the horns of a dilemma

Volatile equities and macro concerns have led investors to the perceived safety of fixed income funds, but the next bull market could be right around the corner, if it hasn’t started already.

the horns of a dilemma


In early November, the Financial Times ran a front-page article with the headline ‘Bonds overtake equities in pension funds for the first time since the ’50s’. The move into fixed income, analysts said, began back in 2002 and is the “most significant shift in market allocation since George Ross Goobey made a landmark speech praising quities as a way of generating inflation-linked growth in 1956”.

For those not so familiar with Ross Goobey, he invested the entirety of the Imperial Tobacco Pension Fund in equities, a move central to the widespread shift in the asset allocation of pension funds, which traditionally invested predominantly in fixed income.

The trend towards fixed income – especially corporate bonds – has been a big issue for retail investors this year, even though IMA statistics for September showed overall net retail sales of equity funds (£541m) outstrip fixed income for the first time in 12 months.

The question is, which asset class is going to deliver the most satisfying returns in 2013? And is the ‘cult of equities’ really a thing of the past?

Wall of worry

For Simon James, founding partner at Gore Browne Investment Management, we are already in an equity bull market, which started during the first quarter of 2009 following the low after the unveiling of the credit crisis.

Continuing our history lesson, James refers back to a saying popular during the ’80s – ‘climbing the wall of worry’, which he believes is entirely relevant today.

“Slowly but surely, even though there were all kinds of nasty things out there, markets went up because they were coming from a place where there was much so much anxiety that people invested their money cautiously,” he explains.

“A bull market is one that goes up slowly but surely over time; it doesn’t have to go soaring. I think we need to understand that, especially at a time when cash gives you virtually nothing.”

Since the beginning of March 2009 – recognised as a market low – to the end of October 2012, the FTSE All Share and the S&P 500 both climbed 79% in total return terms, according to FE Analytics. The MSCI World registered a healthy 66% rise.

James does not necessarily believe that equities are attractively valued, hence why those investors that do take the plunge have largely been following the same mantra – pick companies with strong balance sheets and excess cashflow so they can pay dividends.

“But will there be a ‘nifty fifty’ effect where those kinds of company really do become very expensive relative to everything else?” he asks.
“I feel uncomfortable with that idea, but I can see why it might happen.”

‘Nifty fifty’ is a term more commonly associated with buy and hold growth stocks listed on the New York Stock Exchange in the ’60s and ’70s, though that does not mean it cannot be applied to other markets.

Across Europe, for example, the clamour is for a limited number of large cap, high-yielding multinationals rather than heavily indebted banks or southern European businesses.

Barry Norris, founding partner at Argonaut Capital, has this preference in his European Alpha Fund, though he stresses that new bull markets are almost always led by unexpected sources, such as tech in the late ’90s.

“It’s rarely the ‘problem child’ sector that exhibits market leadership,” he says. “Sector leadership is almost inevitably those sectors that benefit from the stimulus, but don’t necessarily need it. So we think this time around it will be consumer staples, technology, healthcare and non-life insurance. The boom in commodities and emerging markets that we saw for almost ten years came out of a fairly long bear market for those asset classes in the ’90s.”

Expect the unexpected

Nick Sketch, senior investment director at Investec Wealth & Investment, agrees that any new boom will not be triggered by those assets that have led previous cycles.

“Unlike many parts of a stockmarket, there will probably always be a place in portfolios for the Unilevers and Nestlés of the world, but they are not obvious candidates to lead the next bull market,” he says.

“Past evidence suggests that the next leader will be from an area that hasn’t been hot for years, that looks cheap against its own history, and can’t find enthusiasts even among those who already own it.”

Considering relative cheapness, Sketch points to the potential of less liquid assets: “From bonds and minor share classes to small caps and property, investments seem to be more fully priced the more liquid they are – the extra return investors are demanding for holding less liquid assets looks very wide.”

Bond bubble?

What we can probably guarantee is that greed will inevitably bring investors back into risk assets, perhaps at the wrong time. From a North American perspective, Jeffery Saut, chief investment strategist at Raymond James, says retail investors in the US have also been piling into bond funds, something he says is “an accident waiting to happen”.

Commentators often talk of the risk of a bond bubble and a potential liquidity squeeze if investors were to choose to leave fixed income en masse. However, Saut does not believe the switch will necessarily happen so soon.

He remarks: “I don’t think it is going to be quick; it will be over a long cycle and eventually we will see a switch out of fixed income that will initially start with endowment funds because they can’t make their mandates – there’s no way you can make a mandate of, say, 8% a year with a 1.7% yielding ten-year treasury.

“It starts with the institutional accounts and a switch into dividend-paying stocks. Then once the stock market starts to rally, in a period of years, the retail investors will come back.”

Saut believes there is only a 20-25% probability that a new secular bull market has already started in equities, with the chances are that we will see a “few more years” of the wide-swinging trading range. However, like James, he remains convinced that March 2009 represented the nominal low.

“I’m not in the camp that says that the markets hate uncertainty. For the well-prepared investor, volatility and uncertainty create huge investment opportunities,” he says, adding that it would be a bullish event if Greece were to exit the eurozone.

“I could foresee a scenario whereby Greece and Portugal opt out of the euro and it’s actually a good thing for the European Union because it leaves the rest of the countries in a stronger position. And if it’s a good thing for the EU, then it’s probably a good thing for the rest of the world.”

Whenever the next bull market does come, it will not necessarily be recognised immediately and, as Sketch suggests, we may not actually know about it until “five to eight” years after the date at which it started.

“It will probably get going in Europe soon, and it may have already started in the US,” he adds.

“And one thing that every bull market has shown, is that very few of us will get the timing (or anything else) perfect when talking about it afterwards.”