Comment and opinion for retail investors in the UK
A PS to my recent posts about markets rising when conventional logic says they are too expensive.
Bloomberg today reported that the start to this year has been the best one for the S&P500 since …… 1987.
If you are too young to remember stock markets in 1987 (or for that matter the weather in October that year) refer to Google.
This year has seen strong rises in most stock markets and previously I have commented that this seems mysterious given all the main risks remain unabated.
I have remained relatively pessimistic largely because of the evidence of company reports and the trend in profits, as well as some plain barmy pricing of new companies coming to market, which has all suggested a disconnection between market sentiment and valuation.
Recently, markets have reacted positively to economic news:
Growth in various major economies, low levels of unemployment, Brexit deferred, low inflation and so on.
Now I will always say that there is no connection in reality between news about economic data (which is often selective and misleading) and the likely long term valuation of investments. Chinese business confidence picking up is for example probably only due to a worried Chinese state pushing banks to lend heavily to the commercial sector!
Of course, real changes like say a US/China trade deal that reduces tariffs will be good for businesses and probably profits, dividends and share prices in selected business sectors. That is a concrete event, something ending with a decent outcome.
But one significant and real measure of secure economic growth is action by central banks to control it – putting up interest rates. That is not happening and in fact recent decisions suggest rate rises are being pushed back.
Retaining cash while markets keep rising requires an iron discipline. Remember that you have other money invested, so even if markets are not going to fall back, you will only miss out on returns on a portion of your funds. That cost is an insurance premium.
Personally, having lived through this sort of market valuation pattern at the turn of the Millennium, I am happy to buy insurance and keep plenty of cash ready for a sell off. I still think the probability remains on the balance of the known facts. New purchases might be made cautiously on the ‘drip feed’ basis, but I am not even contemplating that yet.
The Brexit show moves on like a cup of tea – an analogy I heard used by a Lithuanian political commentator. The idea being that you can leave the tea bag in the cup (UK in Europe) as long as you like now, up until October 31st anyway, and when you take it out will just mean the tea is stronger or weaker, hotter or colder. All a matter of (political) taste.
The immediate reaction of stock markets is a bit like that of the woman to the noisy arrival of a husband who has come home drunk so many times now, it is only remarkable if he comes home sober!
So what might shock markets would be some well supported concrete decisions from the UK government and some definite changes with actual guaranteed dates attached.
In the short term, we will need to see if Mrs May is really prepared for a fight with the hard Brexiteers and if she is prepared to seeks an element of support from the Opposition in defeating them. That would be pragmatic but I personally think not very likely.
Should investors assess the markets as now carrying less risk? Absolutely not. Other economic news has got worse. Markets may rise in the short term because they are set in that groove, but growth in asset prices like we have got used to is unsustainable and I would be using any unexpected spike up to bank more profits.
If you disagree and want to buy the cheapest assets, then probably certain segments of the UK market are the best value, but I would only drip feed money in very slowly.
On the currency front, which is still a very relevant consideration in the light of global trade disturbances, one should look to see where interest rates will rise first and the US is not so much the certainty that it was. Trump may well be pressurising the Fed not to do what it ought to in the light of US economic data. How long that can last is anyone’s guess.
Having said that, if I were buying global funds at the moment I would concentrate on global players with plenty of cash in hand and incomes and share prices in US dollars. As a diversifier for higher risk investors, Japan looks logical.
Having been pretty nervous and indeed pessimistic about the direction of stock markets for nearly 12 months now, I am beginning to think about what investors ought to do now we are very close to getting a resolution of some sort (ie more certainty about what will happen) on Brexit.
Once any really concrete decisions are made, currency and stock markets will react very fast, so it will pay investors to have at least thought about what options they have for action. I am assuming that most sensible investors will have taken some profits from their portfolios in 2018 or even this Spring and have some cash to invest. Those who do not still need to think about the implications for their asset mix and fund holdings.
Forming a policy for action is in my opinion a process: I don’t have any magic intuition as to what to do! So a starting point is to consider possible scenarios and then assess the way they might, most probably, pan out.
