The Small Print

The contents of these muses are my own opinions, should not be taken as a personal recommendation to invest in the areas mentioned and does not replace the need for individual independent advice.

Lions, £50 Notes, Bitcoins and the Yield Curve

I came away from a lunchtime investment seminar in Brighton on Thursday with lots of thoughts, a pack of fund brochures and a cuddly toy – a lion. No surprise perhaps since the company hosting the event was Liontrust Asset Management. They are a relatively small independent and respected fund manager with strong investment returns. Presenting was head of multi asset at Liontrust, John Husselbee, an experienced investor who has “run money” for 30 years. This is in house jargon that fund managers often use. I subsequently had visions of a 100 meter race between a fund manager and a £50 note, but enough of the trivia. The key point is he has seen it all from the dot com bubble to the financial crisis. In contrast some young fund managers may never have managed investments through a stock market crash.

Husselbee started his presentation with a compelling argument that by protecting capital during sell-offs investors have less losses to recoup when markets rise. Consequently reducing the downside is crucial in achieving good long returns. From June 2011 to December 2017 a multi-asset portfolio he co-manages matched the total return from the FTSE 100 i.e. including re-invested dividends – but crucially with significantly lower volatility. This is pretty impressive given the fund in question only held 56% in equities at the end of the period. The principle here is winning by not losing. The outcome is good returns and with lower risk.

Husselbee then covered Bitcoins. Clearly some people have made fabulous returns from this cryptocurrency but that in itself is not a reason to invest. First Husselbee highlighted a graph that showed a remarkable correlation between the vertiginous rise in the price of the Bitcoin and google searches. It strongly suggests that prices have been driven by a fad and a mad scramble to buy, not by compelling investment fundamentals. Whilst Bitcoins have features that might identify it as a currency, for example some retailers accept payment in Bitcoins, its price is far too volatile to be considered a credible currency and it has no central bank backing. Moreover on what investable means Husselbee quoted the highly respected economist and investor, Benjamin Graham. He wrote in a landmark book of 1949, “The Intelligent Investor,” that:

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

Husselbee concluded as I do that the Bitcoin is not an investable asset but a speculative one. In fact I have not come across a single fund manager who includes it in their portfolios.

Another take-away for me from the presentation was the mixed messages about the global economy from the bond and equity markets. An OECD* study showed global strong and synchronised economic growth in 2017. The organisation monitors 35 OECD and 10 non-OECD economies and in 2017 all were expanding with a majority demonstrating accelerating growth. Not one was contracting, the first time this occurred since 2007. Last year equity markets rallied on the back of this positive backdrop combined with strong company earnings. In contrast the bond market is more pessimistic about the global economy. Here it gets a little bit technical but I’ll try to explain it simply. Economists and fund manager place a lot of store in what is called the “Yield Curve.” It refers to the chart of yields of government bonds with different maturities. Typically the normal yield curve shows that long dated bonds have higher yields or interest rates than shorter dated issues. This is because investors demand to be rewarded for the risk of future inflation. When inflation or interest rates or expectations of such rise bond prices fall and yields increase and the shape of the curve changes and vice versa. Longer dated bonds carry the most risk. However since 2014 the difference in the yield between US Treasury 10 year bonds and two year bonds fell from about 2.6% to about 0.5% in early 2018, before a spike to around 0.75% during the recent market sell-off at the end of January. In other words in the last four years the flattening of the yield curve means the bond market has been pricing in low growth and inflation, arguably even recession. Of course this period has coincided with very accommodative central bank policy and QE life support. I asked Husselbee what he considered the more reliable indicator – the equity or bond market and surprisingly he said the former. Instinctively I would have thought the equity market was given synchronised global economic growth. I conclude the mixed signals must make fund management a tricky business and being cautiously optimistic is probably a good middle ground, not being too gung ho nor too defensive and being selective in what you choose to invest in. Add a dash of flexibility and this probably a good recipe for fund managers.

Finally Husselbee’s presentation emphasised the need to ignore headlines (news events such as the UK snap election, the North Korea crisis or Catalonia) and focus on fundamentals. He also suggested Trump’s economic policies have yet to benefit the US domestic economy as evidenced by the fact that since his presidential election victory in November 2016 US smaller companies have significantly lagged US larger firms. On another point he and his highly experienced co-fund manager, Paul Kim, have tilted their portfolios from growth to value with expectations of rising growth and inflation.

