October 19, 2015December 23, 2015 by Chris Brown

Some good news and some bad news

A couple of thoughts on markets after the nasty June to September equity market sell-off. I have two pieces of bad news and only one of good news, but the good news about the good news is that it is actually by far the most important of the three for longer term returns so please try not to get half way through this blog piece and then give up!

Our first note of caution is we think the structure of the equity market is shifting to be structurally more volatile. ETFs and computer driven robo-traders play a much larger role in daily volumes. Many of these players are programmed to sell automatically as volatility rises (and buy as it falls). This means high volume selling in falling markets and buying in rising markets. Market makers are also playing a reduced role as margins in that business are continually eroded. These factors work together to create days like August 24^th when the Euro Stoxx was down over 8% by lunchtime and the S&P 500 limit was down at open. These sort of short, sharp corrections are never pleasant and unfortunately, are very hard to trade around as they happen so fast. All we can do is to continue to stress test our portfolios so we are able to ride them out if needed.

Secondly, we think the scars of 2008 still run deep in the equity market. Post-crisis, investors understandably wanted to own companies that were lower risk, with strong balance sheets and predictable earnings growth. Many of these companies also paid a steady dividend which has an obvious attraction in a zero interest rate environment. Equity managers who focussed on these companies became “winners”. Being essentially Darwinian, money flows from the losers to the winners in fund management. The winners attracted more funds, more money flowed into the low risk stocks. These stocks then looked even more attractive: good performance in up markets combined with real out-performance in down markets when their defensive qualities really shone though. However, over time the prices of the winners creep inexorably up. The result is a market that is extremely positioned, with investors increasingly crowded into a smaller and number of high quality performers (see the chart below on high risk and low risk valuations, via Schroders).

Why is this all a problem? Well, any expensive asset is by definition its own set of risks, whatever the quality of the underlying asset. There is always a danger that the cycle reverses: low risk (for whatever reason) loses its sheen, flows reverse and the momentum factors work the other way round.

If and when this happens, the quality or otherwise of the companies involved won’t help the starting problem of too high a valuation. The relevant example is the Nifty Fifty phenomenon of the late 60s and 70s. These were similarly high quality, strong companies well-positioned for the turbulent 1970s. After peaking at an admittedly bubbly 45x earnings in 1972, the bubble popped and they collapsed back to a p/e below 10x over the next 10 years causing large losses in absolute and relative terms. The important point is that the quality of the companies and their earnings did not really shift over this period, simply investor perceptions and their attractiveness. They simply moved from being far too expensive, to fair value and then to cheap. Though not yet at the Nifty Fifty extremes, we see some of this momentum driven over-valuation in the “safer” parts of the equity market. Conversely, there is an avoidance today of much with an emerging markets, China or cyclical focus. These extremes of equity valuation are not healthy and, we think, add to the risks embedded within the equity market.
But what about the good news? Well, after some substantial falls in Q2 and Q3 (Germany’s DAX market and the MSCI emerging markets are both off over 25% from their peaks for example) equity markets outside the US look around fair value to us. One measure of this (via Morgan Stanley) is that equity markets ex-US trade around 12.5x forward earnings or close to their long term average (see chart).

Global equities ex-US are now fair value

This is important for our clients because fair value markets should be able to generate reasonable equity market returns (maybe 7% or so per annum) over the medium term. In one sense, for a part of the market, the problem that “everything is expensive today” has been removed. Inevitably, there is a mix of markets that are cheap for a reason and genuine opportunities. As have written before, we continue to prefer markets that unambiguously benefit from cheaper oil and where central bank liquidity remains supportive. This means much of Europe and Japan. We think there is real upside to earnings in these markets which should help drive future market returns.

So the good news is that we think there is a reasonable case to expect decent returns from equity markets (especially outside the US) in the next few years. The bad news is the journey may well be bumpier than many of us would like. We, as ever, will work hard to smooth out as much of these bumps as we can but we remain ready for plenty more to come.