Current times are often said to be some of the most uncertain in recent history. Extreme polarisation has infected our politics, with increasingly populist leaders frequently contradicting themselves and taking unexpected positions. On top of this the technological revolution has upended so many aspects of all industries creating big dispersions between winners and losers.
A whole swathe of trends such as self-driving cars and firms creating software applications for everything from boiling the kettle, to finding a soulmate and indeed the automation of investing. This has profoundly changed the foundations of financial markets and many believe that the new trends we have seen in the last five years are here to stay.
A big issue with this is that many of these trends have now become so well-known and popular that it has created massive dispersion within valuations – whether it be of the market size for these new innovations or the value of the individual companies operating within them.
This is also exacerbated by the incredibly low cost of debt prevalent in the world economy which causes valuation models favoured by asset managers to produce extremely high valuations. This is because low interest rates make future cash flows more valuable as high interest rates will not erode their value.
Finally, if you add the phenomenal growth of market-cap weighted passive investing where more money is allocated to currently in-favour growth companies, and away from the unpopular value companies, then you have a confluence of factors that have created massive dispersion in markets.
This dispersion can be seen in many different areas of the market, for example:
- The difference in performance in the last 5 years of stocks with low price/earnings ratios compared to those with high price/earnings ratios has been at its largest since the tech bubble at the start of the millennium (see chart).
- We have seen investors flocking to ‘safe haven’ assets such as gold, which has recently broken above the $1500 mark, despite low inflation and strong equity markets.
- In the US long-dated government debt which has caused the yield curve to invert, a common recession indicator. On the other hand, we can see the S&P 500 Index trades close to it’s all-time high reached in July; indicating that the economy is on track and positive earnings accretion will ensue.
This chart shows the performance of value investing compared to growth investing. A score above 1 indicates that value has outperformed growth. There have only been three occasions since the start of this index in 1973 that it has fallen below 1 (i.e. when growth has outperformed value over the long-term).
As a result of these conflicting messages, the risk of market rotations and a change to the recent status quo is heightened. The start of September has already brought some early indications that this might be closer than many suspect, with quantitative momentum funds (the strategy of buying yesterday’s winners) suffering their largest drawdown since the financial crisis in the last few weeks.
In order to navigate through this uncertainty, it is important to remember that diversification is still the single-most useful tool to help investors limit drawdowns but still achieve their return targets over the long-term.
From recent fund manager meetings there seems to be as many managers that think global growth is going to continue for a while longer as there are managers preparing for the worst and the next bear market. All of them point to relevant data that backs up their convictions and make a compelling case, but they can’t all be right.
Therefore, when reviewing your portfolio, you should consider if it reflects too many decisions that look good in the context of recent times and popular market trends but might not stand up in the long-run. Have you underweighted key strategies such as value investing, or absolute return/alternative funds because of their recent poor performance, or allocated even bigger amounts to passive funds that will offer no downside protection in a bear market? The value of disciplined and process driven decision making with a long-term view is paramount.
Louis Tambe is a fund analyst at FE