In conclusion I thought Husselbee talked a lot of common sense, he has a clear and compelling investment philosophy which he articulates well and he clearly understand markets and what consumers need. For example he expressed some mild exasperation at regulators who in seeking to improve transparency end up making things more complex and confusing, a view I wholeheartedly share. For example under the new MIFID II** rules which require disclosure of fund transaction costs you can end up with a negative figure! Yes, that is true. It implies a fund manager can undertake multiple trades each year within his or her portfolio and incur no expenses in doing so, for example stock broker fees or stamp duty. Not only that someone plucks £50 notes from a money tree and pays that to the fund.

I may have said this before but I tend to buy fund managers more than funds. It is not easy to articulate but every now and again I listen to a fund manager, something connects and I think I really like the way he sees markets and manages investments. I can see myself entrusting client money to him and his multi asset funds.

*OECD is the Organisation Economic Cooperation and Development

**MIFID II is the EU’s second Markets in Financial Instruments Directive, a complex and bureaucratic piece of legislation affecting fund managers and IFAs alike and which the FCA adopted. It came into force on 3/1/18.

The content of this blog is my own understanding of the global economy and stock markets based on John Husselbee’s presentation. My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice, for example to buy Liontrust funds. You should seek individual advice based on your own financial circumstances before making investment decisions.

Stick or Twist – Time to Sell?

Following a review I advised some clients to undertake risk reduction and profit-taking from their investment and pension portfolios by switching selected amounts from pure equity to cautious risk funds. In response although they were happy with my advice they raised a perfectly reasonable question. Should we wait for a recovery in the equity markets before selling from the equity funds I recommended? Here is the gist of my reply.

The issue you raise is a difficult one to call as we do not know how serious this correction is. Waiting for the recovery instinctively makes sense given the sharp falls on global equity markets. Overnight the Dow Jones fell more than 4% whilst in Asia the Nikkei and Hang Seng fell more than 2% and 3% respectively. With ongoing volatility the fallout could continue, equity prices may drop further and markets may enter a longer term slump, suggesting selling pure equity funds later will not prove beneficial. If however there is a V shaped recovery in the near term it suggests waiting to sell is best. We just don’t know whether the slide will continue or reverse in the short term nor the medium term direction of markets, so do we stick or twist?

In favour of selling now is the argument that in some cases market indices have fallen back to their levels of just a few months ago. For example the Dow Jones peaked at 26,616 on 26/1/18. It has fallen to 23,680, its level on 29/11/17. The Hang Seng is now back to levels at the end of December 2017. Your portfolio was very profitable then and had I been advising you a few months ago I would have advised risk reduction and profit-taking. You can see that an emotional reaction to the short term volatility can cloud the fundamentals here. The FTSE 100 however has fallen back to levels last seen in May 2017 and so arguably the reversal is more significant.

In favour of waiting to sell is the strength of the underlying global economy suggesting the fundamentals are supportive of rising equity prices and the recent falls are just a correction to somewhat exuberant markets rather than the initial tremors preceding a global financial earthquake.

In conclusion I am happy to hold fire on all recommended pure equity fund sales. The alternative is we still proceed but reduce the amounts sold by a fixed 10% to account for the market drop. I could also undertake the sales on a phased basis, some today and some next week perhaps over several days. What this achieves is better prices if markets rally next week. The risk is of course that prices continue to fall and the later sales are at lower prices. It is a difficult decision and I am struggling to say what is the best to do. However if I have to get off the fence I would say sell all that I have recommended now reducing the sums by 10%, remembering I have not proposed disposing entirely of profitable equity funds. You will maintain substantial equity investment. What this means is you will still participate in a market recovery whether in the short or medium term. The risk of selling now at lower prices than a couple of weeks ago is arguably not too significant. You will only bank strong profits as opposed to very strong profits.

This blog is intended as general commentary only. Please note this advice is specific to these clients and should not be construed as general advice that other investors sell-down pure equity funds. Nothing in this article is intended as personal investment advice to my readers. You should seek individual advice based on your own financial circumstances before making investment decisions.

