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“I made a fortune getting out too soon” ~ JP Morgan (1837~1913)

Simon Martin from the Leeds Office of Charles Stanley offers his regular market commentary for clients and prospective clients

by
Simon Martin

24.07.2017

WHAT WE ARE TRYING TO DO AND WHY

To break things down to the simplest common denominator we are running a strategy whose aim is primarily to grow client funds and protect the long term purchasing power.  This involves growing the capital in a rising market and protecting asset values if the market falls.  

Consequently, looking after client money involves trying to understand the bigger picture whilst being aware of the smaller details.  We appreciate that there is a risk, when looking at too big a perspective and it is sometimes easy to become obsessed by small intricate details.  So when we step back and look at wider perspectives we have to be very careful not to get too drawn into an overtly negative or wildly optimistic view.  To paraphrase Sam Zell, founder and Chairman of Equity International, “If everyone is looking left, sometimes it does make sense to also look right” 

At this junction, I feel that it is sensible to establish our investment base case going forward.  Last week we had a fascinating and highly illuminating presentation by JP Morgan’s economic team here in the office, who provided a great insight into their projections for the market over the next few years. Hence why I feel that the above quote, by the founder of their firm, is so relevant to the plans we are putting in place.

Key to the JP Morgan economists’ long term strategy is a belief that over the next three years the US economy will go into recession and consequently markets will fall.  They don’t believe that it will be within the next twelve months, but can’t say this with any degree of certainty.  The Charles Stanley central case is that we expect further growth from global equities over the next twelve months, as global growth is likely to remain healthy especially in Europe and Asia.  Global growth will also encourage corporate earnings to remain healthy particularly as there are few signs that the global pickup in inflation is sustainable, especially as oil prices have started to weaken.

It’s important to draw a few distinctions between the short-run and the full market cycle – which is commonly measured as the market peak to peak, or trough to trough.  In the short-run, market returns tend to be influenced mostly by a combination of investor sentiment, risk preferences and price momentum, all of which are interrelated.  Over the course of a full market cycle however, valuations are ultimately what matter. 

Ironically in the short-run, investors can sometimes be disadvantaged by following the familiar approach of trying to buy low or sell high.  This is because momentum inevitably carries on and can impact on very short term performance.  Yet, a full market cycle tends to be enormously forgiving to investors who decide to reduce their risk when markets are at or close to their high point.  This is true even if investors do this a little bit too early, and miss out on the final stages of upside.

To emphasise this point, bear in mind that a five-year return profile of 10%, 10%, 5%, 5%, 0% beats returns of 20%, 20%, 10%, 10%, -25%.

 

 

Portfolio A

 

 

 

Portfolio B

 

 

£100,000

     

£100,000

 

10 %

£10,000

£110,000

 

20%

£20,000

£120,000

10%

£11,000

£121,000

 

20%

£24,000

£144,000

5%

£6,050

£127,050

 

10%

£14,400

£158,400

5%

£6,353

£133,403

 

10%

£15,840

£174,240

0%

£0

£133,403

 

-25%

-£43,560

£130,680

Illustrative purposes only

Whilst Portfolio B does better in the run up to the correction the more cautious one, Portfolio A has a higher capital value by the end of the period.  This is because the mathematics of compounding dictates that large losses have a disproportionate effect when it comes to amassing returns.  Therefore, from a full-cycle perspective, avoiding them is critical.

Investors always face the difficult question of what is more important when thinking about their portfolios – capital growth or capital preservation.  Most people naturally want both!   But sometimes we simply can’t deliver both.  In this note, and subsequent ones, I want to deal with the challenge of capital preservation. 

The purpose of our comparison between the two return profiles above is not to advocate permanently taking a defensive stance.  Far from it.  The key issue is more that the avoidance of losses is generally worth pre-positioning for. 

Although there are no guarantees, we are concerned that some asset markets are over-valued and on the basis that we are overdue some form of economic slowdown in the US (still the key driver for Global growth, general market performance and market sentiment) we have advocated a cautious view for most of the last quarter, especially in the run up to the UK election.

Despite some markets being expensive on almost all valuation metrics, there are a few assets that we think, in combination, have the potential to not only help preserve capital in the present environment and hopefully continue to increase it in a sensible risk-adjusted manner:

Some say our ‘road maps’ may be inaccurate and our investment compasses no longer work.  But we are facing a new investment world and in some cases a concerning one ― a continuing period of low interest rates and , over the next few years, steadily slowing worldwide economic growth out of which it is difficult to see an escape route.

