Climbing a Wall of Worry

Imagine being a rock climber. The higher you get up the rock face or cliff the scarier it gets, particularly if you dare to look down. So it is for investors as stock market indices in the US and the UK scale new heights. A widely expressed fear is we are heading for a crash and investors are getting nervous. So should you be banking profits or switching to the safe haven of cash? Let’s examine some facts that will hopefully provide some guidance.

The current bull market in equities has been going for more than five years and this is significantly longer than average. Data from the US since 1932 suggests this is just over three years and a correction is arguably due. That said the current equity rally started from a very low base after the worst financial crisis since the 1930’s depression. This bull market therefore incorporates a strong element of recovery in very beat up asset prices. It may be dangerous to suggest this but this bull market may be different. Moreover equity performance has been variable in different global markets. The US followed by the UK have led the way being the fastest economies out of recession. The EuroZone in general has lagged whilst global emerging markets have delivered poor returns in recent years with slowing economic growth in China which is seeking to reform its economy, a flight of capital with “risk off” investor sentiment and tapering of QE. Japan had a strong equity rally that lasted for a year but this has since stalled with the third arrow of Abenomics*, structural reform being difficult to fire.

In support of the bears, who might be happy to climb a tree but not a rock, it is true in some markets valuations are stretched with prices rising faster than earnings. For this reason earlier this year asset allocators began rotating from US to UK equities and downbeat sectors such as miners and emerging markets have started to attract investor interest. Moreover a few months ago there was a sharp sell-off in UK mid-caps after a very strong rally in recent years. The best explanation appears to have been this was profit taking by nervous investors. Interestingly undervalued mega-caps are now back in favour after years of dull relative returns.

So what do I think? I am not unduly worried by a correction. The global economy is still in the early stages of recovery and whilst there are systemic risks from a property bubble and bad debt in China and deflation in Europe, my sense is these are relatively small compared to the global banking crisis of 2008 and the EuroZone fallout in 2010 and 2011. I suspect the biggest risk is fear itself. Investors like lemmings have a habit of throwing themselves off the top of the cliff. A sell off will be caused by investor panic rather than fundamentals. In support of this view it was telling to read fund managers suggest in a bull market you buy on the dips and add to your best ideas. A correction itself triggers buying but is healthy in removing the froth in valuations. It may cause the bull market to pause for breath but it may not alter the upward trend. As an example consider the famous stockmarket crash in October 1987 when equities fell 22% in two days. You may recall the chart of the UK equity market I cited in my last blog:

In the context of the equity rally of the 1980s and 1990s the 1987 crash appears as a relatively small blip and the FTSE 100 finished higher at the end of 1987 than at the start of it.

My guidance would be to adopt a long term buy and hold strategy and ride the volatility but it is your money and I can’t take your place on the rock face. You may prefer to be cautious and undertake selective profit taking and risk reduction or rotate to undervalued equity sectors and markets. It is a perfectly reasonable strategy to invest tactically, bank what you have and for caution to take precedent over gaining more. The risk of risk reduction is the correction may not happen, an investor holds cash earning diddly squat and they pay more to buy back into equities later on. This is precisely what happened in late 2011. At that time I was convinced a EuroZone inspired crash was imminent. I was wrong. Guessing the market is notoriously difficult.

*Abenomics is the name given to Japanese Prime Minister Shinzo Abe’s policies to revive the Japanese economy.

This blog reflects my own understanding, views and interpretations of global stockmarkets . It is intended as general investment commentary and is not an invitation to invest or not invest in the areas mentioned. You should seek individual advice before making investment decisions.