The recent equity market rally has shown signs of tiredness, though many are positioned for a far more painful sell-off in risk assets over the short term. 
The likes of the FTSE 100 had been powering forward following the historic EU referendum in June as sterling weakness and a change in tune from the Bank of England had pushed the index higher – despite the uncertainty created by the vote for Brexit.
While the blue-chip index has still rallied by 8 per cent since 23 June, the graph below shows that returns have been far harder to come by during the usual thinner trading volumes of recent weeks. What’s more telling, however, is that data and anecdotal evidence suggests many investors are preparing for a far more painful period for equity markets.
Performance of indices since EU referendum
Source: FE Analytics
Numerous FE Trustnet articles have highlighted this trend, whether it be that cash weightings have reached three year highs in the UK sectors or that the majority of readers are preparing for a significant correction in the market before 2016 is out.
In truth, it is understandable why this is a general sense of nervousness as the rally seems to have been driven by added liquidity rather than anything else, which macroeconomic risks such as the US presidential election loom on the horizon.
On the other hand, some argue that with bond yields at such low levels, investors have no option other than equities – suggesting the rally can continue for the time being.
Nevertheless, Andy Merricks – head of investments at Skerrits Wealth Management – is one market commentator who is fully expecting a more difficult environment for risk assets over the short to medium term.
“A correction is coming,” Merricks (pictured) said.
“These are not our words, but those of BCA Research who have issued a report with that title. After a tremendous rally in markets across the world since Brexit, and with US equities in particular being virtually priced for perfection, trading at average P/E ratios well above the post-1980s average, it will come as no surprise that a correction of sorts is on the cards.
“If words don’t do it for you, maybe pictures do. The graph below shows very clearly why, if a correction is due, the month of September is the most likely to herald its arrival.”
Average monthly performance of S&P 500 since 1928
Source: BCA Research
He added: “This is all very dramatic and scary stuff, but what does the average investor actually do about it?”
The usual trade when investors are worried about the future direction of equity markets is to ‘de-risk’ their portfolios, but this is one piece of advice Merricks says simply doesn’t work in the current environment.
For example, data released by the Investment Association last week showed that the IA Short Term Money Market sector was the third best-selling peer group in July with inflows of £292m – while equity funds saw outflows of £2.2bn (including close to £1bn worth of redemptions from the IA UK All Companies sector)
The five best-selling Investment sectors in July 2016
Source: FE Analytics
However, Merricks questions whether or not investors can really ‘de-risk’ their portfolios at the moment – even if that means selling equities and hoarding cash as that involves trying to time the market.
“In its basest form, risk off means sitting in cash. Cash is the most commonly used gauge of risk free assets, except of course we all know that if one sits in cash for too long this in itself creates risk in terms of inflation and opportunity,” Merricks said.
“It would be very interesting to find out how many private investors went to cash prior to the referendum in June for fear of exactly the kind of short term sell off that we saw immediately afterwards, yet failed to get back into the markets within the next couple of days to benefit from the massive rally that we have witnessed which has taken a number of indices to near all-time highs.”
“Of course we’ll never hear about it because very few will actually own up in public.”
As the table shows, though, many investors have attempted to ‘de-risk’ their portfolios by upping their exposure to other perceived ‘safe’ asset classes such as fixed income and absolute return.
However, due the recent dynamics within markets (a continuation of extra-loose monetary policy from central bankers) Merricks says investors will not find a genuine safe haven for some time to come.
“What is low risk anyway? Gilts have delivered equity-style returns in both the last three months and two years, which is behaviour inequitable with a low risk asset.”
According to FE Analytics, 10 year gilt yields have fallen by some 55 per cent to 0.7 per cent since the EU referendum as investors embarked on a ‘flight to safety’ and the Bank of England slashed interest rates to 0.25 per cent and initiated a new quantitative easing programme.
It means that the FTSE Actuaries UK Conventional Gilts All Stocks index has rallied 17 per cent over 2016 so far. The index has also had a correlation of 0.7 to the FTSE 100 over that time, which is far higher than its longer term average
Performance of index in 2016
Source: FE Analytics
Merricks continued: “We’ve seen suspensions in property funds and the gold price has gyrated, and a high number of so called absolute return funds were seen to be absolute rubbish in offering protection from falling markets earlier in the year.”
“Yes, a good manager will include diversification within a portfolio to try to protect it, but when all’s said and done, if you can’t stomach the ups and downs of the roller coaster, it’s best to stay away from the theme park in the first place.”
As such, Merricks advice to investors who are concerned about the potential for a correction in equity markets (providing they hold a diverse portfolio of lowly correlated assets) is to sit tight and do nothing.
Indeed, by reacting to short-term trends, Merricks says investors can inadvertently damage their potential for longer term returns.
“If you are a private investor, or indeed a discretionary portfolio manager or fund manager, there is not much that you can really do to dodge a short term correction other than brace yourself as if you’re in a dodgem, knowing that the imminent impact is coming, but being prepared to pay again for the thrill of the overall ride and experience that is the bumper cars.”
“No gains are made in a straight line, and increasingly in recent years as volatility has spiked, much of the annual gain (if there is one) has been concentrated into just a few trading days in the year.”
“If, as we expect, a correction is due, one has to think that once the US election is out of the way in November, we could see a “Brexit-type” rally as a major source of uncertainty is removed from the equation. Whether we like the answer to the equation is another matter entirely.”
