A challenging macro environment and expensive valuations across the board are likely to result in a significant market correction in the coming years, according to the Trojan fund’s Sebastian Lyon. Lyon (pictured), who also heads up the Personal Assets Trust, says he’s struggling to find attractive value in anything at the moment, which in his experience implies that a market shock could be on the horizon.
“My expectation is that we will see another correction – perhaps not on the same level as 2008 – but I wouldn’t be surprised to see valuations go considerably lower,” he said an exclusive interview with FE Trustnet.
“Now reminds me a bit of 2006 and 2007, when everyone was asking: “equities won’t go down from here – why would they?”
“In 2007, I found myself thinking that I couldn’t find anything to buy. I feel a little bit similar now. I feel that in two or three years’ time – or maybe closer – we will get a lot better opportunity to buy than the current menu on offer.”
Lyon believes “a deflationary shock” is likely to be the trigger for a significant downturn, which he says could come from problems in the eurozone. However, he points out the lack of value across the equity and bond markets are the main reason for his concern.
“We live in precarious times, with equity and bond markets at all-time material highs,” he said. “The bond market bull run has to come to an end at some stage soon. The downside risk compared to the upside risk is pretty phenomenally in favour of the former. If inflation comes into play, anything with a coupon will be disappointing for the next decade.”
Performance of IMA sectors over 5yrs
Source: FE Analytics
“The S&P 500 is at all time high, the Dow hit it back in May – there was a point when the market went up 13 days in a row, which is unprecedented. We saw the FTSE hit 6,800 – higher than it was back in 2007.”
“We’ve hit a period of an ever increasing lack of risk aversion. My instinct is that from here, the risks are tilted more towards the downside than the upside. I wouldn’t want to forecast anything in the short-term, but looking at valuations from a top-down and bottom-up, I don’t think there is much absolute value to be had.”
“People often say that we obsess over the macro, but we believe it’s valuations that drive returns – not the macro. If you buy a stock on 20 times earnings, then the chances of making money are less than if it’s on 10 times.”
“Momentum works up until a point, but it gets investors into trouble eventually.”
Lyon points to the in-favour equity income market as a particularly expensive at the area – frustrating for him, he explains, because he likes dividend-paying quality companies.
“Equity markets have benefitted from the thirst for yield, in the same way as emerging market debt has,” he said. “I think a lot of people are looking at the yields and not thinking about the downside risks.”
“Look at something like Diageo, for example, which has seen its share price double since 2009. The yield has gone from 4.5 per cent to around 2 per cent over that time. People are still confident about the company and like the fact it’s got a yield, but I don’t think they’re thinking about the potential for downside risk.”
Performance of stocks and index since March 2009
Source: FE Analytics
Many managers make the case for equity income because shares of companies are currently yielding more than their debt, but Lyon thinks this view is dangerous.
“The problem is, equity isn’t debt – it’s not just about the coupon. This argument really worries me, because people aren’t thinking about the downside,” he said.
Lyon sees the slowdown in emerging markets as a potential headwind to companies like Diageo, and says it could be a catalyst for a significant de-rating.
He commented: “We saw in 2007 that when extrapolated earnings were cut for highly rated companies, even by just a little bit, there were massive falls,” he said.
“It would only take a cut of 10 per cent of earnings, which could come from the slow-down in emerging markets or a move in a currency, and you could see a de-rating. If P/Es [price-to-earning ratios] came down from 19 or 20 to 15 or 16, falls of 25 and 30 per cent in some shares is very possible.”
Investors may be surprised to read that Lyon holds Diageo in the Trojan fund, though the weighting has come down significantly of late.
“People ask: “Why hold these companies at all? Ultimately, these are the kinds of companies that I want to own, but right now is not the time to add more capital to them,” he explained.
The manager currently holds just 34 per cent of his Trojan fund in equities. Just over a quarter of the fund is in cash, 28 per cent is in inflation linked bonds, and 13 per cent is in gold and gold equities.
Lyon made the case for holding gold in an interview with FE Trustnet last week.
The manager explains that he brings down the equity weighting of the fund as markets go up, in order to capture the upside and protect the portfolio from rising valuations.
The fund had as much as 75 per cent in equities in the aftermath of the financial crisis.
“Our view is that we’ve been in a secular bear market since 2000, and since then have decided to drip in and out of the market to get some of the upside,” he said.
“The problem with stock markets is that they rise steadily and slowly but fall sharply, which is very difficult to time. This is why we increase our equity exposure aggressively when the market falls, and decrease it slowly as it rises.”
“The risk is the same as when people started to buy in early 2008. When sentiment is positive is when it’s the most dangerous, but when sentiment is poor, valuations are protected on the downside.”
“We see a yield of 5 per cent as a green light almost regardless of what’s going on in the macro, which it hit for a short time in 2008.”
This way of investing is very similar to the process used by FE Alpha Manager Alex Grispos, who runs the CF Ruffer Equity & General fund.
Though Lyon believes a deflationary shock is very possible in the shorter-term – which is in part why he has significant exposure to cash – on a long-term basis he anticipates high levels of inflation. This, he explains, is why he has a high weighting to inflation-linked bonds and gold.
“From a totally top-down view – i.e. three to five years – we anticipate significantly higher levels of inflation,” he said. “Essentially we think there is only one way out of the problems that we have, and that is by inflating away the debt.”
“We never run the fund on a one month or even a one year view, but we have to recognise that there short-term risks as well. At the moment we think there is a big deflationary threat coming, which could completely marginalise and actually compromise the long-term prognosis.”
“The problem at the moment is that index-linked bonds are being dragged down by what’s going on in the bond market. At some stage they will decouple, and given our view on inflation this is where we want to be in the long-term,” he added.
Lyon’s cautious stance – particularly his high weighting to gold, cash and linkers – has resulted in the Trojan fund underperforming its IMA Flexible Investment sector and FTSE All Share benchmark over a one and three year period.
The fund has a particularly poor record over a one year period, with returns of just 0.96 per cent.
Performance of fund versus sector and index over 1yr
Source: FE Analytics
Lyon acknowledges that investors are likely to be disappointed with these returns, but points out that the fund needs to be judged on a longer-term track record.
The manager adds that he’s encouraged to see that the fund has seen very little in the way of outflows in recent months.
“I think we have a very loyal investor base we have been very clear as to how and why we are invested,” he said. “We are never going to be able to generate good returns over every time period. We’ve had our moments in the past, it’s worth pointing out.”
Performance of fund versus sector and index since launch
Source: FE Analytics
“The last year has been very lacklustre, but we think and hope people realise what we are doing. We’ve never been one to say Trojan is a fund for someone who has too much cash in the bank and wants an alternative. You need a three to five year investment horizon with this fund.”
The £2.4bn Trojan is closed to new investors, though can still be accessed through a select number of platforms. It’s a top decile performer in its sector over the last decade, with returns of 133.88 per cent.
The Personal Asset Trust remains an option, however. It has ongoing charges of 1.01 per cent, and is on a slight premium to NAV.