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Perma-bears warn on 2018’s “excessively bullish investor sentiment”

01 February 2018

While equity markets have largely posted gains in January, a handful of fund managers are warning investors to prepare for more challenging conditions.

By Gary Jackson,

Editor, FE Trustnet

Stock markets around the globe may have started 2018 with a bang but fund managers such as Aberdeen’s Bruce Stout, Schroders’ Marcus Brookes and Troy’s Sebastian Lyon continue to warn investors on the need for a cautious mindset.

At the time of writing, the closely watched MSCI World index was on track for its 15th consecutive monthly gain after rising 0.92 per cent up to 30 January. The S&P 500 has enjoyed a similarly strong run, making 1.23 per cent in the first month of 2018.

As the below chart shows, equity indices across the globe have started the new year with gains. The exception is in the UK where the FTSE All Share fell by 1.29 per cent after easing concerns over a ‘hard’ Brexit led to a stronger pound.

However, the closing days of the month were marked by a sell-off and should serve as a reminder to investors that volatility could return after an extended period of relative calm.

Performance of indices over 2018 to date

 

Source: FE Analytics

Aberdeen’s Stout (pictured) – who runs the £1.6bn Murray International Trust – said recent gains have been powered by little more than momentum and maintained his bearish view on the post-crisis rally, which has been fuelled in no small part by the ultra-loose monetary policy first adopted as an emergency measure.

“Seldom has such widespread complacency prevailed in financial markets as the current over-whelming mood of optimism resolutely refuses to entertain the possibility that this ever-expanding bubble might at some point deflate,” he added. “The risk associated with a sudden change in sentiment has arguably never been higher.”

Indeed, the latest Bank of America Merrill Lynch Global Fund Manager Survey, which polled 183 fund managers with total assets of $526bn, showed that asset allocators went into 2018 in a buoyant mood.

The poll found the net allocation to equities stands at a two-year high, average cash balances have fallen to a five-year low and the balance of investors taking out protection against a near-term market correction is at the lowest level since 2013.


Against this positioning backdrop and a nine-year bull market, Stout – whose trust is top-quartile over 10 years but is lagging its average AIC Global Equity peer over three and five years – said the developed world’s economic situation can only be described as “insipid and uninspiring”.

“Arrest this moment. With the world’s attention captivated and obsessed over the future path of interest rates, an inflection point appears to have been reached,” he added.

“Depressed bond yields suggest fixed income investors are not convinced in the sustainability of the current business cycle; rampant stock markets suggest equity investors believe a re-acceleration of corporate profits and dividends are imminent.

“Economic history strongly suggests the odds are stacked in favour of the former, therefore great caution will continue to be exercised.”

But Stout is not the only manager who has maintained a defensive portfolio throughout the bull run and thinks this stance is even more warranted from now on.

Performance of trust vs sector and index over 10yrs

 

Source: FE Analytics

FE Alpha Manager Sebastian Lyon, who runs the £4.5bn Trojan fund and is chief investment officer of Troy Asset Management, is another who argues that, after 15 months of gains in the US stock market, several indicators are signalling “excessively bullish investor sentiment”.

“Whilst 2017 saw an improvement in global growth, the increase in asset prices has more than reflected this,” he said. “Following two years of standstill, the earnings of the S&P increased 12 per cent in 2017; price level rose 19 per cent. Earnings for the US stock market are projected to increase 12 per cent in 2018, before accounting for the expected one-off tax benefit. Expectations are high.”

Lyon, who builds his portfolio around blue-chip equities, index-linked bonds, gold and cash – noted that he went into 2017 with “considerable caution” and has become even more cautious at the start of 2018. Owing to this, Trojan made a total return of just 4.14 per cent in 2017 but the manager stands by the positioning, pointing out that a low equity allocation and high liquidity means the fund can capitalise on any market corrections.

Another manager running a high cash balance and relatively low equity position is Marcus Brookes, who is head of multi-manager at Schroders and runs the firm’s MM Diversity range. The £757.8m Schroder MM Diversity fund he manages with Robin MacDonald has just under one-quarter of its assets in cash, alongside a 32.5 per cent allocation to alternatives.


In his outlook for 2018, Brookes pointed out that a peculiar feature of bull markets is that very expensive assets often exhibit very low volatility, creating the impression that risks are low despite prices being high.

This is the situation the manager sees now and he gives the US stock market as a case in point, also noting that the S&P 500 has not been hit with a negative month since Donald Trump was elected president in November 2016.

“Returns have been terrific and volatility has been very low. So low, in fact, that in the last year the S&P 500 has produced a spectacularly high Sharpe ratio of approximately 4.5. To put this into context, a good long-term Sharpe ratio would generally be something that falls between 0.5 and 1.0 on an annualised basis. Indeed, the average for the US market between 1928 and 2016 is only 0.4,” he said.

1yr Sharpe ratio of S&P 500 over 20yrs

 

Source: FE Analytics

The multi-manager warns that investors could be in danger of going into 2018 with a mindset of chasing historical performance at a time when valuations have rarely been higher. Added to this is the fact that central banks are tightening policy and removing some of the stimulus that made these historical gains possible.

“High valuations are widespread and largely inescapable. For some, there may be no alternative to speculating in risky assets regardless of their valuations,” Brookes concluded.

“We consider overall risk within the context of capital preservation, so our perspective is somewhat different. As a consequence, we continue to look for value and a margin of safety, while importantly carrying defensive hedges.”

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.