Global Equity Markets Slide

Last Friday the Dow Jones Industrial Average fell 2.5%, its biggest one day fall since June 2016. In the week as a whole the index fell 4.1% whilst the S&P 500 dropped 3.9%. The latter as you may recall is more representative of the US economy as a whole. The trigger for the falls was a sell-off in government bonds. US equities had a terrific start to the year, the best since 1987, on the back of the passing of a bill to slash corporation tax from 35% to 21%. The euphoria was hit by a sell-off in the bond market at the end of January due to higher than expected wage growth, inflation and fears of more aggressive interest rate rises. On January 29th in the US the benchmark 10 year Treasury yield rose to 2.73%, the highest since April 2014. To remind you of the relationship between bond prices and yields, when prices fall yields rise and vice versa. This is because a bond is issued with a fixed rate of interest, called the coupon. If the price of the bond falls the value of that coupon and the yield rises (see example at the bottom of the article).

The falls in the US bond and equity markets have now impacted global markets. As I write the FTSE 100 index is down 1.12% to 7,360 in morning trading, well off its peak of 7,778 on January 12th. Japan’s Nikkei 225 lost 2.55% overnight and the Hang Seng fell 1.09%.

So what do I conclude? It is too early to say whether this is the start of a major rout on global markets, an early warning of trouble ahead or merely a minor correction. In some ways the “correction” was entirely predictable. Concerted global economic growth was bound to fuel inflation and trigger rises in bond yields. The other question on a more positive note is to ask who are the potential beneficiaries of rising interest rates and market falls? It is widely agreed that banks and insurers benefit from higher interest rates whilst active fund managers with strong stock picking skills are likely to perform well, at least in a relative sense, compared to index tracking passive investments. Finally I have wondered if there is a self-correcting mechanism in the bond market. This may be simplistic but if yields rises it should attract income investors to buy, pushing up prices.

If a government bond is issued at £100 with a 2% interest rate the bond holder is entitled to receive a £2 interest payment or coupon each year. Once bonds are issued they are traded in the market and the price may rise or fall. If the price of the bond falls to say £95 and investors buy at that price they will receive the £2 coupon and the yield on the bond will now be (£2/£95) x 100% = 2.1%. At a price of £90 the yield rises to 2.22%. The converse also applies.

The content of this blog is my own understanding of the global economy and stock markets. My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice, for example to buy financial stocks or bonds. You should seek individual advice based on your own financial circumstances before making investment decisions.

Black Tuesday – The History and Legacy of the Wall Street Stock Market Crash of 1929

This little book by Charles Rivers Editors made very interesting reading for me over the Christmas period. It was not technical and was written in layman’s terms so it is well worth buying a copy if this brief summary piques your interest. I can only do scant justice to the lessons investors can draw from these historic events in an investment blog.

The crash in October 1929 was the culmination to what became known as the Roaring Twenties, as the US economy and stock market boomed, driven by strong industrial production and new technology. Employment was high and prices were stable. Prior to 1920 few ordinary Americans owned stocks but as prices rose through the 1920s middle class Americans piled in, often buying stocks on credit or margin. Stock prices had a momentum all of their own and became detached from the real economy and investment fundamentals. From 1922 they rose almost 20% p.a. on average, although not uniformly. Although concerns were raised in early 1929 the market continued to rise fuelled by speculators. From May 31st to August 31st 1929 Westinghouse Electric Corporation rose 89%, Steel was up 56% and the market overall rose by just under 25%.

On 5/9/29 Roger Babson, an entrepreneur and economist predicted a crash at a meeting of the National Business Conference. It was a repeat of an earlier warning he made at the same time in 1927 and 1928. Babson’s comments evoked retorts from economists and stock brokers. For example Professor Fisher, a noted Yale economist claimed, “stock prices are not high and Wall Street will not experience anything in the nature of a crash.” In early October 1929 Thomas Lamont, head of Morgan Bank wrote to President Hoover, “The future appears brilliant. Our securities are the most desirable in the world.” Almost every business leader and banker was saying how wonderful things were and the economy was only going in one direction, up.

