Mark Wilkinson tackles the tricky question of trying to assess the best time to re-enter the investment markets
Imagine my trepidation when faced with the subject of equity investing and, in particular, to address the question of when is the right time to go back into the market! My sense of dread heightened when I saw recent press reports appearing to highlight conflicting views on the current economic situation from two of the fund management greats of modern times, Anthony Bolton and Neil Woodford. The thing is, this is the type of question to which everyone has a view of the correct answer but nobody knows for certain who is right, and will not know until (possibly well) after the event.
In the absence of the proverbial crystal ball, we are left with educated guesswork, gut feeling and, of course, looking back in history to see if something close to what is happening now has happened before and, if so, what was the outcome then. For those seeking to rely on past experience, one thing that seems to me to be common to financial crises of the kind we are currently experiencing are the cries of 'this time, it's different!'.
The current situation, with bank bail outs, massive budget deficits and quantitative easing, certainly does feel different to anything many of us have ever experienced. It even appears to be calling into question the very viability of capitalism itself - not a good recommendation to get back into equity investing any time soon. That said, I can remember the same feeling of 'we've never quite been here before' at the time of Black Monday in 1987, the Sterling and Rouble crises in the 1990s and, most particularly, the bursting of the tech stock bubble in 2000 followed closely in 2001 by the attack on the World Trade Centre in Manhattan. I am assured by those old enough to remember the oil crisis and bear market of 1973 and 1974 that it was 'different' then too.
The truth was, that in each case, it was different, insofar that the precise set of prevailing circumstances had never presented itself before but, notwithstanding this, the equity markets did bounce back with a degree of predictability (see chart one) that is very easy to appreciate in hindsight but not quite so comfortable to put your shirt on in the midst of the crisis.
I think the only area of certainty at the present time is that stock markets will continue to be volatile for the short term and equally certain at this stage is that anyone who believes that they can predict the exact day, month or possibly even quarter when things will turn around is either blessed with perspicacity beyond comprehension or is fooling themselves.
So, how do we know when is the right time to get back into the market? The short answer to this is that we don't, but there are a number of useful indicators that could be used to determine when may be an appropriate time for an investor to dip their toe back in. For example, the price to earnings ratio is one of the most common valuation measures for equity markets. The lower the ratio, the less one has to pay for the anticipated future earnings of a company. The 'cheaper' the market is at the time of an investment, the better the returns an investor could expect to make.
Chart two, which uses data from the Datastream Total Return Index of UK Equities, illustrates that there is a reasonable relationship between the 'value' of the market and likelihood of strong returns over the following five years.
Every rolling five year period in the UK market since 1970 is represented by a dot on the chart. The horizontal axis shows the price earnings (PE) ratio at the time of investment. The vertical axis shows the annualised returns an investor would have made over the following five years. Where PE ratios are less than 13, the compound annual return over the subsequent five years has, in the period looked at, never fallen below 10%. The PE ratio as at 18 March 2009 was 7.3, up slightly from the preceding two months.
Of course, PE ratios are not the only factors to take into account. The spectre of deflation looms, and any prolonged period of falling prices would be very bad news indeed for equity investing, with people deferring their spending and hoarding cash, which would be increasing in value in real terms, and many companies failing as a result. The good news, if one can call it that, on deflation is that the Government and Bank of England have clearly recognised the problem and are taking steps to deal with it and, if anything, it may be equally likely that we are heading for a period of higher inflation than we have been used to over the last decade or so.
There is a lot of data around at present that looks back at past recessions and supports what many advisers intuitively know. Time out of the market may mean missing out on the recovery when it comes (see chart three). Markets tend to bottom out well before a recession ends. When a market has had two or more successive years of negative returns, the recovery, when it comes, is often pretty spectacular.
It seems to me that successful investment is a matter of setting a strategy in line with the degree of risk a client is prepared to take, their timescale and investment objectives, and then sticking with it, rebalancing and refining as necessary. Unless you have that crystal ball, or the investor (and their adviser) has the nerves of steel required to take a contrarian view and "be fearful when others are greedy, and be greedy when others are fearful"*, it should almost certainly not be about deciding when to be in and out of the market at all.
*Source: Warren Buffet, New York Times, October 2008
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