While we still advocate owning risk assets and seeking a reliable income, we have to take seriously the risks to the outlook from politics, high corporate debt levels, over-extended property markets in some parts of the world and the rising medium-term risk of a recession.

The clear implication is that we, being in control of client assets, should be balancing portfolio risk against defensive strategies to provide some downside protection to portfolios and, potentially, broader diversification.

 

WHAT ARE OUR CONCERNS

One of the defining features of financial disasters throughout history is that afterwards it seems remarkable that investors failed to see the danger.  The bursting of the South Sea Bubble in London in 1720 or the stock market crash of 1929 on Wall Street look, with hindsight, to be the inevitable outcomes of an avoidable mania that should have been obvious.  Yet for some reason everyone danced on — to borrow the infamous phrase of the boss of Citigroup in 2007— until the music stopped.

I recently listened to a very interesting podcast about George Soros which highlighted that his skill when managing money is in understanding what is going on with people, and identifying human personalities and interactions.  His main belief throughout the years has been not to bet on the event of something happening but to bet on investor reactions, and the reaction to the reactions.  Therefore it is important to understand investor behaviours and what will happen as a result of that action.

Inevitably investors are generally fuelled by fear and greed, and follow the underlying market momentum.  Hence we get overreaction to both the upside and downside.  We therefore have to try and think about what participants will do, be it politicians, traders, or so called long term fund managers and make decisions based on our feeling as to how investors will behave i.e. believing that the markets will overreact, and this should give us an advantage.  

Another contributing factor to market irrationality is the fact that more and more people are using computers and machines to invest money, which do not have the ability to second guess human criteria and are therefore basing a lot of their investment on purely fundamental analysis of figures i.e. crunching lots of numbers hoping that they will provide an answer.  Markets are experiencing huge inflows based purely on momentum and as a consequence we feel that they are swinging to a huge overweight position.

When you combine this artificially reasoned momentum with politicians who are creating highly inflationary policies resulting in huge amounts of further increase in debt to try and spend our way out of trouble, we are wary that we are moving further and further into a very alarming situation.  

As we have pointed out on numerous occasions, we marvel at the size that risk assets have risen over the past few years.  It is not just equities but also corporate bonds and basically any assets that investors can get their hands on.  For fund managers who have followed what they believe is the prudent path and chosen not to participate fully in these markets, say since early 2015 when the Fed ended its QE(Quantitative Easing) programme, they now run the risk of losing client assets and being vilified by the media.

For those remaining fully committed to risk assets, whilst they may look like heroes we are not sure that the same outcomes will be seen in the next few years.

We feel that with US equities at or very near all-time highs, the risk premiums may be compressed in all assets, but we have to be mindful and set the scene of what we are thinking.  We have been in the prudent camp for the last few years and when we step back from day to day market gazing and try to rationalise the current valuations we have to be mindful that it is valuations that drive long term returns, but investor risk appetite that is driving short term returns.

Many of the trends we have seen in the media over the past few months have been going on for a long time:  the outperformance of US equities, the relentless decline in bond yields, the bull market in the dollar, pessimism about the benefits of active management and the huge surge in momentum investors chasing yield.  As such, investors get used to them and become almost resigned to their persistence.

We believe this is exactly the time that active, patient and disciplined asset management can add most value from a full-cycle perspective.  We therefore remain alert to profiting from the opportunities that may present themselves as these trends begin to tire.  We also emphasise that as investors we need to think about longer term horizons, 3 - 5 years not 3 - 5 weeks.  Hence we have to focus on capital preservation and the dynamics that can help markets to recover after a fall

2016 reminded us of the challenges faced at the height of the technology bubble as momentum, not valuations, drove share prices.  Much of what we saw in 2016 does not appear to be grounded in fundamentals.  In the long run, fundamentals are all that matter for share prices, but over shorter periods, they can be overtaken by other drivers, such as sentiment and the sheer volume of money being invested.  That certainly appears to have been the case in 2016 and the first half of 2017 where market performance has become increasingly concentrated in a handful of stocks, most of them technology related

In the past we have explained the risks associated with the fact that momentum-driven markets test the resolve of active fund managers.  This problem is being further compounded because once the momentum is identified it has the effect of attracting a different crowd of investors who in turn send up generating a second set of momentum trades.  Therefore once a ‘momentum’ starts to exhibit performance, money is thrown at it and the factor becomes self-fulfilling, right up until it doesn’t.