For this post, as a starting point, I am going to over simplify a little and suggest there are two possible situations after a final Brexit plan is settled (or possibly even no Brexit!). One is that the markets are relieved and like the outcome and the other is naturally that they are horrified and there is a ‘flight to safety’.
If the former situation prevails, the pound will likely strengthen and UK shares may come back into favour – the shares in the UK outside of the big global players in the FTSE 100 are oversold (ie cheap) at the moment. That would suggest it would be a good time to buy global stocks as they will be cheaper and my judgement, a rising pound would be short lived as reality sets in. As a result the overseas stocks will benefit from a windfall gain in currency terms later on. Some selected UK funds would look like a good bet too – those most hammered in late 2018, broadly investing in ‘value’ shares.
If the markets sell off and the pound tumbles, then it would be unwise to invest in shares valued in other currencies using a low value pound and there will likely be the afore-mentioned cheap investments to be bought in the UK, but they could be at real bargain prices. This is based on the observation that markets over-react to major changes in the global economy.
As to fixed income holdings (bonds), these are likely to benefit from extra demand if investors are really worried. That would push prices up. However, they are already expensive. It is also hard to know in what direction central banks will move interest rates in either scenario (not at all would be the highest probability in my view), so that is a good reason for not buying into bonds – there is a risk of sharp losses if interest rates rise more than the market has allowed.
In summary, I see opportunities to put cash to work as soon as we have decisions clear enough for markets to re-position. But I would not join any reaction of fear by buying bonds and that means avoiding most cautious managed funds.
As we approach some critical dates in terms of global financial risk, I have been asked about the pros and cons of being “out of the market”. By that I mean having all or a large part of your portfolio in cash.
The obvious disadvantage in recent times to holding cash is that it generates a very low return, but that is usually taken as read and the ‘quid pro quo” for not carrying the risk of a loss of capital value. What people worry about in addition is the possibility that the market might go up a worthwhile amount while they are not fully invested. Our old friend FOMO – the fear of missing out.
Actually, it is good that people have this worry. Recent data from the Financial Conduct Authority shows that a high proportion of people who access their pension fund to get out the tax free lump sum, then go on to leave the balance in cash or a totally unsuitable default investment fund. This really reduces the chance of their pension being even as good as an insurance company pension annuity.
For those who want to know whether it is sensible to have loads of cash, some cash or no cash in their portfolio, I would suggest that one ought to think about where we are in the market cycle. In other words how are markets valued – have they been going up for ages, have they just collapsed, or something else?
I will explain this with an example. Let’s say there is 40% of a well diversified portfolio in cash The rest is exposed to what we will call the ‘market’ although in reality returns will come as an average from lots of differing assets.
Let us say ‘markets’ are currently near an all time peak and we assess the possible further increase in the next 12 months as being a maximum of 10% – we read of strategists predicting “high single digit returns’ (they really do say that sort of thing).
So if 40% of our money misses out on a 10% return, we will only get 6%. and will have missed out on 4%.
If the market is really high, we can say from past experience that a setback of 30% plus is also entirely feasible. If the market fell 30%, we would lose 60% of 30%, so 18%. That means our cash reserve has ‘earned’ 12%: the amount we did not lose.
Clearly in this example, which reflects where we are now in my opinion, the risk/return ratio is not symmetrical. There is a better risk/return ratio on holding cash than not.
Why then would I not suggest holding 100% cash? The reason is that if we had all the portfolio in cash the ‘missed return’ if the market went up would be the full 10% and that might be psychologically painful. In other words, we need to get as near as we can to having our cake and eating it, or to hedge our bets and the desired balance will vary from person to person.
Some people might say it is fine to miss out on 10% upside after a very good run, rather than take the risk of a 30% loss, especially if they need access to the investment quite soon.
I must emphasise that if markets had recently sold off, like in 2008, the estimates in the example would have to be quite different. Perhaps not surprisingly, at such times people want to carry on holding cash (another recognised psychological bias) and in fact they really need to be brave.
