By Ian Heslop
The year has begun with a bit of a bang as far as equity markets are concerned. Though the strength of returns has caught many investors out, the small number of negative days has broadly been seen as opportunities to buy – or to put it another way, to capitulate on longer-held asset allocation positions.
After many years of bond markets having all the headlines, we may now be seeing the beginning of a period when equities are once again ‘cool’. Bond yields have risen, even if only a little and from extreme lows. The Dow Jones has pushed through to an all-time high. The Topix in Japan has hit a 52-month high.
It can’t be just me looking on with a somewhat jaundiced eye. Volumes have been especially low, though that is not the only issue leading to questions on the conviction behind current market moves.
Don’t get me wrong, it has been good to be an investor in equities since the trough of the market in 2008, with the MSCI World Index – comprising developed markets – rising by over 100% in those five years. The fall in 2011 feels like a long time ago, volatility remains subdued; there is a feeling of a one-way bet forming in market behaviour.
But we have seen this before, right? 1995 and 2007 both looked a little like now. In 1995, the five-year recovery in equity prices from the lows posted in 1990 was also impressive, as was the recovery into 2007 from the lows touched in 2002. However, you don’t need to be a scholar of the market to know the outcome of these two periods was slightly different.
So where are we, 1994 or 2007? When you turn on the radio, is Celine Dion serenading you with Think Twice or is it Rihanna and her Umbrella? Or indeed is it (perhaps preferably) neither.
No-one wants to win the ‘least ugly’ contest, but that may be where we are with equities, that they are benefiting from being somewhat more interesting than other investment opportunities. Many sovereign bonds currently trade on a duration that gives a feeling of bond returns with equity risk, not a top-notch situation. The dividend yield on European equities recently passed above the corporate bond yield, suggesting equities are cheap (or corporates expensive, you decide).
As we all know, equities prices are driven by a price/earnings multiple and earnings per share assumptions. P/E multiples for global equities, at 12.5 times, currently stand at levels in line with the average over the last five years. On a 20-year view, they currently trade slightly below the 14.5 times average, even when removing the insanity around 2000. There remains room for further multiple expansion, although arguably not a lot.
Earnings, on the other hand, have had a very good run. Margins remain high relative to historic norms, in no small part due to the lack of pricing power held by labour in the current economic cycle. Looking at the US market, aggregate earnings per share have doubled since the cyclical low posted in 2008.
The risks outlined above are essentially beta risks. These are good risks when the market is rising, as it has been. But this is an age of astonishment, an age in which completely unpredictable events in obscure places can ambush the mightiest, most liquid equity markets, New York, London, Frankfurt, Tokyo – events, as an example, the political intricacies of deposit insurance in Cyprus can wag the entire dog of global equity markets.
In such an age, fundamentals are contingent and trends are unreliable indicators. The solution – one solution – is to cover beta risks with alpha risks, either through absolute return or market neutral, or both.
Ian Heslop is portfolio manager of the Old Mutual Global Equity fund
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