Investors should consider taking “a more adaptive and contrarian approach” if they are to succeed in the challenging period that could follow the post-financial crisis bull run, according to Fidelity’s Matthew Jennings. 
This year marks the 10th anniversary of the start of the global financial crisis, but the harsh falls of 2007 and 2008 gave way to some strong market returns over the following eight years. This ‘long summer’ for equity markets has been driven by falling interest rates and rising average valuations but commentators have pointed out that these will not last forever.
Taking inspiration from the popular Game of Thrones TV series, Jennings – an investment director in the asset management house’s UK and European equity team – quoted a Westerosi saying from the show: “Longer summer means longer winter.”
Comparison of UK bull markets > 20% since 1966
Source: Fidelity International, Datastream. August 2017
“As the White Walkers bring winter to the kingdom of Westeros, and September brings the end of summer to the only slightly less politically fragmented UK, it could be a good time to start thinking about whether a change of season is on its way to equity markets,” he said.
“Like Westeros, equities have seen an unusually long summer. An investor in the FTSE All Share has enjoyed total annualised returns of 10 per cent in the eight years since the end of the financial crisis, significantly above long-term averages – the Barclays Gilt study currently puts the 50-year average at 5.3 per cent (real return). The current 102-month bull market is the longest in 50 years, although well below the magnitude of some other bull runs.
“Although people often become more confident in the sustainability of a trend the longer it persists, this means we can get caught out by change when it inevitably arrives. It doesn’t need to be an invasion of the frozen undead to set change in motion. Sometimes, something as prosaic as a statement from a central banker can have an equally chilling effect.”
Looking at why equities have enjoyed such a long summer, Jennings said “generous” overall market returns of the post-crisis period have been driven more by higher valuation multiples than rising earnings. In fact, UK-listed companies’ underlying earnings have only just recovered to similar levels to those seen in 2010.
However, he pointed out that investors have been encouraged to pay ever-higher multiples of these earnings by the “omnipotent gods of central banks” flooding the market with liquidity through ultra-low interest rates and quantitative easing programmes, thereby driving stock prices higher.
“All we need do is admit that interest rates may have stopped falling and we find that equity indices have lost a major source of price returns over the past eight years,” Jennings said.
FTSE All Share price vs earnings since 2010
Source: Fidelity International, Bloomberg. September 2017
“Of course, if you believe that the liquidity tap will keep gushing and interest rates will be going lower, then maybe you can bank on a higher valuation for equity markets in future.
“But if you believe that a couple of years from now interest rates are more likely to be the same as they are today, or possibly slightly higher, you will need to identify a different source of return.”
The investment director also noted that earnings in the UK have recently shown signs of improvement thanks to recovering commodity prices and supportive underlying global GDP growth trends.
A further acceleration of this could create another leg of support for the bull market, leading to a surge in share prices as part of some late-stage euphoria. But at the same time, this growth could prompt central bankers to lift interest rates, causing a de-rating in some sectors.
“The wintery scenario I have outlined describes a market which could spend a period of time in a sideways holding pattern or perhaps moving lower in the face of negative surprises,” Jennings concluded.
“While this means a period of lower returns for equity indices on average, there could be a significant change in market leadership that creates an opportunity for investors willing to be selective and forward looking. Following long-established momentum trades is likely to be much less successful in this kind of environment.”
So, what strategies should investors consider pursuing in this environment? The investment director argued that they should be looking for “more esoteric” sources of return, such as those that have been overlooked in the ‘summer’ of the bull run.
He pointed out that the consumer staples sector has re-rated by 40 per cent over the past eight years; the banking sector, on the other hand, has been relatively held back due to the nervousness that surrounding it after the crisis.
A side-effect of this need for selectivity, he added, is that index investing – which has performed strongly when markets were supported regardless of fundamentals – might not be as well placed as active management.
“A change in season could create a more favourable environment for investors focusing on the esoteric stock-specific issues that will drive performance of individual companies but not stock market indices,” Jennings said.