Investment newsletter - January 2017

Investment Newsletter January 2017

Playing it safe Legendary investor Warren Buffett has come up with some great quotes in his time.

Right now, Buffett’s “rules of investing” are at the forefront of our minds: “Rule number one: never lose money.

Rule number two: never forget rule number one.”

Mike Deverell

Unfortunately, in investing it is impossible to never lose money. However, minimising losses is equally (if not more) important than maximising gains.

Investment Manager

Ultimately, markets will go up and down and our portfolios are likely to go in the same direction.

However, it is the ratio of gains and losses which is important. For example, if we capture only 70% of the gains in rising markets but are only exposed to 50% of the losses in down markets, over the long term

portfolios will outperform. However, it does mean there will be times when they can underperform the markets quite substantially.

Successful investing is all about balancing the risks of any investment against the potential rewards. At present, within equities we think that the balance has shifted towards higher risks and lower possible rewards.

Colin recently sent out a bulletin to our clients outlining the reasons why we are being cautious right now. One of the main reasons is valuations. To read the bulletin in full click here.

Right now the price/earnings ratio on the UK stockmarket is around 20. That means that the market is valued at a multiple of around 20 times the aggregate earnings of the underlying companies. That is well in excess of long term averages.

Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.

Investment Newsletter January 2017

Chart 1 below shows the past returns of the UK stockmarket when the PE ratio has been at different levels.

Each dot represents a different 10 year period on the market. The higher the dot, the higher the return was over the 10 years after the market reached the valuation. The further to the left the dot, the lower the PE ratio was at the start of the period. Further right indicates a higher ratio.

There is a clear correlation between a low PE ratio and high returns, a high PE ratio and low returns. When the ratio has been 20 in the past, we have typically seen returns of around 6% pa over the following 10 year period, well below our long term expected return of 10% pa.

Chart 1: PE ratio vs 10 year annualised

Source: Thomson Reuters/Equilibrium Investment Team

Of course, in the current environment 6% pa would be well ahead of cash, and probably well ahead of inflation and bond returns too. There are still good reasons to invest in the stockmarket if we take a long term view.

However, if we look at the same thing but over two year periods (shown in chart 2), we see a different picture.

Very frequently, when the PE ratio has been 20 we have seen a negative return over two years (but not always).

From this we can observe that the risk of a short term pull back has risen substantially. That doesn’t mean it will definitely happen and there are periods in the past where markets have carried on rising for some time from these levels. However, when that has happened the pull back has been more of a crash than a correction.

Chart 2: Key ratios vs 2 year annualised

Source: Thomson Reuters/Equilibrium Investment Team

Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.

Investment Newsletter January 2017

What are we doing?

Given our concerns about the shorter term direction of markets, we think it makes sense to reduce equity and reduce risk.

However, taking a longer term view we would still expect markets to be higher in a couple of years time.

As a result, what we’ve decided to do is to sell around 3% equity and invest this in a defined returns product.

A defined returns product provides its potential return should the market be the same or higher than the starting level, on any of its first six anniversary dates.

This means we don’t need markets to go up to achieve a return, only to go sideways (or go down and then back up).

Given our view that markets could go down in the short term but are likely to be higher in the long term, this type of investment makes sense in our view. By switching equity into defined returns we are therefore reducing market risk (however we are exposed to the credit risk of the bank which provides the product).

We are currently in the process of making this move and the rate of return we will be given will only be known once the new product is up and running.

However, we have indicatively been offered a rate of above 11%.

Alternatives

As well as defined returns, we are currently holding more than usual in alternative equity, where certain funds can make money even in falling markets (should they get their calls right of course). Within the “alternative” category, we are also investing into infrastructure funds, which tend to provide a slow and steady income above inflation.

The product we are setting up is based on both the FTSE 100 and the S&P 500. Should both be the same or higher on the first anniversary the product would end and we would get a return of 11% (should that be the final rate).

If the indices are below the start level on the first anniversary, the product rolls on to its second birthday.

If markets are the same or higher on that date then we get the rate times by two (so 22% if the rate is 11%). If not, it rolls on to the third year when the possible rate is 11% x 3 = 33%.

This can happen at any of the six anniversaries. If the market is still not above its start level at any of these dates then investors will just get their money back, unless one of the markets is down 40% or more on that date. If they are, then we lose money on a one for one basis, so if the market is down 41% then we lose 41% etc.

In our judgement, this product has a higher possible return than the stockmarket over the next few years.

Of course that is not guaranteed, but we do think the relative risk and returns are well balanced.

We will be selling equity at the same time as setting up this product, so the buy and sell points should be at the same levels.

rewards. Ultimately, our current approach does mean that if markets carry on rising we will make less money, but it should mean that portfolios would keep going up.

Should markets go down, we should lose less money and be well placed to take advantage of such a fall.

In the meantime, we should not forget rule number three: “refer to rules one and two.”

We are also holding more cash than usual. Should markets dip we will use this to buy in at lower levels and try to profit from volatility. Holding this cash allows us to act quickly.

Given the recent direction of markets, and our caution about the outlook, we think it makes sense to continue to keep cash levels. However, we are looking at options to invest some of this in areas which might increase the return but without taking too much risk. For example, this might include very short dated bonds where risk is reduced because there is only a short time until maturity.

It’s fair to say we are having to be more creative at present in order to balance those risks and the possible Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.

Investment Newsletter January 2017

General Economic Overview Economic data across most of the major economies indicates that growth has picked up. The markets are anticipating a significant rise in fiscal spending from the new Trump administration although there remain risks from any protectionist measures the new President may look to implement. Recent comments from the Federal Reserve point to further rises in interest rates in 2017.

The weakness of Sterling has served to lift the rate of inflation as imported prices have risen although any changes in UK interest rates are likely to be modest.

Asset class key + positive - negative = neutral (normal behaviour)

+5 strongly positive -5 strongly negative

Asset Class

Score

Equity Markets Equity markets have rallied strongly over the last two months. Whilst earnings expectations have risen, most markets now trade on high valuations relative to historic levels. In this light, we have moved our score from -3 to -5 since last month. Japanese and Asian equities offer the best value in relative terms.

-5

Fixed Interest The rise in rates of inflation in many developed economies and the Federal Reserve’s outlook for higher interest rates provide a challenging backdrop for bonds. Our score is unchanged at -3 since last month.

We continue to hold some index-linked gilts but otherwise prefer corporate bonds.

-3

Commercial Property Recent news regarding the transfer of London office staff to Europe underpins our preference to avoid the capital’s property market. Our score remains unchanged from last month as property yields remain attractive but there will be little in the way of capital growth.

Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.

-3 -5

Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest and equity, and hold only a small amount of property. This is balanced by additional holdings in defined returns, alternative equity and tactical cash.

A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for residential property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5% means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall.

These represent Equilibrium’s collective views. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser.

Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.