The Dow Jones Industrial Average peaked at 381.17 on 3/9/29 and then declined to 320.91 by 21/10/17. The sharpest declines then occurred on Monday 28th October, with the index falling 12.82%. This was followed on Black Tuesday, 29th October by a further drop of 11.73%. Further losses occurred subsequently and the Dow finished the year at 248.48, a decline of 34.8% from the peak on 3/9/29. This was followed by the Great Depression with 50% declines in industrial output and international trade. Unemployment rose to 25% and around 9,000 banks collapsed. The stock market continued to fare badly. In 1930 the Dow fell a further 33.76%, in 1931 it lost 42.67% and in 1932 the market was down by 22.64% (Source: ). If the Roaring Twenties was a heck of a party the Thirties was the mother of all hangovers, with the Great Depression going global. The cause of the Great Depression is still not agreed by economists but it may not have been simply due to the 1929 Wall Street crash. One observer noted that the market slump reflected the change which was apparent in industry and the economy. In other words the stock market merely acts as a mirror on the economy i.e. cause and effect runs from the economy to the stock market, not the other way around. I am not convinced about this argument but space does not permit me to express my thoughts.

There are several other interesting facts to note. Firstly the Dow Jones did not recover back to its former peak until 1954, 25 years after the crash. Secondly the biggest ever one day fall was not in 1929 but on 19 October 1987 when the Dow fell 22.61%. What is it about October? This sell-off in contrast to 1929 did not lead to a recession. Thirdly on the reasons for the crash an article from the New York Times on Tuesday 22nd October 1929 was illuminating. This was before Black Monday and Black Tuesday but after three days of losses in which billions were wiped off the value of shares. Five reasons were given for the falls which I paraphrase:

*Readjustment of stock prices to levels that are justified by earnings, economic fundamentals and company prospects.

*Unanswered margin calls from thousands of small investors. In order to cover the loan repayments or interest payments stocks were sold. This downward pressure on the market was enhanced by stop-loss orders. These are where investors instruct sales once a floor in the stock price has been reached.

*Foreign selling on a large scale especially in railroad stocks as overseas investors protected their interests.

*Short selling by investors taking advantage of a falling market.

*Negative sentiment amongst stock holders even those with profits. This is about investor psychology, rushing on mass towards the exit.

This analysis more than 87 years ago feels like a modern commentary on the causes of stock market crashes in more recent times. Nothing has changed. Once the slide starts it is like a snowball gathering pace and size as it accelerates down the hillside. Big market crashes are sudden, (the warnings and red signals are not but the immediate triggers are), sharp and self-perpetuating. Nothing has changed and although we have not had a crash since 2008 why should we think another is not coming? John Templeton famously noted that the four most expensive words in the English language are – “This time it’s different.”

So what do I conclude and why have I raised this subject now as my first blog in 2018? It is certainly not because I wrongly called a correction in late 2017 and am seeking justification for my view. Moreover I don’t believe the economy and stock markets in 2018 are anything like they were in the US in 1929. I don’t think there is a bubble in equities in general nor have prices become universally detached from economic reality. My concern is due to a bullish and perhaps complacent attitude amongst investors. The global economy is going through a synchronised recovery, central banks are cautious and accommodative and people made money in 2017 from equities. So why not again in 2018? My message is investors need to keep in mind a sell-off will happen again, no-one knows when, and plan accordingly. That does not mean avoiding equities completely but being cautious and investing a significant part of a portfolio in defensive assets. This will require adjusting expectation of returns from “shoot the lights out” performance to beating inflation or cash, more modest outcomes. Of course individual needs and circumstances will dictate the correct investment strategy and asset allocation, notably investment timescales, attitude to risk, capacity for loss and cash reserves. There is no one solution for all.

Finally it is worth Babson got it wrong calling a crash in 1927 and 1928 but then it happened in 1929. I got it wrong in 2017. I hope I also am wrong in 2018 and I would take no pleasure should 2019 prove to be a terrible year for equity investors.

The content of this blog is my own understanding of the 1929 Wall Street crash and the global economy and stock markets today. My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.

Synchronised Global Economic Growth & Stock Returns

There is a wide consensus that in 2017 we have witnessed a broad based global economic pick-up. This has been accompanied by all major equity market indices posting strong gains with many hitting new highs. Emerging markets, Europe, the US and Japan have led the way. However within markets there has been a wide dispersion of returns. Leading UK fund manager Neil Woodford recently highlighted that in the year to 31/8/17, eight stocks accounted for just over 50% of the gain of the FTSE All Share index returns with the remaining 650 stocks making up the rest. These eight stocks were Unilever, Diageo, Glencore, Vodafone, Prudential, British American Tobacco, Rio Tinto and HSBC. Woodford concludes the UK equity market has been narrowly led by stocks exposed to Chinese credit growth.

