It's an old cliché that the five most dangerous words in financial markets are ‘it is different this time' and cynical investors howl with derision when they hear this line.
In practice of course, economies and markets are dynamic with constant change and too much ‘autoregressive thinking’ - merely extrapolating historical trends - can be just as dangerous as overemphasising trivialities. Theorising aside, there are a couple of big changes afoot, one of which investors are underestimating - the nature of the global economy - and the other they may be unaware of - investor behaviour.
Hopefully everyone has now realised that the ‘nice decade’, as Mervyn King so quaintly puts it, is now over. What probably isn’t fully understood, and this worryingly includes a number of fund managers I’ve heard recently, is just how ‘not nice’ the current environment is. This doesn’t necessarily make me bearish, it just inclines me to expect only limited upside from all asset classes.
This is a completely different market to the one most of us have been used to. 1981 to 2006 was a period of disinflation, falling interest rates and steady but limited growth. The pleasing result was a 25 year bull market in bonds and a 19 year bull market in equities – portfolio managers got used to everything going up and only needing to use two asset classes to diversify portfolios. Pension Fund allocations and the APCIMS benchmarks rather prove this point. Gold bugs were regarded as crazies.
The 2003/7 equity bull market reflected the credit-fuelled drunkenness of the times and was a real sweet spot with this soothing disinflation combining with the growth rocket fuel of the emerging economies. Now we have the hangover, inflation and the business cycle are back. Much more gentle than the 1970s of course but enough to make it tough sledging to produce consistent double digit returns, and making it increasingly important to think downside as well as upside when investing.
So much for the ‘big picture’, but what’s different about market behaviour? One rather fondly imagines that most investors are looking for long-term value and employing a buy and hold strategy. Sadly not true. The market is increasingly being dominated by hedge fund/investment bank proprietary traders with very short time horizons, the ability to go short as well as long and a remuneration incentive to take excessive risk.
This has markedly increased volatility and can cause momentum trading to obscure value. There has been an increased tendency for assets to move as ‘risk acceptance/aversion’ plays rather than on their inherent merits. Thus the ‘risk’ assets (equities, emerging markets, high yield credit, US dollar) have moved up and down en bloc in the opposite direction to the ‘safe’ assets (government bonds, gold, commodities, €/Yen/Sw FR.) It’s all felt a bit simplistic, especially as commodities, bar gold, have been placed by the market in the wrong camp. Wheat might be an excellent long-term investment, but risk-averse it ain’t!
The other problem of this ‘instant gratification’ culture is that seemingly everyone tries to jump on the bandwagon, creating an ‘elephants in a revolving door’ situation where long-term institutional investors as well as traders get involved – commodities being a great example what is euphemistically called ‘a crowded trade’. The upshot of this is huge volatility and utter confusion for retail investors who run the risk of buying and selling at just the wrong point in the cycle.
What to do
So we have a more challenging fundamental background than we’re used to, compounded by markets frequently resembling an infant playground at first break. So what do you do? The answer is to apply some common sense and stick to some basic principles that too many investors ignore
- Play the Long Game – be strategic rather than tactical, markets will always be very difficult to call in the short term.
- Use a Wide Range of Assets – a bond/equity split doesn’t cut it anymore, over the long term you need property and commodities (real not paper assets) and should consider a small exposure to emerging but genuinely non-correlated asset classes like non-securitised asset baked lending, unlisted infrastructure or senior life settlements.
- Always remember you should be buying long term value and there is a correct price for everything. An investment idea is rarely compelling when it has performed strongly and is being heavily promoted.
- Don’t be scared of illiquidity in asset classes where it is appropriate such as property and private equity. Sacrificing liquidity hugely enhances the potential for returns.
- Use strategies that increase the risk/return profile of your assets, such as fund of hedge funds and structured products. If you can get capital protection together with geared upside then isn’t this better than a long-only gamble?
- Use smart people to manage your assets. Amidst a sea of mediocrity there are some great fund managers out there who have consistently beaten their peers and the market indices over long periods. Careful due diligence can identify such mangers in alternative as well as mainstream asset classes.
Rob Pemberton is Investment Director at HFM Columbus
The views expressed in this article are those of its author and do not necessarily represent those of the company he represents, IFAonline or any other Incisive Media affiliated organisation.IFAonline
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