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Market calm masks risk of market correction

30 July 2014

Tom Richards, head of private investment management at Thomas Miller Investment, tells FE Trustnet why investors should be taking profits from the more expensive areas of the market.

By Tom Richards,

Thomas Miller Investment

The effects of loose monetary policy are all around us.

Major developed economies had a deep but relatively short recession and have since established positive, albeit sub-normal, levels of economic growth. Those predicting rampant price rises as a consequence of fiscal spending and ultra loose monetary stimulus have thus far been disappointed with sub-trend, low inflation.

UK headline unemployment peaked at a whisker under 8.5 per cent in late 2011, but has since steadily trended downwards to its present rate of 6.6 per cent. UK corporate balance sheets and earnings are generally fairly healthy; and Britain’s consumers relatively confident.

Of course, spending on today needs to be paid for tomorrow and the other side of the picture is that we should be rightly concerned by total (published) UK public debt to GDP levels of over 90 per cent, which hasn’t yet peaked despite the impact of well-publicised austerity measures.

However, while this level of UK government debt will prove a drag on future growth, at least we can derive some comfort from its relatively long duration compared to the US and Europe which reduces the likelihood of UK sovereign bankruptcy, in the near term at least.

The authorities will be hoping that economic growth becomes self-sustaining to the point that stimulus can be unwound and interest rates rise to more normal levels.

The market on the other hand is a fickle and short-sighted creature and, whilst fixated on the timing of the first interest rate rise; is blithely ignoring the fact that what is really relevant is the speed and trajectory of those rises.

Perhaps the implication of all this is that, given likely slower economic growth and sub-par inflation, we will see interest rates peak much lower in this than in previous cycles.

Steadily declining economic growth and interest rate cycles… Japan, anyone?

Just as interesting is the incredibly low volatility across major equity markets. With Wall Street’s “fear gauge”, the Vix volatility index, lingering around 12 – well below its long run average of about 20 – some are even willing to proclaim the “death of volatility”.

Performance of index over 1yr

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Source: FE Analytics

Markets seem convinced that central banks will keep easy monetary policy in place and support risk assets indefinitely.

This should act as a reminder of the old adage that the best time to buy an umbrella is always before it starts raining.

However, we are amidst a multi-year stock market bull run.

Performance of indices over 5yrs

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Source: FE Analytics

This year’s outperformance of traditionally defensive sectors including utilities and energy suggests investors may be considering parts of the market somewhat frothy; and are seeking protection in traditional equity safe havens with strong dividend streams and non-cyclical business revenues.

This isn’t in itself a danger sign; it is fundamentally healthy when stocks and sectors are able to self-correct their valuations without disturbing the broader bull market.

One nascent issue for equities is that in the main it has been price, not earnings, which has been driving strong returns.

Growth investors are typically less interested in valuations but are attracted to upwards momentum and most mainstream assets have been rising in the last five years. This starts to cause problems as rising correlations between bonds and equities conspire to make well-diversified, “safe” portfolios riskier than they first appear.

Diversification is like insurance; we don’t need it until we need it.

Ongoing bull markets herd investment managers towards engaging in a performance race that then speeds us too quickly into the next corner in the road. Ersatz diversification enables better headline returns in the good times but allows a gradual underlying creep up the risk spectrum.

Perhaps it is not a bad current strategy to be actively trimming profits to reinvest into lagging areas of the market; and even retaining a little dry powder for use if markets correct, as they surely will.

FE Trustnet interviewed a host of experts earlier today who are also expecting poorer performance from risk assets in the coming months.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.