On a similar theme Bill MacQuaker from Fidelity noted that just four stocks accounted for the two-thirds of the move in the MSCI Asia Pacific (excluding Japan) Index over the last year and if you missed out on holding these companies your returns would appear pedestrian. MSCI have created a very wide range of global and regional stock indices which tracker funds invest in. The MSCI World Index is a market capitalisation weighted index of 1,652 global stocks from 23 developed markets. The index rose approximately 18% over the first 11 months of 2017, a decent return. Whilst I do not have full data I suspect much of this rise is due to strong gains from a few companies. For example Apple the largest constituent of the index at around 2.27% is up nearly 47.5% in 2017 whilst the next biggest stock, Microsoft at about 1.44% of the index is up around 34.6%.

So what do I conclude from these observations? First it is clear that the broad based global equity rally reflected by index returns masks a wide disparity of stock returns within each market. This challenges the view that equity markets are universally expensive across the board. Certain sectors and stocks clearly are but good stock-picking fund managers will find opportunities to invest at decent prices in strong undervalued companies with good earnings growth. At the same time savvy investors might avoid the current winners. For example Woodford observed that whilst the share prices of the super eight stocks (my phrase), have risen sharply, earnings forecasts have lagged. For example HSBC has rallied around 66% since the June 2016 lows even though the earnings forecast is up only 5% in the current year. Conversely Woodford highlighted other companies such as Lloyds Bank and the AA where earnings growth has been good but share prices have fallen, in the case of Lloyds since its May 2017 peak. Domestic UK stocks now trade at a rare discount to UK exporters and it is in these domestic sectors such as healthcare that Woodford is investing. Aside from the opportunity set here, sector and stock selection is also about mitigating risk. If the Chinese economy stalls and the burgeoning bad debt bites the biggest stock fallers in the UK may well be the super eight. The positive side here is that other parts of the market with less bloated valuations should offer defensive qualities.

As we approach the year end I am pleased to have been proved wrong that I called a stock market crash, which didn’t happen. I think with hindsight I misjudged the equity markets to be universally highly valued. Indices might have peaked in 2017 but most stocks seem not to have joined the party, enviously watching from the side lines as the likes of Apple and the super eight jived merrily on the dance floor. Looking forward into 2018 I see selective opportunities for these bridesmaid equities. The word selective is key here. Active fund management should be favoured over passive index tracking. At the same time the risk of a hangover for the dancers could lead to a market correction.

The content of this blog is my own understanding of the global economy and stock markets. My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice, including to buy shares such as Lloyds Bank. You should seek individual advice based on your own financial circumstances before making investment decisions.

Investment Intelligence

I regularly attend investment seminars for IFAs run by Invesco Perpetual called “Investment Intelligence.” In a presentation last week the speaker reviewed the global economy and markets and addressed the issue of the US Federal Reserve unwinding its Quantitative Easing or QE programme. As you are aware central banks in the USA, UK, EU and Japan have undertaken considerable asset purchases since the financial crisis to support the economy and their balance sheets have ballooned. The unwinding of QE called Quantitative Tightening or QT should not be confused with tapering. The latter is the reduction in QE purchases – the European Central Bank (ECB) will begin to do this in January 2018 whilst QT is the next step i.e. the disposal of assets that central banks have acquired. This has to be done carefully and slowly as wholesale dumping of bonds onto the market could trigger a collapse in prices. Instead in the US is as bonds mature there will be a reduction in the amounts re-invested by the Federal Reserve. Whatever the methods deployed and stages that different economies are at, tapering and QT are both clearly signs of recovery in the global economy.

This conclusion was a key message from the seminar. A recent OECD (The Organisation for Economic Co-operation and Development) study showed broad based economic recovery in all 45 countries surveyed with many exceeding forecasts. Whilst global equities have been the best performing asset in 2017, emerging market equities have outperformed. This is a reversal of a five trend of declines compared to developed market equities, a whopping 50% in relative returns. Improved fundamentals and a weaker US dollar have contributed to the turnaround. In summary the bull market in equities could continue as economic growth is anaemic and central bank policy is accommodative. The speaker observed that bull markets don’t die of old age, a phrase that is clearly catching on, and he cited Australia which has not had a recession for 26 years. The message I am hearing from various investment companies is we have a Goldilocks economy, even if that phrase is not used – one that is not too hot and not too cold.

