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