the sidelines, it's possible that this "speculative rally" could go for "longer than reasonable investors expect." The S&P 500 could rise to above 1,000 "in the next two to three quarters". But even so, he reckons that it's time to take some profits. "We are in for seven lean years in which the market will be looking for an excuse to be cheap."

More important now is to look at "which types of equities are cheaper... than the market." And for Grantham, that's now high-quality US stocks. The current "dash for trash" rally, where investors have driven up the price of low quality stocks in the most vulnerable sectors has left solid defensive stocks flailing in their wake.

We've been backing defensives for several months now, since the first big market slump back in November – you can read one of our more recent cover stories on the topic here: Seven safe stocks that will last longer than the rally. But if the market rally might have further to run, shouldn't you be sticking your money into a FTSE 100 tracker?

I don't think so. Sure the market might go higher, but there's a good chance it'll come off again before the end of the year. Certainly, if you're happy to take a punt and you like the odd spreadbet or two (always remembering to set stop losses of course) then by all means try your luck against the market.

How to invest for the long-term

But if you want to invest for the long term, we firmly believe the best way to do it is to buy assets when they're cheap. Cheap assets can always get cheaper, but they're more likely to deliver you a good return in the long term than buying something expensive in the hope that it'll get even more expensive.

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On top of that – it may just be me – but the market right now feels uncomfortably similar to the late spring of 2007, just as the credit crunch was getting ready to kick off in earnest. Back then, although few people were acknowledging it, the economic outlook was darkening fast. The US housing market was already falling hard, and the subprime lending debacle had already blown up. Bear Stearns' hedge funds were shortly about to blow up and within a few months, Northern Rock would follow.

Yet stock markets were still rising. The FTSE 100 was above 6,500 and targeting its all-time high of 6,930. The Dow Jones was heading for 14,000. A frenzy of mergers and acquisitions was driving prices ever higher. Everyone in any position of authority, from central bankers to governments to high-profile economists – you know, the same ones who just felt the need to explain to the Queen why none of them saw the credit crunch coming - was still pretending that the collapse in the US housing market wouldn't even have a big impact on Americans, let alone the rest of the world.

The truth is, most people knew something was wrong. Nobody really understood why share prices were rising – but because they were, they found arguments for it to continue. The "wall of money" story was told a lot back then too. This time the "wall of money" is set to come from institutional investors sitting on the sidelines; back then, the "wall of money" was going to come from sovereign wealth funds (SWF).

That particular flood of cash never materialised. Most SWFs ended up getting burned when they shovelled their spare cash into the western banking sector. So will the "wall of money" argument win out this time? We suspect not. There's plenty of room for investors to be unpleasantly surprised by how weak the eventual recovery actually is.

Emerging markets show promise for the long-term too

If you are looking for a more general market to invest in for the long term, emerging markets look far more promising. Getting back to Grantham, he reckons that although they've had a strong run-up recently, emerging markets will command a premium over developed markets in the long run, "to celebrate their obviously superior GDP growth compared with that of an ageing world". You can read more about the prospects for emerging markets and the key stocks in some of these countries in the current issue of MoneyWeek: How to profit as wealth and power head East (if you're not already a subscriber, claim your first three issues free here).

By John Stepek for Money Morning , the free daily investment email from MoneyWeek magazine .

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