Although the strength of returns has caught many investors out, the small number of negative days have broadly been seen as opportunities to buy – or to put it another way, to capitulate on longer-held asset-allocation positions. After many years of bond markets having all the headlines, we may now be seeing the beginning of a period when equities are once again "cool".
Bond yields have risen, even if only a little and from extreme lows. The Dow Jones has pushed through to an all-time high. The Topix in Japan has hit a 52-month high.
It can’t be just me looking on with a somewhat jaundiced eye. Volumes have been especially low, though that is not the only issue leading to questions on the conviction behind current market moves.
Performance of index since Nov 2008
Source: FE Analytics
Don’t get me wrong, it has been good to be an investor in equities since the trough of the market in 2008, with the MSCI World index rising by almost 100 per cent in those five years.
The fall in 2011 feels like a long time ago, volatility remains subdued, and there is a feeling of a one-way bet forming in market behaviour.
But we have seen this before – 1995 and 2007 both looked a little like now. In 1995, the five-year recovery in equity prices from the lows posted in 1990 was also impressive, as was the recovery in to 2007 from the lows touched in 2002.
However, you don’t need to be a scholar of the market to know the outcome of these two periods was slightly different.
Performance of index over 20yrs
Source: FE Analytics
So where are we, 1995 or 2007? Or indeed is it – perhaps preferably – neither.
The next leg for equity markets remains frustratingly difficult to forecast.
Are we at the beginning of a multi-year bull run based to a degree on the largess of the world’s central banks and their ultra-loose economic policy, or is now the time to strap in for a very bumpy ride?
One thing is certain, which is that the impact of macro news continues to be highly price-sensitive.
The influence of fundamental data on individual stocks, while in no way negligible, can be drowned out by these occurrences.
The disruption caused by the Italian election results, and more recently the Cypriot banking crisis, has been a salutary reminder of the type of market we remain in.
Correlations between regional markets remain high, with opportunities for diversification within global equity funds little more than illusory. The hunt for uncorrelated returns isn’t getting any easier, but that doesn’t mean we should give it up.
Correlation of indices with MSCI World
| Index | 3yr correlation | 5yr correlation |
|---|---|---|
| S&P 500 | 0.94 | 0.96 |
| FTSE 100 | 0.91 | 0.92 |
| DJ Euro Stoxx | 0.85 | 0.92 |
| Topix | 0.53 | 0.74 |
| MSCI EM | 0.78 | 0.86 |
Source: FE Analytics
No-one wants to win the "least ugly" contest, but that may be where we are with equities, in that they are benefiting from being somewhat more interesting than other investment opportunities.
Many sovereign bonds currently trade on a duration that gives a feeling of bond returns with equity risk, which is not a good situation to be in.
The dividend yield on European equities recently passed above the corporate bond yield, suggesting equities are cheap on a relative basis.
Stripping back equity market returns to their most simplistic assumptions can be quite informative. As we all know, equity prices are driven by a price/earnings [P/E] multiple and earnings per share assumptions.
P/E multiples for global equities, at 12.5x, currently stand at levels in line with the average over the last five years.
On a 20-year view, they currently trade slightly below the 14.5x average, even when removing the insanity around 2000. There remains room for further multiple expansion, although arguably not a lot.
Earnings, on the other hand, have had a very good run. Margins remain high relative to historic norms, in no small part due to the lack of pricing power held by labour in the current economic cycle.
Looking at the US market, aggregate earnings per share have doubled since the cyclical low posted in 2008.
This does add up to at least a measure of uncertainty as to the likely continued expansion of earnings without a commensurate increase in revenues.
The risks outlined above are essentially Beta risks. These are good risks when the market is rising, as it has been.
But this is an age of astonishment, an age in which completely unpredictable events in obscure places can ambush the mightiest, most liquid equity markets: New York, London, Frankfurt, Tokyo.
As an example, the political intricacies of deposit insurance in Cyprus can wag the entire dog of global equity markets.
In such an age, fundamentals are contingent and trends are unreliable indicators. The solution – one solution – is to cover Beta risks with Alpha risks, either through absolute return or market neutral, or both.
Ian Heslop runs the Old Mutual Asia Pacific fund. The views expressed here are his own.
FE Trustnet will look at funds with a low correlation to their peer group and the wider market, in a series of articles later this week.