Its Not Harry

Comment and opinion for retail investors in the UK

Mark Potter

Diversification works

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In my training sessions for people who want to understand or even manage their portfolios, I generally get to deal with the fairly widespread failure of many so called absolute return funds to deliver on their objectives.

I usually talk through the facts about different funds having different strategies and mention that not all funds that are good diversifiers will be easily recognisable by their name, nor will they necessarily be ranked in a homogenous (the same sort of funds) peer group, so they may have what look to be weak quartile rankings over some measurement periods. Of course, my subscribers know that past performance is informative, but not on its own a useful criterion for selecting funds.

One fund that I often use to make my point is the JP Morgan Global Macro Opportunities fund. This fund uses a themed approach and draws on JP Morgan’s long term application of behavioural finance theory. To understand it better, you need to do a little reading of the supporting documentation.

I used the fund in the advisory Tactical Cautious Portfolio which I often recommended as a portfolio element when I was an IFA and which I still maintain personally.

Take a look at its performance over recent weeks. You will see that one can invest in ways that take the worst shock out of market corrections.

What to buy?

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A follow on question to my last blog post about timing re-entry to markets must be ‘what would you buy?’

At an asset class level, that is easy to answer: equities. With global interest rates back down to super low level, bonds will have served their defensive role and maybe do a bit more, but are not likely to be at bargain basement prices.

It is well known that although many fund managers can be criticised for not adding much value in rising markets when compared with the raw market indices, it is fairly easy to see that passive, index tracking funds and ETFs lose more money in falling markets. In other words most actively managed funds have at least some defensive characteristics.

It follows that passive global index tracker funds have probably sold off more than the sort of funds we own. I checked that out using the well regarded Vanguard Lifestyle Equity range and it is certainly true.

So as a quick way of getting exposure to equities while we wait and see what permanent changes are going to result from the current market crash (there are always some), buying into a global passives fund or ETF sounds like a good call to me.

I will write more about this after doing some detailed research.

Catch a falling knife?

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The title is the investment market cliche for buying into a rapidly collapsing market or share price. It is pretty self explanatory – most people will consider the risk of grabbing the sharp blade with painful results to be too great.

How can one apply a logical process to timing new purchases into a market that, as now, is manifestly much cheaper but could get cheaper still?

Firstly, my experience is that not even the most talented of investment experts ever know the exact bottom of a market until some time after the downward trend has permanently reversed. One reason for that is that there is plenty of algorithm driven trading in the markets these days, so short term reversals may just be computers buying, not people deciding the crisis is over.

A logical approach

I tend to make my decisions using the ‘opportunity cost’ approach. In other words what happens if I don’t invest and miss the the lowest price on the one hand versus what’s happens if I do invest and the price falls a lot more?

Assuming that my readers are like me with some of their assets in the market in diversified portfolios, but plenty of cash on hand, here is how one can work through the logic.

Keep calm and keep your cash? I personally will be doing that for now.

If you don’t invest and miss the bottom, your invested assets will be going back up and your cash is still available to invest when assets are cheaper than they were, albeit not the very cheapest they have been. The current correction is sharp enough for one to observe the reversal after it is set in and very likely still buy at cheaper prices than we saw a month ago.

If you do invest and the market falls more, both your invested assets AND your new assets fall and you have less cash to buy more when the reversal can be confidently expected to be set in. In addition, your stress level will go up.

It is obvious that this pair of risks is not symmetrical. The first option means losing out on some upside but still gaining something from having prudently reserved cash; the second involves a distinct misjudgment with an immediate cost and the dilution of future opportunities.

Of course, no one can be absolutely certain that a bear market has ended and a bull one has begun and some decisions to buy might just by luck be very close to the bottom.

Upslope not downslope

My approach is to aim to purchase on the upside slope of a V shaped recovery in prices, not the the downside slope. Furthermore, as I can only observe a promising rather than a certain turn around, I will buy very modestly to start with, investing larger slices of money as I become more confident. My upside slope might be a short term ‘bounce’ only.

One other point I have made recently that I want to restate is that when markets are panicking, it is really important to remember that in the end share prices and bond prices are determined by fundamentals (ie facts about interest rates, profits, dividends and so on) even if In the short term they are determined by human behaviour, just like the supply of toilet paper!

So until there is positive news that the spread of Covid-19 is contained and new case numbers are falling across the globe, I don’t see any reason to be optimistic about share prices, even if there are short term improvements in the market indices.

Readers need to think about their personal asset mix and risk tolerance and apply the sort of considered logis described above. I will post blogs frequently about my judgement on current market valuations.

In summary, at the moment I am saying: cheap, maybe good value, but still at risk of extreme volatility.

The same but different

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I enjoyed an excellent brunch yesterday at a cafe/bistro in Bath called Same, Same but Different. If you are in Bath, I can highly recommend it. It inspired this title above.

