Sullivan (pictured), who runs the £858m fund of funds with FE Alpha Manager Martin Gray, is concerned by the optimism sweeping through markets and thinks it is likely to make the eventual correction much worse. "The S&P is up 20 per cent in dollar terms this year, while earnings growth is in the single digits," he explained. "Of course, markets and earnings shouldn’t go up in a line together, but it’s very clear that the Fed has fuelled a lot of these gains."
"Consider this: in the second quarter of this year, the proportion of unpleasant earnings surprises versus pleasant surprises was at its highest since 2001. In the third quarter, the proportion of unpleasant surprises was the second highest since 2001, behind the second quarter."
"I think it is perverse that markets keep rallying aggressively while earnings are so moribund. All the signals to me suggest there is going to be a blow-up, which means a significant correction in markets."
Performance of indices over 3yrs
Source: FE Analytics
The MSCI AC World index is up 30.98 per cent in sterling terms over a three-year period, while the S&P 500 has rallied by an even greater amount.
Japan has had a particularly good 2013: our data shows the Nikkei 225 has returned 24.01 per cent in sterling terms over the period.
Inevitably, Sullivan’s view has ensured that CF Miton Special Sits is significantly underweight risk assets. The fund can have up to 100 per cent in equities, but the current weighting is at just 37.7 per cent. It also has a very high cash weighting, at 25.5 per cent.
Bonds and alternative assets such as absolute return, litigation and infrastructure funds make up the rest of its assets.
Sullivan says he and Gray are prepared to increase their risk exposure even if economic growth and corporate earnings growth do not radically improve – but only if markets fall to much lower valuations.
"We don’t need to see a full resolution of macro headwinds to invest – we know that debt will stay high and growth will stay low for a very long time to come; however, with such a bleak outlook we need to be compensated with cheap valuations."
"If you look at the Japanese market, it is still trading on one-times price to book, which is fair given the bleak backdrop. However, we’re not seeing that cheapness across other developed markets."
Sullivan says US equities are by far the most overvalued at the moment, which is why CF Miton Special Sits has just 0.5 per cent invested in the S&P 500.
"In the past, UK investors holding US equities have got that dollar exposure, which has acted as a hedge. However, this will only keep being the case if monetary policy doesn’t completely distort the way currencies behave in relation to each other and markets, which isn’t yet clear," he added.
The manager says the optimism surrounding improving unemployment is flawed because there are close to record levels of part-time workers in the US and UK, with the total pool of employable people falling due to the current generation retiring earlier.
"If the employable rate stayed at the same level in the US as it was five years ago, unemployment would be at 10 per cent," he said.
Even if the economy were to improve at a faster rate than Sullivan expects, he thinks the impact of tighter monetary and fiscal policy on certain companies and households would be too great – a factor he explored in greater detail in a recent FE Trustnet article.
Summing up his frustrations, Sullivan said: "The problem is that markets will stay irrational for a lot longer than we would like, which has been the case before."
Gray (pictured) has been proved right on more than one occasion before when predicting sudden corrections. He became extremely cautious in the lead-up to the dotcom crash in 2000 and the 2008 financial crisis. On both occasions, CF Miton Special Sits underperformed for a substantial period before the markets took a turn for the worse, but in the end his actions proved fully justified.
Performance of fund 1998 to 2010
Source: FE Analytics
Gray has run the fund since 1997, and was joined by Sullivan in 2008.
The fund has endured a tough period recently as a result of Sullivan and Gray’s ultra-cautious stance. It has underperformed its IMA Flexible Investment sector average in three of the last five calendar years, which has seen it slip into the bottom quartile over one, three and five years.
Performance of fund vs sector over 5yrs
Source: FE Analytics
CF Miton Special Sits, which does not have a benchmark, remains in the top quartile of the IMA Flexible Investment sector over a 10-year period though, with returns of 141.61 per cent.
Sullivan says he has been encouraged by the fact that existing holders of the fund have been so patient with the team.
"Like the Trojan fund, we haven’t really had anything in the way of outflows," he said. "This is really good news – it shows that our clients have a good understanding about what we are about and why we’re doing what we’re doing."
On numerous occasions, Sullivan and Gray have stated that capital preservation is the key to their investment process.
CF Miton Special Sits requires a minimum investment of £1,000 and has ongoing charges of 1.86 per cent. Sullivan also co-manages the £237m CF Miton Strategic Portfolio and £13.4m CF Miton Total Return funds with Gray.
