As an asset allocator and strategist it is important that one celebrates ones successes so please forgive me my moment of glory – they don’t happen publically that often!
Success is always followed by failure
But, like any triumph one is all too aware that success can turn to failure overnight, especially given the volatility we have seen over the past year. The fact that global equities have rallied over 10% this year and that government bond yields have risen by some fifty basis points is testament to the resilience of investors and their confidence that central banks and policy makers have taken sufficient steps to stabilise some of the uncertainties that dogged markets last year.
There is also some optimism that the macroeconomic environment is perhaps in better shape than previously thought and that the recent pick-up in leading indicators and demand are sustainable.
However, I have already consigned this minor success to history and am now trying to address the questions we really need answers to; does the investment case for equities still hold? And if so, where does the market go from here after such a strong run?
In answering this dilemma, we are faced with a number of fundamental problems. The key one is the lack of correlation between stock market returns and economic growth, particularly in developed markets. The recent rally has undoubtedly been aided by better macro data.
However, over longer periods of time the correlation between GDP growth and returns is limited, so we cannot rely on further positive surprises to automatically advance risk assets. Similarly, we cannot conclude that the recent high oil price is a harbinger of lower prices. In this particular case it is not the absolute level but the rate of change that influences the market.
A fundamental approach
I am also aware that investing with 20:20 hindsight is not an option, so how do we determine whether equities are good value or not?
As with most problems there is no one simple answer but two fundamental factors that do have significant positive correlations with returns – valuations and liquidity. These are absolutely critical, not just for equities but for all asset classes. By analysing these factors it is possible to assess whether or not a particular investment strategy should be deployed at a particular time. The key point is that valuations are assessed at a company-specific level, after all, we invest in companies not markets and by using these metrics we can assess their relative attractiveness.
Likewise with liquidity, we can assess this by analysis of publically available data, but none of these metrics make any sense unless they are put into context. Therefore, we must put valuations and analysis into perspective of where they sit in a historical context. The other historical comparison to be avoided is the “this time it’s different” investment strategy as it does not stand up to scrutiny.
So what are these metrics telling us at the moment?
If we look at the broad equity market index the answer, as it often is, is not much. For consensus earnings and dividend growth the current market multiples are fair – not expensive, not cheap – which I suppose is some comfort, but we have already said that we must look at a company-specific level.
More quant analysis needed
We need to look closer, and we need to find stocks with the prospect of sustained earnings potential for them to move ahead significantly from here. At an aggregate level this has to be reflected in positive earnings momentum to justify any re-rating. Many stocks have reached their target level based on current assumptions which is why I am encouraged to report that we have just seen global earnings post the first week of positive revisions after 41 consecutive weeks of downgrades; hopefully more to come.
2011 was a rollercoaster of a year which had almost every type of difficultly investors have to cope with. Optimism, pessimism, political and macro worries and several tragic natural disasters. The only fundamental factor that held any sway was yield, and again we know that investing in income does not outperform over the long term.
Quality and diversification will, over the long term, provide a basis for superior returns. But this can only be achieved by digging deep into company fundamentals. Although there will be challenging times ahead, I remain committed to equities as an asset class and optimistic that quality companies outperform over any investment cycle.