In the UK, Invesco’s view is that inflationary pressures are easing. Technology is keeping down prices although unsecured consumer debt, for example car financing is a concern. Brexit considerations will of course be a key factor for the UK economy as markets hate uncertainty. Surprisingly UK larger companies have underperformed smaller ones despite the tail wind of a weaker pound which boosts the value of overseas earnings. This is because 60% of overseas earnings are derived from the US and the $ has fallen against the £ in 2017. In another presentation by Prudential I listened to last week the lack of dividend cover and profits warnings from FTSE 350 companies was highlighted. Dividend cover is the ratio of earnings to dividends. If too high a level of earnings is paid out to shareholders it can leave companies financial vulnerable and shareholders at risk of future dividend cuts.

Other takeaways were very high asset correlations and very low volatility. Gold however may be a hedge against equity market falls and can play a useful role in a portfolio. Whilst there are political risks overall the back drop for the global economy is benign. I have no truck with this analysis but I have said on various occasions previously stock market crashes may be triggered not by deteriorating economic fundamentals but irrational investor psychology. Caution remains the order of the day for me.

The content of this blog is my own understanding of the global economy and stock markets. My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice, including to buy gold. You should seek individual advice based on your own financial circumstances before making investment decisions.

Eeyore Gets Onto The Dance Floor

Following a house and home office move just over a month ago I am slowly surfacing from the many distractions and I am starting to think about investment again. The equity sell-off I expected hasn’t materialised and so it was with interest I read an upbeat assessment for global and UK equities in a trade magazine by Trevor Greetham of Royal London Asset Management. He countered the fears of the more bearish amongst us about the length of the bull market with the pithy remark that they don’t die of old age! However he did back up his observation with sound analysis.

He noted that inflation in recent years has run well ahead of interest rates. With sluggish economic growth and a recovery which central banks do not wish to derail, interest rate policy has been very dovish. Rising inflation and static interest rates are the perfect storm for cash whose value is eroded in real terms without the compensation of rising interest rates. The disincentive to hold cash which has been prevalent since the financial crash is very supportive for equities. It pays to stay invested Greetham concludes.

Greetham also argues correctly that none of the obvious triggers are evident to send equities into a tailspin. The economy is not overheating with excessive wage growth or consumer spending, there is no evidence of excessive valuations as in the dot com boom of the late 80s and early 1990s nor are there signs of excessive financial debt or a banking crisis as in 2008. Bank balance sheets and regulation are now stronger. Although there are political risks such as with North Korea, Greetham argued that the macro-economic fundamentals are supportive of equities. For example he showed graphs of the inverse of the US unemployment rate and global stock performance relative to bonds. The two charts were highly correlated. In other words when unemployment is falling equities do well.

It would be hard not to conclude that Greetham thinks we are in a Goldilocks phase of the economy, not too hot and not too cold. You might even conclude “this time is different,” although I must stress these words are mine not his. In the past other economists and investors have made the error in assuming that past excesses or flaws in the financial system have been cured, only to be disappointed. Greetham is certainly not saying that a crash can’t or won’t happen, just that he does not see an obvious trigger at this stage in the cycle, although he does expect a bumpy ride from political risk or hawkish central bank concerns.

I have no truck with Greetham’s fundamental arguments and conclusion. He presents a reasonable bullish case for equities and there is not much between us. However many of the new jobs created especially in the UK are poor quality and interest rate rises may shock markets as they did in 1994. Crucially though it is not really the fundamentals that concern me but the potential for irrational investor behaviour facing a “wall of worry” syndrome about ever climbing equity prices. An unexpected trigger could send everyone to head for the exit.

Finally I said above that the equity sell-off hasn’t materialised. I could have added the word “yet.” I sincerely hope for the sake of my clients that Greetham is right and I am wrong. We might then see two iconic pessimists Eeyore and Private Fraser from Dad’s Army both getting to the dance floor to do a tango.

The content of this blog is my own understanding of equity markets. My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.

Crying Wolf?

