UK markets: Using short-term volatility

These developments reinforce current positive sentiments as the markets digest the European Central Bank’s recent long-term refinancing operation to help counteract the eurozone debt crisis.

Data released included news that the US jobless rate had fallen by 50,000 in the previous week to the lowest level since April 2008. In the UK, retail sales data for December lifted sentiment towards retailers following generally disappointing Christmas trading updates.

However, the eurozone has seen plenty of false dawns before and there is still a very long way to go before investors can put the issue behind them. Meanwhile, growth in the UK is likely to be lacklustre at best this year. We certainly believe that UK equities will encounter considerable turbulence over the next year. However, we also think that the volatile market conditions of the past decade reflect a return to normality after the unusually low volatility seen in the 1980s and 1990s.

If you look back over history, negative real return years are not unusual and there have been decades, such as the 1910s and the 1960s, when there were more down years than up. Thus, the 1980s and 1990s were in fact unusually prosperous, which partly explains why it has taken some time for investors to adjust to the return of volatility seen since the early 2000s.

If we are back in a more typical environment of continuing volatility, there are two potential ways of investing.

The first is to take a shorter-term, reactive view in an attempt to exploit choppy markets, a trading mentality that has grown in popularity over the past 10 years. However, higher trading volume results in greater trading costs, which can wipe out any advantage gained from excessive dealing. In addition, the algorithmic models used in this trading often work very well for long periods but, when they go wrong, the results tend to be spectacular, with investors losing substantial sums.

Consequently, we believe a more considered approach based on detailed research of long-term company valuations, resulting in high levels of conviction that allow managers to see past short-term distortions, is the best way of investing in volatile markets. If we have spent a number of years getting to know a company’s management team and business model, we can accept that share prices go up and down and use any periods of weakness to add rationally to our positions rather than being forced sellers. By using this approach, we can actually take advantage of volatility to our investors’ advantage without raising trading volumes, as we are merely using short-term volatility to exploit our long-term views on valuations.

Turning to the market’s likely performance this year, valuations are not stretched currently, so shares should be able to perform at least in line with earnings, which we are forecasting to grow by 8 percent in the UK over 2012. Performance is likely to be increasingly divergent at the stock level, with stronger franchises prospering, while weaker business models and poorly managed or over-leveraged companies struggling. This means that stock selection will be crucial. A carefully selected portfolio, actively managed to take advantage of price anomalies, should be able to deliver double-digit returns this year.

Simon Brazier is head of UK equities at Threadneedle Investments