So we are starting to see a major paradox where the traditionally high volatility stocks (the larger capitalised technology stocks) are increasingly being considered as low risk /low volatility stocks whereas the so called low volatility stocks are currently more volatile than the market (UK Government securities certainly have been).   At some point this thinking will come to an end and the counter switch will be dramatic for conventional markets.

 

RECESSION THREAT

As we highlighted earlier the JP Morgan economist commented last week that they forecast that there will be a recession in the US within the next 3 years.  On the basis that the last US recession ended in 2009 Wall Street is now almost eight years into what has to be classed as one of the greatest value-creating eras in capitalist history.  This is largely down to ultra-lax monetary policy and rock-bottom bond yields, which have made shares much more attractive. 

However over the past 10 years the market has pulled back by an average of 14% at some point in each year.  So far this year we have seen a 3% pull back so we feel it is prudent as we are looking after your money to hold with our conviction and wait for the pull back. 

In all probability Britain could also due a recession at some point in the next few years.  Since the 1970s there has been one every decade with the last also ending in 2009/10.  As we will point out later given the uncertainty over Brexit, slowing economic growth and a change in consumer spending it could evolve far quicker that the one forecasted for the US economy.  We also have to consider the increasing political risk and the weakened pound

On the positive side global growth remains broadly intact, but we are fearful that momentum is slowing.  Europe has surprised on the upside and it is currently our favourite market, especially as we believe that US investors will be galvanised by low growth in America and reallocate the money removed from Europe ahead of the political uncertainty late last year.  The US remains clouded by the uncertainty on Trump’s policies.  

Thankfully, world trade remains encouraging and inflation dynamics are losing momentum, but overall the fear of being wrong is driving equities up and not holding on to convictions as people chase short term performance.  When we look at the Invesco Perpetual UK Economy indicators, in the second quarter of 2016 there was only one red indicator with public and private debts as a percentage of GDP. The majority of the indicators were green, with just four amber.  However since then we now have three indicators negative (real wage growth, CPI and public and private debt as a percentage of GDP) and a significant increase in amber warnings including house prices, consumer confidence, retail sales and the trade balance.

At the moment we see these indicators getting weaker.

THE BIG ISSUES

At this stage, the one phenomenon that we have to be aware of is that since the start of the last recession we have seen a massive injection of cash into the system via quantitative easing.  Looking at the data, QE in America created $4.5 trillion of new money, in the UK £375 billion, Europe 1.1 trillion Euros and rising, and Japan has moved to unlimited quantitative easing.

Since March 2009 the FTSE 250 has risen by 240%, the FTSE 100 by 115%, the S&P index in America by 256%, Europe by 138%, NASDAQ by 454%, global commercial property by 150% and UK commercial property by 67%.  As a consequence it is pretty obvious that prices have risen largely due to asset price inflation caused by quantitative easing, and more importantly a chase for yield as investors have had to operate in a practical zero interest rate policy (with negative interest rates in Japan and most of Europe).

One issue we have to bear in mind is that we have seen examples in the US, Europe and China, the main sources of market stimulus in the past few years are starting to be reversed indicating that all are now in the early stages of tightening economic policy.  Therefore we have to seriously consider that stopping QE, could trigger problems later this year especially when we add into the mix a potentially much stronger dollar.  We absolutely have the recipe for financial market losses that have not been seen for a few years.  We also have to bear in mind the fact that Central Bankers are also starting to talk about increasing interest rates and are worried that the US Federal Reserve will tighten until something breaks.

That said, we all know that timing bear markets is next to impossible, but we would offer the viewpoint that markets usually spend time topping before the real losses occur.  With that market topping process in mind, our view is that the greatest risks lie a few months from here.  We suggest that equity and credit markets are already starting to lose momentum and we may start the topping process sooner rather than later.   

If correct, further portfolio gains will be hard earned in the months ahead, and volatility should start increasing from a very low base.  A recent Bloomberg article tried to offer a timeline between the current US equity market and that in the late 1990s.  It offered a view to readers that they should not worry as current market conditions are similar to the ones we saw in 1997 (i.e. we have another 3 years before the market corrected).  Some look at things differently and believe that we are either late 1999 or early 2000, a period where risk reduction may have looked ridiculous on a day to day basis but in hindsight was breathtakingly obvious.

