In the absence of any other information, the right time to invest is today, and today the market is most likely to be higher than it was in the recent past.
The problem with this is that markets do, in fact, very often fall. In almost every year, the market will experience a fall from its highest point to a lower point at a later date. Of course there are the occasional, and much more profound, bear markets where the market falls significantly. In fact, in more than 50 per cent of past periods, the market falls 10 per cent or more from its peak during a year, yet most years it ends higher than in starts. Equities, while in the long term a successful strategy, do give a bumpy ride.
It is the prospect of smoothing these bumps that makes mixed asset funds in general, and outcome-driven ones in particular, attractive. Clearly, a diversified asset allocation, across a range of equity markets and other asset classes, is likely to smooth returns to a greater or lesser degree, depending on the mix of assets chosen. But to what degree can we predict when the bumps will occur and adjust our portfolios to reflect this?
Looking through this lens, what can we tell about today? Equity markets have had a strong run from the lows of early 2016, but at the same time the outlook has improved over that time. Company-reported earnings and forecasts have greatly improved and analyst forecast profits have been rising, which is an unusual occurrence. In general, analysts are overly optimistic and have to revise down their forecast over the course of a year. This year, they have, on average, been upgrading. At the same time, valuations on many measures are high compared to the past, so are arguably discounting this reality.
The factors that might drive future profitability, such as the economic prospects, inflation and interest rates, have also been relatively supportive. Although recent evidence might suggest that the acceleration in growth is slowing, there is little, if any, evidence to suggest a contraction is on the horizon.
Economic forecasts have little accuracy, so we should not apply any great weight here. However, we can reasonably assess that in the absence of any signs of stress, we are unlikely to move from this benign environment to an extremely negative one in the near term. Generally, large market setbacks coincide with bad real world events that impact profitability of companies materially. These often follow periods of excess that need to be reversed. Examples would be the financial crisis that followed a period of reckless mortgage lending in the US, or the Asian crisis that resulted from an excessive reliance on US dollar-denominated debt in Asia.
While it is possible to point to some areas of risk at present, such as US auto lending or traditional retail contraction, there is nothing of the scale of even the recent shale bust to worry about at present.
So we should not be thinking we are about to enter another bear market just now, although one will no doubt occur at some point in the future. But as we pointed out earlier, smaller corrections are a constant feature of markets. These can occur at any time for reasons that only become evident afterwards, often simply because the market narrative changes such that it reacts to the negatives it previously chose to ignore. Corrections are the markets’ way of dealing with near-term excess and, arguably, the market is overdue one. When and how deep are the imponderable questions?
It is possible to deal with corrections partly in advance, through a constant process of position scaling. Investment professionals can scale positions for risk, not conviction. Thus, as individual positions rise, we are often taking partial profits as they become bigger in our portfolios, in order to keep risk in line. When corrections arrive, it is often the strongest recent winners that are hit hardest. Additionally, we are prone to act into the event.
Once markets begin to correct, the event becomes self-fulfilling, as many investors will be aware that markets are overbought in the near term. This way, fund managers can temper the impact, but given we have limited insight into the timing and depth of corrections, one only hopes to smooth the bumps, not avoid them altogether. In many ways, they should be seen as an opportunity to build positions at lower prices.
Bear markets are another matter. Although infrequent, they can be extremely damaging to your wealth. Fund managers aim to be able to tell the difference early, if not in advance. The challenge here is to recognise the characteristics of the phase that precedes the bear market; irrational exuberance, accelerating returns and so on, to know that the bear phase might be approaching.
Eventually, something will burst the bubble and then we must recognise that something significant has changed, to identify the problem either in advance or quickly once it starts to unfold, and reduce risk appropriately and aggressively.
In these times, it does not pay to have a concept of a neutral position or be concerned about a benchmark, as these are totally backward looking. The benchmark for clients is the outcome, not some notion of sector or index, and the outcome managers aim to offer is a degree of capital preservation in bear markets.
David Jane is manager of the Miton multi-asset fund range
Key points
In the absence of any other information, the right time to invest is today.
Equity markets have had a strong run from the lows of early 2016.
It is possible to deal with corrections partly in advance.
