The rally in financial assets will “end in tears” at some stage but there is no reason why equities cannot continue to deliver strong gains over the foreseeable future, according to FE Alpha Manager ‘hall of famer’ Jan Luthman, who urges investors to not make the mistake of hoarding cash in the current environment.
Given that the rally in equities has, except for periods of weakness in 2011 and 2014, been going strong for more than six years as the likes of the US Federal Reserve have pumped huge amounts of liquidity into the financial system and stuck to their emergency monetary policies of ultra-low interest rates, it is understandable that investors have become more and more bearish.
Performance of indices since Jan 2009
Source: FE Analytics
Many, such as Capital Gearing’s Peter Spiller, have warned that equities will deliver paltry returns over the medium to long term as the market has been pumped artificially high by quantitative easing, meaning that it is only natural it begins to fall as the liquidity is removed from the system.
Others have been even more alarmist and one of the most notable examples has been star manager Crispin Odey, who said an economic downturn which will be remembered for a 100 years is on the horizon as, despite central bankers’ best efforts, economic growth is still weak while debt burdens have piled up.
On the face of it, there does seem plenty to be worried about in the current environment – especially as most developed markets have hit their record highs over the past 12 months or so.
The possibility of a ‘Grexit’ is the most pressing of those, but there is also the issues surrounding a potential interest rate rise in the US as well as the murky outlook for the Chinese economy given its unsustainably high levels of growth.
Luthman, who co-manages the Liontrust Macro Equity Income and Liontrust Macro UK Growth funds with fellow FE Alpha Manager ‘hall of famer’ Stephen Bailey, understands why there have been the swathes of bearish opinions flooding through the press so far in 2015 – but he sees no reason why equities will crash dramatically anytime soon. 
“The overall message is that we are positive on equities,” Luthman (pictured) said.
“At some stage, it will all end in tears but because of the liquidity from central banks the bull market could run for some time and hit some quite significant heights. If you want to be gloomy you could well see a 1987 or even a 1929 happening again as though things are different this time, the main driver – human greed – is still there.”
“However, at the end of the day there is a lot of liquidity out there and it is looking for a home. Even Greece, yes it could be apocalyptic, but it could fuel the bubble even more as it could prompt further QE from the ECB.”
“The main point is, where else do you go? I don’t think investors are ignoring the dangers of the world but they are just being swept along by a tidal wave of liquidity. The blunt answer is, there ain’t any other game in town.”
Luthman points out, however, that the unprecedented levels of stimulus from the world’s central banks has created a very strange environment but he urges investors to not try and be too clever by attempting to time the market.
“Clearly, there are major risks of bubbles developing as a result of quantitative easing [QE]. Central banks around the world have been pumping enormous amounts of money into global financial markets and it is still there and is mostly tied up in fixed income,” Luthman said.
“Still, very little has flowed into the real economy. There are signs that it is starting to migrate as major financial institutions, like pension funds that have a duty to preserve capital, are moving money into equities and real estate.”
He added: “Although there is a strong possibility that it will all end in tears, until then (and who knows how long that will be) asset prices will keep inflating as money migrates out of bonds and into equities.”
That’s not to say Luthman doesn’t think there are areas of the market which aren’t at risk in the current market, as he fully agrees with the likes of Martin Walker, Richard Buxton and Henry Dixon that ‘bond proxy’ stocks are in for a period of underperformance.
These bond proxies, which are commonly viewed as large-cap defensive dividend paying companies in sectors like consumer staples and utilities, have been in a sweet spot of the past six years since the financial crisis.
While they offer exposure to equity markets, they have been the go-to asset for ‘tourist’ bond investors who want a reliable income but have been forced out of the fixed interest market by central bankers.
Performance of indices over 5yrs
Source: FE Analytics
In fact, there have been funds within the IA universe such as CF Lindsell Train UK Equity, Fundsmith Equity and to lesser extent Invesco Perpetual High Income which have massively outperformed as a result of this phenomenon.
However, as income has been so en vogue due to ultra-low rates investors have bid up valuations on bond proxies and many experts now warn that there outlook is closely tied to that of the fixed income market – which is expected to fall over the coming years as monetary policy starts to normalise.
As the graph below shows, both consumer staples and utilities were adversely affected by the recent bond market rout.
Performance of indices during bond sell-off
Source: FE Analytics
While Luthman says investors need to avoid those areas of the market, he finds it odd that so many of his peers have warned about general over-valuations in the market.
“I completely agree with the argument surrounding bond proxies, but I’m not sure I agree that the market is universally overvalued,” he said.
“It’s difficult to see how you could say that, as our fund yields over 4 per cent and there is no dodgy stuff in there. If we can attain that sort of yield when interest rates are still so low, I find it difficult say that the market is overvalued.”
Luthman does have his reservations about why the market has been pushed higher over recent years though, as he questions the real impact years of QE have had on the real economy.
“QE doesn’t seem to have found its way to the ordinary man or woman. For most people, the benefits of QE are as yet intangible.”
“It has been regressive, as it is only benefitting people who already have savings and therefore it seems a very unfair recovery. For the time being, that’s why we think it is difficult to see interest rates moving too high.”
Again, this is another reason why he thinks investors are wrong to be overly bearish on equities.
The manager, whose £544m Macro Equity Income fund has been the best performing portfolio in IA UK Equity Income sector since its launch in October 2008 and has beaten its FTSE All Share benchmark in eight out of the last 10 calendar years, says investors need to have a more realistic outlook.
Performance of fund versus sector and index since launch
Source: FE Analytics
Nevertheless, the latest Bank of America Merryll Lynch Fund Manager Survey shows that the large majority of Luthman’s peers have been upping their cash weightings over recent months in preparation of market volatility.
However, not only does Luthman think those who are upping their cash levels are in danger of missing out on potential returns, he warns that cash will be one of the worst places to be over the coming years due to financial distortions and the race between central banks to debase their currencies.
He therefore thinks investors need to be in equities and real assets more than ever.
“I think it is the people who are hoarding cash for safety who will be the worst hit,” he said.
“To me it beggars belief that, despite central banks ‘magicing’ money out of thin air and saying its real, that people think cash is a safe asset. I think the powers that be would be very surprised that neither my wife or I have cash in our pension.”
“They would say ‘at your age you should be all in fixed interest’ – yes, ok, if I want to be impoverished in 10 years’ time. I live in the real world.”