The outlook for expensive bond proxies is looking increasingly perilous, according to James Clunie, manager of the Jupiter Absolute Return fund, who is shorting so called ‘expensive defensives’ as well growth stocks in the US within his portfolio. 
Shorting (or short selling) is when an investor or manager sells a security they do not own to buy it back at a (hopefully) lower price.
While quality growth stocks have been massively benefitted from the recent market dynamics of central bank intervention, low inflation, lack of economic growth and a general sense of investor nervousness, Clunie says many of these companies are now too overvalued.
Performance of indices over 7yrs
Source: FE Analytics
In the UK, Clunie (pictured) is short on a number of quality stocks – defensive holdings – like consumer goods companies which have been bought up by ‘tourist’ fixed income investors who have been forced out of the bond market by central banks.
“What we are finding is that quality stocks are so heavily valued that it’s probably a long-term mistake to buy them,” he said.
We think it’s a collective mistake from investors right now – we think we understand why it’s happening but actually the right thing to do long term is to short it. So we are net short of quality stocks right now and it feels awful and we’re long on this ugly stuff long on miners and oil.”
He says many of the stocks – known as bond proxies – are being used by investors to find income, with many priced off the back of the extremely low bond yields.
“But if there’s any kind of change in the bond market these guys are in dire trouble could lose 20-30 per cent quickly even in quality firms. We call them ‘good firms, bad stocks’.”
There are many who agree with this view as well, with numerous industry commentators arguing in recent weeks that more economically sensitive value plays will outperform overvalued quality growth companies from now on as bond yields inevitably rise.
It is because of this dynamic, among others, that Clunie believes being able to short companies will give investors the edge over the medium term.
“If you’re an active manager you have to try to develop and maintain some sort of edge some kind of reason why you might win in markets, why you might beat an index fund after fees and that means you have to have some kind of process or ability that beats the others,” Clunie said.
“I’ve focused for about 20 years on one specific area – single stock shorting. We are identifying what we think are overpriced assets, waiting for the right time to short it and then shorting it.”
Shorting is (by definition) a preferred method for managers when markets are falling, but since the financial crisis in 2008, the market has been on a bull run and policies from central banks such as quantitative easing and ultra-low interests have meant nearly all areas of the equity market have performed well to a certain extent.
Performance of indices post-financial crisis
Source: FE Analytics
As the graph shows, the main market in the UK and US (the two markets Clunie focuses on) have risen steadily over the last seven years, with the US performing particularly well of late.
Indeed, since Clunie took over the Jupiter Absolute Return fund three years ago, the S&P 500 has risen 61.23 per cent while the FTSE 100 has climbed at a steadier 21.39 per cent.
“For the three years since we started we have made absolute profit short selling stocks despite the fact that it’s a bull market and if we can do that in a bull market I think it all bodes well for a bear market,” Clunie said.
Performance equities and bonds in 2016
Source: FE Analytics
The £478m fund has returned nine per cent so far this year, and while this is below equities and bonds, this is to be expected due to the nature of the fund – to make a return in any market condition.
“We’ve added value through our edge during the toughest of times for short sellers and there aren’t that many people who short-sell left standing.”
While he has made a profit from short selling, he says it also has the added benefit of providing a hedge against unexpected events, such as the Brexit vote.
“If you’re a single stock short seller it naturally adds robustness to your portfolio because it can reduce your overall market exposure to factors quite easily,” he said.
“And when asset prices are high as now you would expect future returns to be lower than we’ve experienced, so it’s actually quite a useful time to have a robust portfolio.”
Clunie has around 60 longs in his portfolio and 110 shorts, building the fund to a net 15 per cent short position.
Outside of the UK, he is major shorts are in the US, where valuations have jumped so far this year on positive earnings and the Federal Reserve’s unwillingness to raise interest rates.
“If you look at our shorts, stocks like Netflix and Tesla these are stocks that there are reasons for them to go down,” Clunie said.
“They are overpriced on our fundamental analysis, they have falling earnings they have fragile balance sheets a couple of them are loss-making meaning issuance is coming.”
This strategy has proven successful this year, with Tesla falling 15.5 per cent over the course of 2016, while Netflix has dropped 12.5 per cent.
On the other hand, he is long the under loved sectors of the market including oil and miners. He says the two previously unloved companies are due for a recovery as many are on low price to earnings multiples.
Performance of stocks in 2016
Source: FE Analytics
Within this, Clunie says he is positive on BP, which has fallen to levels where investors “are saying that it will never find a good project again”.
The company is in the fund’s top ten holdings (2.8 per cent) and Clunie has more than six per cent of his fund in the oil & gas sector, the third most within his portfolio.
Of the miners, Rio Tinto he says has a good balance sheet, while newly created South32, which was spun out of mining giant BHP Billiton last year, has performed exceptionally well this year, gaining an impressive 128 per cent so far this year.
