Investors may be taking too much risk at a time when it would be prudent to consider shifting towards a more defensive stance, according to Schroders’ Marcus Brookes, as the market cycle looks like it is close to turning over.
In his latest update Brookes, head of multi-manager at Schroder Investment Management, was keen to stress that he is not forecasting an imminent market crash and is instead focusing on where we are in the market cycle.
“This should not be mistaken as a forecast of an imminent market decline. It’s just we have always believed that successfully navigating the full market cycle is what matters most in the end, so we reflect upon the current conundrum quite a lot,” he explained.
Performance of indices over 10yrs
Source: FE Analytics
Brookes, who runs the Schroder MM Diversity funds with Robin McDonald, maintained that it is essential for investors to differentiate between the short-run and the full market cycle as different forces are at play in both.
“In the short-run, market returns tend to be influenced most by a combination of investor sentiment, risk preferences and price momentum, all of which are interrelated. Over the course of a full market cycle however, valuations are ultimately what matter,” he said.
“In the short-run, investors are often penalised for following the familiar approach of buying low and selling high. Yet a full market cycle tends to be enormously forgiving to investors who decide to reduce their risk when markets are at or close to their high point. This is true even if investors do this a little bit too early, and miss out on the final stages of upside.”
Brookes illustrated the importance of avoiding market pull backs by noting that a five-year return profile of 10 per cent, 10 per cent, 5 per cent, 5 per cent and 0 per cent beats the cumulative returns of 20 per cent, 20 per cent, 10 per cent, 10 per cent and a loss of 25 per cent.
“Investors always face the question of what to emphasise in their portfolios – capital growth or capital preservation. You can’t do both,” he said.
“The mathematics of compounding dictates that large losses have a disproportionate effect when it comes to amassing returns. Therefore, from a full-cycle perspective, avoiding them is critical.
“The purpose of our comparison between the two return profiles above is not to advocate permanently taking a defensive stance. Far from it. The point is more that the avoidance of losses is generally worth pre-positioning for.”
Brookes highlighted four trends that have been in play for a long time but he thinks will not be able to continue forever: the outperformance of US equities; the relentless decline in bond yields; the bull market in the dollar; and, the relative bear market of active management, particularly with a value bias.
The average US equity bull market in the post-war period has lasted approximately 64 months and generated a gain of 163 per cent. However, within around 15 months of the market’s peak, more than half of this gain has been lost to a bear market.
To now, the current market cycle has lasted 98 months and led to a return of around 300 per cent, making it 50 per cent longer and almost twice as profitable as the typical US equity bull market.
“Now, we have no special insight into when the bull market in equities will end or indeed what will eventually trigger its demise,” the multi-manager said.
Performance of indices in 2017
Source: FE Analytics
“Recognising this limitation, in the later stages of a cycle our approach has always been to gradually shift emphasis from capital growth to capital preservation over a period of time as market risks build - the objective being to carry less risk as the market hits its peak, than we do as the market hits its bottom.
“This transition phase (which is gradually underway) is invariably frustrating and requires discipline and patience, as while momentum pushes prices higher in the short term it feels as though almost every single thing you do is wrong. From a full-cycle perspective though, it’s perfectly rational, even if it does risk sacrificing some short-term relative performance.”
According to Brookes, the “avalanche” of money that has been pouring into passive investment strategies in recent times suggests that many investors are, consciously or not, behaving with a higher degree of risk than normal.
However, US equities have started to underperform international markets over 2017 so far. Brookes argued that, from a value perspective, this “makes sense” and he suggests that it could be just the start of a multi-year trend.
“Outside of a brief episode in late 1929 and the period from February 1997 to August 2001, US equity valuations have never been higher than they are today,” he added. “From a full-cycle perspective they look unattractive and in time could prove far riskier than is presently assumed.”
US equities aren’t the only market Brookes sees as suffering from overpricing.
The US dollar has been in a bull market since 2011 and the Schroders multi-manager team believes this might now be in the process of topping out. Meanwhile, bonds have enjoyed a bull market since 1981 – leading to, as Brookes said, “valuation levels today that are hard to comprehend”.
“Many of the trends we’ve briefly discussed in this note have been going on for a long time. As such, investors get used to them and become almost resigned to their persistence,” he said.
“We believe this is exactly the time when being active, patient and disciplined could add most value from a full-cycle perspective. We remain alert to profiting from the opportunities that may present themselves as these trends begin to tire.”
Performance of fund vs sector under Brookes and McDonald
Source: FE Analytics
Since taking over the Schroder MM Diversity fund in October 2007, Brookes and McDonald have made a 54.02 per cent total return and outperformed their average peer in the IA Mixed Investment 20-60% Shares sector in the process.
The fund has maintained a cautious stance for some time, leading to fourth-quartile returns over more recent time frames. That said, it has the sector’s lowest annualised volatility over the managers’ tenure and is in the top quartile for maximum drawdown.
The £865.7m portfolio currency has 24.3 per cent in cash, with its top holdings being funds such as JP Morgan Income Opportunity Plus, Majedie Tortoise, GAM Global Diversified, Morgan Stanley Diversified Alpha Plus and GLG Japan Core Alpha.
In a coming article, we will look at four capital preservation strategies currently being used by Brookes.