How to take the markets’ temperature

In the short term markets are driven by greed and fear, and any adviser or client looking to make any tactical or strategic adjustments to portfolios as 2015 ends and 2016 draws ever nearer will therefore be keeping a close eye on the latest round of market volatility.

Two of the biggest – and hardest – decisions which come with any such fine-tuning are:

  • Whether to run with the winners and stick with positive momentum.
  • Whether to go against the crowd and try to sniff out value.

From a strategic perspective, the valuation of the underlying assets addressed by a fund should be the deciding factor on either count.

Not everyone will have the time to do the painstaking work required here but there are some pointers which can be followed relatively quickly. These include credit spreads, the make-up of key indices, the relationship between new highs and lows, fund flows and selected relative performance stats.

In sum:

  • Increases in credit spreads and bond yields in the sub-investment grade area of the debt markets both suggest risk is being re-priced (and not before time). Select value may be appearing here but caution is still required.
  • Emerging equity markets are getting more interesting, as evidenced by Goldman Sachs’ decision to fold a fund focussing just on Brazil, Russia, India and China into a broader collective. It could however still be too early, with Brazil and South Africa possible major fault lines.
  • Raw material-related stocks will be attracting contrarians as the Bloomberg Commodity index plumbs 16-year lows, but again the worst may not be over just yet.
  • Margin debt in the US and the deteriorating balance between new highs and new lows Stateside suggests the American market is not as healthy as it could or should be. But with cracks appearing at the periphery – junk debt, emerging markets – US assets could take on core haven status in the short-term, for all of the dangers that huddling in the same shelter tends to offer.

Long-term plan

As already noted, for those advisers and clients working on long-term, strategic allocations, valuation is vital. On a bottom-up basis a good fund manager will work hard to sniff out the bargains and avoid the unduly expensive, be it across individual stocks or even asset classes, in the case of a multi-manager or multi-asset fund.

The price paid for an asset will shape long-term returns, as the chart below shows. It comes from a presentation by Invesco Perpetual’s Mark Barnett at a meet-the-managers event in London in November.

The conclusion is simple: pay low valuations and get higher, 10-year returns from stocks (and thus equity funds). Pay high valuations and you get less back on your money over the same period.

Valuation has a huge say in long-term equity returns

Source: Lazarus Partnership, Invesco Perpetual

The dotted line is where valuations are now – so for the UK the picture looks decent enough, if history is any guide.

Short-term problems

Unfortunately other data and charts look less reassuring, at least for anyone looking to bottom-fish and snap up potential bargains across a number of asset classes.

Bonds. Credit spreads are blowing out. The gap between AAA-rated and BAA-rated bonds is growing relentlessly according to Moody’s, as the yields on lower-rated paper rise.

Rising credit spreads are a potential warning sign

Source: Thomson Reuters Datastream

This suggests:

  • Markets are becoming more risk averse, as they demand higher yields to own lowly-rated (and thus riskier) paper.
  • Companies will find it harder to raise or service debt. This will impact earnings, the ability to fund acquisitions and even jeopardise the existence of the weak and heavily-indebted.

At least the yields on offer are now more representative of the risks involved at the lower end, with the yields offered by a leading global junk debt index reaching 8.7% and the benchmark for debt rated CCC and below reaching nearly 19%.

Junk debt indices show marked rise in yields

Source: Thomson Reuters Datastream

However, the global junk index’s yield still only takes us back to 2005 – when all still seemed well in the world – even if CCC and below is now at levels seen in 2008, when all seemed very gloomy indeed. This may be an overreaction.

Emerging market equities. Fresh plunges in currencies such as the South African rand, Turkish lira and Russian rouble, let alone a steady slide in the Chinese renminbi, show the heat is on.

The chart below shows the MSCI Emerging Markets index (in sterling terms) divided by the FTSE All-World (also in pounds). If the line rises, Emerging Markets are outperforming and if it falls they are underperforming.

Emerging market equities have underperformed for four years

Source: Thomson Reuters Datastream

This four-year stretch could suggest there is some value emerging, especially as price/book multiples are heading toward historically attractive levels, according to both BlackRock and Invesco Perpetual.

However, the above graphic also shows that EM equities lagged global equities from 1994 to 2002 as a debt crisis brewed, broke and then weighed on growth for some time. Lofty debts and falling commodity prices could yet do more damage.

Commodity stocks. The Bloomberg Commodities index stands at a 16-year low of just 78, compared to 2008’s peak of near 250. Mining and oil stocks are plunging as a result as profit forecasts and dividends alike are slashed.

