A four-step method to check markets' health
The FTSE 100’s dash to a new intra-day all time high of 7,130 in early October may remain a source of bafflement to many advisers and clients, given the prevailing uncertainties in the UK across a range of issues, including monetary policy, the wider economy and Brexit.
Yet the UK market’s ability to climb a wall of worry is quite typical behaviour and it provides a timely reminder of fund management legend Sir John Templeton’s comment that: “Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria.”
It therefore seems appropriate to assess Sir John’s four market phases and help advisers and clients decide where we are and whether markets are primed to rise or riding for a fall. They can then think about how to prepare for the end-game they expect, or a range of them.
One of the moments of greatest pessimism in 2016 looks to have been 24 June, when the EU referendum result became known and the FTSE 100 plunged back toward its February lows – and that has proved (at least for now) to have been a buying opportunity.
The FTSE 100 is nearing another new all-time high
Source: Thomson Reuters Datastream
Questions still linger, however, over what Brexit may mean for the UK, the health of Europe’s banks, the state of China’s debts, what the new US President may do, whether key elections in the EU will pose a fresh existential threat to the bloc, whether the Bank of Japan is losing the plot and what any further US interest rate hikes may mean for asset markets. Rising US rates have historically weighed on the performance of US stocks and also driven up the dollar, usually to the detriment of Emerging Markets.
The UK Gilt market is now also pondering whether the inflation genie is going to emerge from of its bottle.
UK Government bond yields are rising
Source: Thomson Reuters Datastream
If UK inflation really does pop its cork, that might not be a good thing, even if it would eat into the UK’s huge sovereign debts. It could drive Gilt yields higher, regardless of what the Bank of England does if the bond vigilantes really get going, with a knock-on effect upon corporate and household borrowing costs, given how the 10-year Gilt yield is the reference rate for so many other bonds and loans.
As such, markets have lots to worry about, if they choose to, and that suggests we could be a long way from a market top, if Sir John Templeton’s maxim is any guide.
One good indicator for broader market sentiment can be investment trusts. Their share prices clearly reflect the underlying performance of the portfolio picks made by the trust manager but they are also a product of the discount (or premium) to Net Asset Value (NAV).
A wide discount to NAV may imply the market has little faith in the fund manager or that the sector in which the trust operates is out of favour relative to other asset class, geographic or sector options.
It is therefore interesting to note that two of the four key UK-based categories trade at wider discounts to NAV than the broad universe covered by industry body the Association of Investment Companies. The exceptions are the seemingly ever-popular Equity Income and Bond & Equity income sections, themselves perhaps less aggressive in their general approach to the market.
Broad UK equity investment trusts discounts to NAV are wider than the industry average.
Source: Association of Investment Companies
Such caution also suggests UK stocks may not be in ‘bubble’ territory, applying Sir John’s four-phase outline.
Share buyback programmes can often be a sign of corporate exuberance and rampant activity, one indicator of a market top. Several FTSE 100 firms have run them in 2016, Royal Dutch Shell, Marks & Spencer, Ashtead, RELX, Kingfisher and HSBC included. This is potentially a warning sign, but it is hardly flashing red, since relatively few firms are splashing the cash and some of those who are buying back stock are not doing so when their shares trade near all-time highs.
Another indicator which suggests gathering optimism is a gradual trend increase in share-dealing volumes on the London Stock Exchange. Even looking through the massive spike witnessed around the time of the June EU referendum, year-on-year growth rates in volumes are gently rising. Although it is possible this is due to the rise of algorithm-based trading funds, it does imply animal spirits are starting to gather in some corners. This needs to be watched as it could suggest we are nearing the beginning of the end of the bull run, providing Templeton’s aphorism holds true.
Trading volumes on the London Stock Exchange are trending higher
Source: London Stock Exchange
It is hard to find anything that matches the euphoria of 1999-2000, when stock markets were front-page news and seemingly everyone wanted a piece of the tech, media and telecoms action. That ended badly, so it’s a relief to see nothing similar right now – barring maybe in the UK housing market, although experts in their field will suggest that other global property markets, Government bonds, art, wine and thoroughbreds are looking pretty frothy.
We are seeing relatively limited merger and acquisition activity in the UK, few if any leveraged buy-outs and the initial public offering (IPO) market is fairly quiet. The autumn Misys and Biffa deals had to cut their prices to get away, while Pure Gym and TI Fluid Systems postponed their listings. This hardly suggests markets are getting carried away and buying any old rubbish as they did in 1999-2000 with tech or 2005-07 with resources firms.
While Misys and Biffa have swelled the number a bit since, there had been just 47 IPOs on the London Stock Exchange’s Main Market and AIM by the end of September. They raised £956 million between them. That compares to 62 deals raising £4.8 billion in the same nine-month period in 2015, let alone the 300-plus deals done in the whole of 2000 and 200-plus in the whole of 2007 as the last market upswings peaked.