It would be great if there were assets you could buy that gave you a modest return and went in the opposite direction to the main investment markets. Clever people have been working on that for many years and almost completely failed. What is available is complicated and hard to analyse. I have commented on Absolute Return funds in other posts and the article ‘Real World Risk’ may interest you.
Even if you could buy an asset that always went in exactly the opposite directions to stock markets (to a degree you can if you understand derivatives), then if you put 50% of your money into that asset you would only ever make a zero or lower (because of costs) return because the two parts would cancel each other out!
Cash is still the best defensive asset and the opportunity cost of holding it is best thought of as an insurance premium well worth paying when risks are high.
With insurance, when the house has burned down to the ground, you don’t pay the premium again until you have re-invested in a new structure! If the site is just a charred heap of rubble or two years, there is no need for insurance. So after a market sell off, cash can get switched to assets that are nice and cheap!
There are other ways of dealing with the loss of return from a cash element in a portfolio notably the ‘bar bell’ approach, where some high risk assets are retained at the other end of the portfolio volatility range and then if markets do shoot up, they make a geared return that compensates for the dull cash element not contributing much. Because the return is ‘geared’, or much greater than the market average, you don’t need to have as much money in such assets and if things go wrong you won’t lose much.
Such strategies require a good knowledge of markets and asset types or a skilled adviser. Some ready made multi asset funds will use this strategy, but it is not commonplace.
In simple terms, a good adviser will help you fight your natural psychological biases. You will need to hold cash after making sales to bank profits following long periods of growth and conversely to invest rapidly after a market sell off. You won’t want to do either, but if you can be persuaded, your long term returns will be rather better.
If the title of this post is a mystery to you, let me explain:
A pump and dump operation is a fraudulent manipulation of asset prices, usually individual shares, to make a large profit from naïve investors.
Essentially, the fraudster will buy a large number of shares that are cheap because the investee business is practically worthless. They then use a variety of illegal or shady methods to increase the price. These will usually include a hard sell over the telephone to vulnerable investors with a fake story attached, placing sales with friends who will sell out later and inventing news. As demand for the shares increases and the price starts to move rapidly because the fraudster may own a large part of the total shares available for sale but only actually sells a moderate amount at this stage, more and more greedy participants can be persuaded to enter the market.
When the fraudster has unloaded enough shares to drive the price up to an implausible level, he or she and friends will rapidly sell off the large remaining stock they have. A drop in the share price initially as liquidity improves may even make unwise buyers think they are now getting a bargain!
The fraudsters bank a large profit and the share price collapses very fast, leaving many inexperienced investors with shares that are almost impossible to trade and therefore worth very little.
I mention this now because it feels to me like global stock markets are operating such a wheeze right now, albeit collectively and without a fraudulent intent.
I suggest this because global equity markets, those investing in company shares, have risen to levels last seen in the mid Autumn and seem to be heading relentlessly up. But there is no change in the global economic climate to justify this. In fact most real news is negative and many of the underlying risks are actually greater.
Many commentators are struggling to explain what element of the combined human psyche is responsible. Some say that the US and China are bound to do a good trade deal. Others say that the likelihood of the UK crashing out of the EU is reduced (although for the life of me, I can’t follow their logic). Others say that although profits are beginning to shrink and dividends might slip back, this is only happening slowly and basically ‘everything is all right’. Some point to central banks being rather worried, so potentially slowing rate rises (that is good news?!)
My feeling is that we have a situation that might be equated to the mindset of a gambling football supporter betting on his or her usually top flight team winning a major competition when they have managed to make it through the early rounds, even though the manager has just been sacked, the best players sold off and until a recent cup run, this year’s league results have been pretty rubbish. Because such a person needs a boost to justify their support, they will bet on the win. The idea of a loss after several years of glory is just too depressing. I think many stock market participants are talking up the market because the alternative is just too gloomy to contemplate.
This is worrying, because if there is a correction back to a new harsher reality, the big players will take their money off the able in a flash, at their pumped up prices, and we small investors will be left holding a lot of assets that have just been dumped. Time to increase cash weightings further? Personally, I think that would be prudent for anyone who does not cope well with short term volatility – and that will be most people.