When I came across an article by Jon Cunliffe, Chief Investment Officer of Charles Stanley entitled “Worries over an equity correction are overdone,” my interest was naturally piqued. As many of you are aware I am currently cautious on equities with concerns about stock market indices hitting new highs and the so called “wall of worry,” syndrome. Although I feel a crash is more likely than not, long term I am strategically biased towards equities.

Whilst Cunliffe acknowledged post-Brexit uncertainty he observed in the UK we have had the best corporate earnings season in six years. As you are probably aware rising earnings are supportive of rising equity prices and valuations. Moreover the low level of bond yields means equities are attractive relative to bonds. As of mid-June the yield on the FTSE All Share Index was just under 4% whereas the benchmark UK 10-year gilt yield was just 1%. In an environment where yields are scarce dividends from equities are attractive for income investors. However as the Bank of England recently finished its latest QE programme bond yields could rise narrowing the gap. An inflation spike or unwinding of the Bank’s asset purchases would act as a catalyst for this. Cunliffe is not overly fazed by this threat citing the fact that many UK companies generate most of their revenue from abroad and the global backdrop is supportive with a broad based economic recovery. Consequently Charles Stanley favour equities.

I cannot fault Cunliffe’s logic and would add that the recent fall in the pound boosts overseas earnings for UK companies. So have I got it wrong and am I just crying wolf in suggesting a stock market crash might be on the cards? I don’t think so even though I agree the underlying economic fundamentals are supportive. My concern is more about investor psychology and the tendency for markets to over-react to bad news and tank irrationally. This threat has been highlighted by the observation that client portfolios are laden with profits. As a result I have taken the view that selected risk reduction and profit-taking should be undertaken by switching from pure equity to multi-asset and other cautious risk funds. This takes into account that profits are merely paper profits until crystallised. That said I have proposed in my investment reviews a light form of risk reduction, slimming but not eliminating equity exposure. In this sense I have been hedging my bets.

Finally I have taken the view that in my advice to clients that the risk of calling a crash and getting that wrong will be less damaging to investment portfolios than the risk of getting the opposite scenario wrong i.e. advising clients stay fully invested in equities because a crash is not coming. In the event that markets don’t fall but continue to rise, clients who have reduced their equity exposure will enjoy lower returns but values will still rise. For me this reduced upside potential is better than a portfolio that loses a large chunk of its value from a stock market crash.

The content of this blog is my own understanding of market conditions. My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions. Cautious risk funds may fall in value during a stock market crash although normally less than pure equity funds. Cash is the only asset that provides 100% downside protection

Turkeys and the vote for Christmas

For investors in equity, bond and property funds volatility of value is an occupational hazard. In fact volatility is normally viewed as negative, a risk to be avoided if possible. This has led to a proliferation of volatility managed funds in the last few years which have targets for limiting downside movements in prices, so much so that the Investment Association, who group funds with similar investment mandates, permitting meaningful comparisons of performance, have recently created a brand new sector to accommodate them.

Volatility only damages portfolio returns if investors sell funds during the troughs as they may end up crystallising losses. Until then they are sitting on paper losses. If they ignore the short term noise and sit tight their equity investments normally recover and deliver good returns in the longer term. It is for this reason that investors need a cash buffer, accessible savings that avoid them becoming forced sellers at bad prices. Of course you could invest entirely in cash where there is no volatility. Although very cautious risk investors might sleep well at night during a stock market crash they are exposed to a different type of risk. With paltry interest rates, cash is unsuitable for income and in time its real value or purchasing power is eroded by inflation. Cash is not a great asset to be 100% invested in for the long term.

All this is standard stuff which you have probably heard me say before, however over the weekend I read an interesting article with some interesting new perspectives on volatility. It was written by Didier Saint-Georges, managing director and member of the investment committee of Carmignac Risk Managers. He argued that an asset moving in opposite directions quickly, the meaning of volatility, does not mean it is fragile. It could be a sign of flexibility. In contrast a stable asset might collapse suddenly or lose value little by little. Saint-Georges gave the example of safe-haven German government bonds. Investors expecting stable values and very low volatility got a shock when German bond prices fell 9% between 20 April and 10 June 2015 due to a brighter outlook on the European economy. He also cited Bernie Madoff’s pyramid investments which had extremely low volatility. This should have been a red flag for savvy investors. Saint-Georges referred to these examples as the “Turkey Syndrome.” A turkey fed regularly through the year comes to view the world as a stable and predictable place until the week before Christmas when this state of affairs proves to be an illusion!