The current global stock market sell off is naturally being compared with the financial crisis of 2007/8. The aspect that is the same is that many stock valuations were at stretched levels being sustained by momentum buying and idiotic ‘expert’ comments suggesting valuations where no longer dependant on profits and dividends . Some bad news that people don’t fully understand is enough to knock over enough dominos at the end of the row and that triggers a collapse that just keeps going.

The aspect that is different is that in the main the extent of the financial fictions created ahead of the last crisis were understood quite quickly and in fact were in the past – the consequences were easily quantifiable (and awful). This time, people are actually anticipating most of the possible (maybe probable) implications of a widespread epidemic impacting the global economy. That has not actually happened yet and really we don’t know exactly what course the virus outbreak will take, nor the full impact.

That is not to say that the pace of the market sell off is in any way surprising or inappropriate. When share prices head up into the stratosphere, the fall back will always be more drastic and rapid because of the volume of high pressure ‘gas’ (fake valuations) built into the market balloon. A ballon burst by a pin deflates much the same as one burst by a flame thrower. The cause is largely irrelevant at this stage – the issue is one of human behaviour.

If it is still bucketing down, you keep your umbrella up. When the sun has been out long enough, you can fold it away.

What to do?

The usual advice not too sell sell out of quality investments at silly prices remains as sound as ever. Hopefully my readers don’t have much money, if any, in fantasy land shares like Tesla or Netflix. So if you have a well thought out diversified portfolios and plenty of cash to meet your needs, sit tight – things will get better at some stage.

But what if you have surplus cash waiting on the sidelines? My view is that the as one cannot ever see the bottom of a market cycle in advance, it is best to wait until the underlying facts that caused the sell off change – ie the immediate trigger issue has been understood and will be worked around. That has not happened yet with Covid-19.

When markets start to pick up solidly, over consecutive days, because there is better news (maybe a vaccination or solid evidence of containment) and some rays of metaphorical sunshine, then the wise investor will start buying, but in a number of tranches to spread the short term timing risk that cannot be avoided.

What to buy might well be different to what might have looked right a few weeks back – seismic changes in the factors that influence investment selections are possible at times like this.

Fed mis-step?

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When I posted yesterday early, markets had ticked up after assorted helpful noises from the World Bank, IMF and others.

This morning, after the US Federal Reserve cut rates by 0.5%, markets are heading down again.

If the doctor prescribes a lot of drugs, you may worry more, not less

As the cut was at the top end of what might have been expected, this is not in the least surprising. It gives a signal to markets that things are ‘really bad’.

There are other predictable effects: the US dollar will weaken which may be good for the US economy and bond prices will rise as yields fall further in the expectation of even lower rates later. That latter impact is good for investors whose main insurance is having a fixed income element set against the equities in the their portfolio – for now at least.

Do dead cats bounce?

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No idea, personally! The phrase ‘dead cat bounce’ can usually be found across the financial pages of assorted media at times like this. I hate the phase because I have a character fault of instantly visualising what words mean without thinking, so it makes me feel rather sad about a cat.

The phrase is getting an airing today because there have been promises from financial institutions, notably the IMF, to pump prime the global economy to avoid a Covid-19 epidemic induced recession. That meant markets jumped up a bit after their heavy losses, so commentators want to know if the issue is fixed (pretty obviously not!) or if this market pick up is just a short term trading behaviour – market players closing short positions, topping up holdings to lower average costs and so on. Or just not being very experienced – there as many duffers amongst investment traders as any other group of humans.

My experience is that one does not get a V shaped recovery from a set back caused by genuine, seriously threating negative events until the worst of the news and the consequent impact is more or less understood. Generally markets will move to well ‘oversold’ values (losses that are more than really justified) first and we are not in that situation yet.

Furthermore, any remedial action needs to be seen as powerful and long term.

Should you be buying up bargains now?

I think neither of those two criteria are met: we really don’t know that the virus can be contained and will die out, nor have central banks got much scope to cut interest rates, buy bonds and so on. They have done all that already – the economic antibiotic/anti-viral of choice is not now so effective.

Governments have also spent their ‘rainy day’ reserve money on tax cuts and politician led (ie get me re-elected) spending in many developed economies, not least the USA and UK.

My view is that things will get much worse before they get better, but I never claim to be a prophet (I am too optimistic to be Jeremiah or Cassandra). I am looking at history and assessing probability.

If I am wrong no one will be upset as they see their portfolios revalue back up – me included.

However, if you rush out and buy stocks or funds now and I am right, and I do think history is on my side, you will be disappointed. You would lose out twice – on the devaluation of your holdings and because you have no money or less money to buy much cheaper holdings later.

In summary my personal view is that this is merely a sinking market grabbing a plank that can’t carry its weight and the risk of drowning has not gone away. Time will tell, as ever!