The oil stocks seem to be further down the road in adapting to the new reality of lower prices, although December’s inconclusive OPEC meeting in Vienna is prompting fresh drops in Brent crude to below $40 – and the big oil firm’s cost-cutting and capex plans appear to price in $60 a barrel or more.

It is tempting to look at the oils, or income funds laden with them, as they offer yields of 7% and 8% respectively and have balance sheets that can take the strain in the short term.

A long run of $40 or less a barrel could pressure even these payments but at least the UK oil sector is trading within 10% or so of its relative low, as compared to the FTSE All-Share Index.

Oil stocks are trading near their share price relative lows, against the FTSE All-Share

Source: Thomson Reuters Datastream

Meanwhile, there are still seven miners in the FTSE 100. More than one wise – and experienced – fund manager has whispered to me that he will only be tempted to look at the mining sector when that figure has fallen to one, replicating the mass inrush and then outflow of technology, mining and telecoms stocks which characterised the 1998-2003 period.

This may not prove as fanciful as it sounds. On a share price basis, the UK mining sector still trades at twice its historic low, relative to the FTSE All-Share.

Mining stocks still trade way above past historic share price lows, relative to the FTSE All-Share

Source: Thomson Reuters Datastream

US equities. The S&P 500 has set multiple new highs in 2015, albeit without anything that could be described as a lot of conviction, given the index is essentially flat on the year in dollar terms.

Although the data are produced slowly, it is still worth tracking the monthly margin debt figures published by the New York Stock Exchange.

This figure has come slightly off its all-time highs, as perhaps reflected in the index’s lack of overall progress this year. If the market ever does wobble, then margin calls could beget further selling and create a vicious rather than virtuous circle.

NYSE margin debt is still near all-time highs

Source: New York Stock Exchange, Thomson Reuters Datastream

This does not seem likely for now, especially as any pain in areas like emerging markets and junk debt could prompt fund flows toward haven assets like dollars and US stocks.

This would mirror what we are seeing in the bond market, where advisers and clients seem to be allocating capital toward investment grade sovereign and corporate debt, relative to sub-investment grade or junk paper.

Short-term problems

And the problem for advisers and clients is cheap stocks or bonds or buildings can get cheaper and expensive ones more pricey in the short term if no catalyst intervenes to change market perception. It can therefore take a brave adviser or client to ditch a winner and dig around the market undergrowth for unloved assets.

As US hedge-fund legend Paul Tudor Jones put it, “There is no training, classroom or otherwise, that can prepare for trading the last third of a move, whether it’s the end of a bull market or the end of a bear market.” (And I thank the ever-informative website of American fund management firm Evergreen Gavekal for reminding me of this gem).

This means we all need to tread carefully. There are signs of distress in relatively peripheral arenas such as junk debt, emerging markets and commodities and this is exactly how the 2007-08 meltdown began, with the shuttering of relatively minor funds operating in esoteric property and debt markets.

What were seen as a liquid means to play an illiquid underlying market proved to be nothing of the sort and panic ensued, initially to the benefit of mainstream, core assets markets like US stocks, which initially rode out the storm very well.

Uncanny echo

The first ripples of the credit crisis became evident when two Bear Stearns credit-related hedge funds filed for bankruptcy on 31 July 2007.

We have not seen fund failures yet, merely closures to redemptions and it is energy, mining and emerging assets that are leading the way down this time, rather than housing-related debt and equity.

Even so, the shuttering of the Third Avenue debt mutual fund and the Stone Lion Capital credit hedge fund in the US could be an ominous sign and one that initially favours the momentum favourites and perceived safe assets.

It took America’s S&P 500 six months to fall 10% after those Bear Stearns funds went down (and it was still flat in early November).

US stocks held their ground for some time even as the credit crisis spread

Source: Thomson Reuters Datastream

The UK showed a similar pattern. Although an August 2007 wobble took it down 10% it rallied to flat by November and went into sustained double-digit losses post Bear Stearns when the US did, in January 2008.

UK stocks did the same

Source: Thomson Reuters Datastream

No-one is lucky enough to have a crystal ball. But as advisers and clients review portfolios and preview the year ahead market action suggests this is not time to be reaching out beyond normal levels of risk comfort, within the confines of a well-built, well-balanced, diversified portfolio.

This column will return on 8 January 2016. Until then, everyone at AJ Bell Investcentre wishes you a Happy Christmas and a very prosperous New Year.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.