Peter Hicks gives his views on investing in these volatile conditions
So now we are more than a year into this financial crisis, but the lengthy process of adjusting to a new, harsher, environment is just beginning. Asset prices are well down, business and consumer sentiment is depressed and the final nail in the coffin seems to be the Bank of England's admission, before official data confirms the case that we are in recession.
Given the trauma of the past few months, investors are easily forgiven their sensitivity to the markets. Investments that were considered safe have been subject to losses; even bank deposits have at times looked in peril.
Investors will be looking to their advisers for an antidote. Having endured two severe bear markets in the past decade, and with likely continuation of the extreme volatility of the past few months, clients will be asking advisers to lead the way along the tricky path to investment success.
Here are some thoughts on how to approach investing in today's volatile and uncertain markets, starting with fixed income.
Investors' retreat to safer asset classes has been pronounced in the fixed income market. The premium (or credit spread) investors are willing to pay for the security of treasury bonds over corporate bonds has been rising.
It is now as high as it has been for 20 years. This indicator has often provided a strong signal for buyers being able to lock-in the comparatively high yield offered by corporate bonds. Although default rates remain low, (usually a positive point) dire economic forecasts mean defaults are likely to rise considerably; the market has factored that into the current prices.
So while it is too early in the cycle to be aggressively positioned, it seems sensible to look for selected opportunities in high quality corporate bonds where yields are attractive without excessive default risk.
The property market has performed poorly for up to two years. Falling US residential property prices were, after all, the tipping point in the financial crisis. The weakness continues and an additional concern in this phase of the crisis is the widespread deleveraging that is under way. The commercial property market is heavily reliant on debt so the combined impact of credit contraction, a retreat from risk, and a recession is likely to challenge prices and rents.
There are some positive signals though. Sentiment is terribly depressed and the very poor outlook is already discounted in many prices; some property funds are priced at a discount to their net asset value. The sector is sensitive to interest rates and so could be an early beneficiary of policy easing.
The world's economic problems will influence equity performance perhaps more than any other asset class. As with fixed income and property, we have reached a point in the cycle where there is a blurred picture of buying signals and considerable risk.
With the economy having been promoted to centre-stage only recently it is easy to forget this equity bear market is pretty mature when compared to others since 1950. Only 1972 - 1974 and 2000 - 2003 stand out as longer and deeper. However, we probably still have some way to sail before the tide turns.
At the expense of long-term investment decisions, a characteristic of the market now is that fear and technical issues have a stronger influence on shares than fundamental measures. This has been the cause of much of the volatility as hedge fund borrowing is called in or clients withdraw their investments, resulting in unwanted trades being unwound and loss-making positions covered.
Return to form
However, a series of fundamental measures suggest there is good reason to expect a return to form for equities. Some believe that when the financial storm has blown over, investors will quickly return to fundamental measures. It may take some time for the storm to blow out, but the value is there and essentially one is being paid to be patient.
By two indicators, stocks are very cheap. You have to look back twenty years to find the UK market as cheap as it is now using trailing price to earnings ratio and price to book value measures. Yes, it is possible that valuations could fall further, but it's difficult to argue against their present relative good value. Add to this that the yield on UK shares is now considerably higher than UK base rates and buying to lock in that value is worth considering.
The big concern for the equity outlook is weakening earnings.
As economic conditions deteriorate, earnings will be challenged pressurising profitability, dividends and even solvency. Equity earnings estimates for 2009 are mixed. Some companies remain optimistic, others more cautious, some have even avoided making estimates until the outlook is more certain. The consensus view is for earnings to fall in 2009 which currently seems pretty obvious.
What does this all mean to asset allocation? Using inflation and growth indicators as a guide to where we are in the economic cycle, we have seen a shift from stagflation (where growth is slowing and inflation rising) towards entering the reflation phase (a period of aggressive bank policy easing to reflate growth but with falling inflation).
During periods of reflation, a defensive allocation has been most effective. Bonds tend to do best, followed by stocks, cash then commodities.
But in this uncertain and volatile environment, timing exactly when a particular investment will do well or badly is very difficult.
Therefore, one strength of a diverse portfolio exposed to a spread of investments, is that it removes the timing decision. Steady, regular investments as part of a long term plan are also better for the nerve-ends and for avoiding often ineffective market timing.
This is a time when advisers can create considerable value for their clients by addressing their concerns and reservations and offering sensible solutions to their investments needs. Above all, this is a time to ensure that clients are well informed and well positioned to take advantage of the next bull market when it does eventually come.
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