There are other benefits of volatility. First it may help remove some of the froth in equity valuations – this is euphemistically called a “correction.” It may also drive out speculators who pile in to a good story and drive a wedge between prices and fundamentals. The classic example here was the technology bubble of the late 1980s. We all know how that ended. Conversely a sharp fall in a stock may be a sign that investors have sold out irrationally and have misjudged its true value, providing an opportunity for fund managers to add to their best holdings at lower prices. Finally if an index crashes it may signal a good time for investors to deploy cash to the market. Volatility does not need necessarily need to be seen as a foe.

The content of this blog is my own understanding of market volatility in part based on Carmignac Risk Managers’ article “Volatility is not to be feared.” My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.

Japan – Land of the Rising Sun or False Dawn?

In the last six months or so I have generally not been recommending my clients buy equities, instead sell them. My advice has been to take profits and reduce risk in an expectation of a stock market sell off, euphemistically called a “correction.” This is investment speak suggesting a collapse in equity prices is actually a good thing. In some senses it is, in paring back overpriced stock valuations to more justifiable levels and reminding over confident investors that shares can down as well as up. But major sell-offs are rarely pleasant as investors discovered in 2008 when portfolio values tumbled.

Anyway back to my main point, the case for Japanese equities, an exception to my advice to reduce equity exposure. Last week I listened to an interesting webinar from the manager of the JP Morgan Japan fund, Nicholas Weindling, someone I had not heard before. He argued the case for Japan was good citing stable government, positive company earnings growth and a growing culture of shareholder value, historically a weakness in corporate Japan. With inflation below target of 2% p.a. ongoing quantitative easing is likely to continue to be supportive of asset prices. In contrast in Europe the European Central Bank (ECB) will begin to taper its bond buying programme in the autumn as economic growth has surprised on the up side. European equities have been the bright spot in 2017.

Weindling argued that corporate governance improvements in Japan were structural with almost all companies on the TSE1 (Tokyo Stock Exchange, large companies) have an independent director, a huge rise since 2010. There has also been a significant increase since 2014 in companies having targets for ROE (return on equity) and ROA (return on asset) in their medium term plans.

Another compelling observation was on the fact that the Japanese equity market is under-researched, in absolute terms and relative to the US and Europe. For example take Japan’s TOPIX index with 2012 companies, a broader index than the better known Nikkei 225. Around 2/3rd of the companies have either one analyst or no analyst cover. The equivalent figures for the US Russell 3000 index and the S&P Europe BMI index with 1,862 names were 10% or less, whilst 50% or more had 2-10 analysts in both regions. What this means is that strong Japanese companies are likely to go under the radar and many of these will be under-valued. This inefficiency strongly favours active stock picking fund management based in Japan, something Weindling claims is rare.

Finally Weindling cited a significant rise in-bound tourism since 2012 and a growing participation of women in the labour market as being good for the economy. Both of these facts I was unaware of.

Of course not all is rosy in Japan, economic growth is sluggish, debt to GDP remains high, consumers are notoriously reluctant spenders and Japan’s demographic is ageing. Moreover Japan has a history of disappointing investors since the great crash in 1990. The land of the rising sun has more often proved to be a false dawn. That said many fund managers and asset allocators see good potential in Japan and are talking this market up.

To conclude a small or additional allocation to Japanese equities may be appropriate for many investors and given the choice I favour unhedged share classes i.e. those that do not hedge the currency risk of investing in a non-Sterling currency. What this means is that if the Yen strengthens against Sterling UK investors will benefit from the currency move as well as the underlying gains in share prices. With the Yen being a traditional safe haven currency, in a global equity sell-off it is likely to strengthen whilst problems and uncertainty with Brexit could weaken the pound. Currency risk is one all UK investors face whenever they buy overseas funds and it is another issue that needs to be considered.

The content of this blog is my own understanding of the JP Morgan Japan fund manager’s views on the Japanese economy and market prospects and my comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice for example to invest in Japanese equities. You should seek individual advice based on your own financial circumstances before making investment decisions.