That suggests we are lacking Sir John Templeton’s dangerous “euphoria” but perhaps the big danger right now is complacency as the UK adjusts to its post-referendum, pre-Brexit state.
The FTSE 100 volatility index, or VIX, trades nearer to its historic lows than highs and below average levels, to suggest markets are pricing in little by way of further wild activity. Perhaps this is the enemy against which advisers and clients need to guard in 2017 and beyond.
FTSE 100 VIX index remains subdued
Source: Thomson Reuters Datastream
Another way to look at this is to see how many days have seen movements of 2% or more in the FTSE 100 index. This year got off to the wildest start in over 20 years, as the benchmark index rose or fell by more than 2% from open to close 12 times in the first two month of the year, in the wake of the US Federal Reserve’s first interest rate hike for a decade last December.
Since then, we have had just eight such open-to-close gains or falls of 2% and the going has been much easier. This is in keeping with a long-term pattern evidenced by the chart below, whereby the FTSE 100 does best during periods of calm and worst during bouts of volatility (although a rapid series of extreme moves does seem to ultimately call the bottom).
It will therefore be interesting to see what happens if the Fed does push through another quarter-point hike at one of its final two meetings for the year, on either 2 November or 14 December.
The FTSE 100 has become less volatile as the year has gone on
Source: Thomson Reuters Datastream
In truth, that brief survey may not provide advisers and clients with the firm steer that they would like. But that in itself may be instructive, because the clear conclusion is that no-one knows what is going to happen.
Central bank interference makes reading markets harder than ever and political risk is growing as party leaders abandon the centre ground in response to disaffected electorates. Inflation, deflation or stagflation could all still result from ultra-loose monetary policy, and fiscal stimulus remains an additional unknown.
Such a scenario leaves advisers and clients with a dilemma, should it come to pass. Deflation would be good for good-quality sovereign and corporate bonds, as well as cash, but bad for equities, high-yield debt and commodities, if history is any guide. Inflation would flip this around.
The good news is there are other tools out there, including target-date funds, multi-manager funds and multi-asset funds, designed to help manage risk and provide inflation-adjusted returns that can help advisers build portfolios which suit a client’s overall strategy, target returns, time horizon and appetite for risk.
Multi-manager funds seek to implement a similar strategy, by investing across a carefully-managed selection of collectives, while a further wrinkle here are target-date funds, which are very much designed with retirement and drawdown in mind.
A target date fund typically rebalances its portfolio to become less focussed on growth and more focussed on income as it approaches and passes the target date of the fund, which is usually included in the fund’s name. It does this by automatically switching its portfolio allocation mix away from riskier areas which focus on capital growth, like equities, to what are ostensibly safer, income-generating areas like bonds. This pre-determined reallocation of assets is often referred to as the glide-path, not least as it is designed to try and provide a relatively smooth ride for holders for the funds.
Morningstar shows it is possible to put capital to work across a wide range of multi-asset and multi-manager OEICs, with Cautious, Moderate or Aggressive allocations. The table below shows the top performers on a five-year view in the Moderate category.
The Investment Trust world offers Global options too, and there are half a dozen which have multi-manager characteristics, including the venerable Witan, plus Foreign & Colonial Investment Trust, F&C Managed Portfolio Growth, London & St Lawrence, Miton Worldwide Growth and Jupiter Global (Primadona Growth, as was). The table below shows the top five performers from the Global category over five years.
Multi-asset ETFs are rarer beasts, even if exposure to global benchmarks within separate asset classes can be easily gleaned. Morningstar data show there are still two multi-strategy ETFs which track hedge fund indices. Their five-year performance is nothing to crow about although both are up by more than 15% in 2016, as this document goes to press.
Best performing Global Moderate Allocation OEICs over the past five years
Source: Morningstar, for GBP Global Moderate Allocation category.
(Where more than one class of fund features only the best performer is listed.)
Best performing Global investment companies over the last five years
Source: Morningstar, The Association of Investment Companies, for the Global category.
(* Share price. ** Includes performance fee)
This is not to say multi-asset funds or multi-manager funds will appeal to everyone. There has been some strong criticism of their performance and fee structures of late, although the tables show a wide range of ongoing charge figures (OCFs) among the leading performers in the Moderate Allocation category. Advisers and clients can therefore shop around, if they so wish.
A further danger is posed by asset correlations. In theory, different assets tend to perform better or worse under different market or economic circumstances – but central bank intervention in markets means stocks, bonds and commodities have often tended to move quite closely. If this trend persists it could at least partly negate the potential for multi-asset and multi-manager funds to create or protect wealth for advisers and clients.