We recently saw a very interesting presentation by Fidelity indicating that their “investment clock” has moved away from overheat into recovery.  However we question how as part of an asset cycle the market can go from overheat, back down the cycle into the Recovery phase!  The indicator has been in the overheat section for more than a year, but if the markets were behaving rationally and following the convention it should be forcing us from overheat into the cash environment.  Therefore by going the wrong way back down the cycle we are confused as to what these signs are saying to us.

 

CONCLUSION

When I started this piece this article came up as being over 30 pages long and my colleagues were naturally dismayed.  I therefore am going to break it down and send out a number of smaller pieces over the next few weeks looking at the separate issues in more detail.

To conclude this piece we are seeing evidence that the VIX volatility index is at an all-time low indicating that people don’t perceive equities as being risky even at these levels, and with the huge amounts of cash sitting on the side line taking advantage of any short term pull back to enter the market we do have to ride a wave of momentum before common sense will appear.  Here in the office we therefore have to balance how long we hold our conviction, knowing that at some point the market will pull back quite sharply.

Do we risk money at this late stage without huge conviction that we are right, or run the risk of falling behind in the performance table but knowing that we can sleep better at night.  When looking at equity markets, it is obvious that there are very few bargains within the blue chip index with many indicators at significant premia to pre-crisis levels and, perhaps even more scarily, tech boom levels.  With investors chasing any asset that has a reasonable yield, we have to be mindful that if bargains are not found in larger capitalised stocks what about elsewhere?

Because of the low interest rate policy we are have seen all risk assets being chased ( especially those offering a good income yield), such as emerging market debt, high yield debt, property markets and now even moving into smaller cap markets. It is becoming increasingly difficult to find attractively cheap stocks in these corners of the market as well.

As we said earlier, it is investor risk appetite that matters for short term returns.  According to Morgan Stanley, American retail investors are the most positive they have been for many years.  Their most recent investor intelligence survey shows that at the moment they are over 60% bullish, which is the highest it has been since 2005.  Whilst it is concerning that investors continue to buy US equities at these current prices, even more so than in the tech boom days, there are factors that are supporting this trend.   

Therefore with historically low and even negative interest rates distorting market prices not just for equities but also for bonds, we also have to look at another scenario.  Because of these low interest rates companies are now being increasingly saddled with debt that would not benefit them in the long term, as their chief executives have been taking advantage of these low rates to build up debt mountains.  The company directors are therefore blatantly using the system to improve their targets and drive up share price initiatives, and again it is another example of short-termism that is distorting the long term market.

Whilst we appreciate that if Trump is successful and does make changes to the tax system which could result in hundreds of billions of dollars moving back to America, we question whether like the UK’s EU subsidy this may have been spent many times over by the time it actually happens.  We also have to be mindful that this cash is concentrated in the coffers of a relatively small number of mostly technology companies, leaving the majority of companies being still very heavily leveraged, and therefore if the Fed finally start to raise interest rates at a slightly faster speed than anticipated this record debt pile is going to become more expensive for the majority of companies to service over the next few years.

Since early January the data shows that hedge funds and institutions have been net sellers of equities, whereas retail investors have been net buyers.  It is worrying that retail investors, who have a nasty record of piling into equities near the market highs and dumping near lows, have suddenly decided after years of Central Bank induced speculation to jump into equities now.  As in late 1990, we know that the final move to the peak must be done as quickly as possible.  We also know that as we get near the very peak of the market more and more people finally succumb and invest at an all-time high, exposing themselves to massive downfalls when the market rolls over.  

“Most investors are wired with every bone in their body to do the wrong thing” ~ Howard Marks, Oaktree Capital

We also suspect that many fund managers are displaying signs of panic as they fear missing out on the current momentum especially as their active funds are being compared to cheaper passive tracking portfolios.  We have spoken to some fund managers who, in our opinion, are compromising on their principles and buying stocks just because they are going up so as not to fall into the bottom half of the performance table.  Others still believe that they are paid to be fully invested and to maintain full exposure to equities, as being in cash could lead to underperformance.  They believe that central banks will continue to provide an unlimited supply of liquidity and that these risks despite all historical evidence can be managed quite safely.  

This is why we believe so strongly that we have to focus on preserving capital so that we keep hold of the capital that we and you have worked so hard to gain in order to fight another day and be able to take advantage of these market conditions, rather than become a victim of them.

Simon Martin

Investment Manager

Leeds

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Past performance is not a reliable indicator of future results

 

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