By Greg Kolb
After five years of stellar gains, it can be easy to forget that investor enthusiasm alone won’t keep markets rising forever. Indeed, it seems natural to question how much longer the good times might last – particularly in light of recent equity market corrections.
It appears the balance between greed and fear that tends to drive markets, especially in later cycle stages, has tipped firmly toward greed, with investors more interested in maximising gains than in avoiding losses should volatility re-emerge.
Today’s optimistic pricing levels pose two major challenges. Firstly, expectations embedded in financial assets have risen significantly, and at some point companies must be able to deliver against these more demanding anticipated results or else stock prices are likely to stagnate. Secondly, the risks of a drawdown and its potential magnitude have dramatically risen. As a consequence, investors need to be keeping an even sharper eye on fundamentals and downside risk to ensure they are not overexposed to potential losses should markets change for the worse.
The best way for investors to prepare for the future is to look forward rather than to try and extrapolate from the recent past. The best time to protect a portfolio from risk is, of course, before losses unfold, and while it is not possible to time markets, it is feasible to assess the balance between risk and reward. It is easy to make money when all markets are climbing, but planning on “more of the same” and leaving risk unattended – especially after years of momentum gains – can leave a portfolio susceptible to significant downside exposure when volatility inevitably reappears.
So today, we find ourselves increasingly worried about the potential for the investing environment to once again become characterized by a greater degree of pessimism and what this could mean for stock portfolios. Even a casual review of the economic situation reveals a number of alarming issues, including the ongoing euro crisis, the Federal Reserve’s “exit” strategy and China’s changing growth dynamics, among many others. More importantly, though, our stock-level research is uncovering significant downside exposures related to earnings sustainability, valuation expansion and balance sheet strength.
It is only natural that valuation multiples have expanded in the recovery from the global financial crisis and, for investors, this higher starting point likely means lower future returns. So it is vital that when reviewing stock valuations around the world, we do so with both relative and absolute perspectives, drawing from long-term averages to assess downside risk and upside potential. It is as a result of this that we favour stocks with reasonable (not stretched) valuations, often with something negative (but temporary) in the headlines weighing on the price. Then we carefully consider how low of a valuation a pessimistic market might assign and explicitly model the loss in that scenario. We are wary of the impact and durability of accommodative monetary policies and consider how valuations may develop if that positive dynamic were to change.
Overly optimistic investors often seem to be surprised by changes to the trend, even though such change has proven to be the rule over the long term. With earnings, valuations and balance sheets each showing vulnerabilities, current reward-to-risk ratios imply that the market may be increasingly ripe for dislocation. Consequently, investors may want to consider locking in current gains and taking the opportunity to rebalance more aggressive portfolio allocations into more cautious equity holdings. At the very least, they should be cognizant of the risks they may be taking on at current elevated market levels to gauge whether their portfolio downside exposure is truly aligned with their expectations moving ahead. When it comes to effective risk management, forewarned is definitely forearmed.
Greg Kolb is portfolio manager of the Perkins Global Value Fund
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