The recent market falls, a lack of corporate spend due to falling cashflows and deteriorating balance sheets show the equity market is “running out of fuel”, according to FE Alpha Manager Sebastian Lyon, who says he will maintain a defensive portfolio to protect against a further slide in global indices. 
It cannot have escaped investors that 2016 has so far proved to be a tumultuous year for investors, with oil price and China-induced volatility weighing heavily on broader market sentiment.
While the likes of the FTSE All Share are only down 4.5 per cent in total return terms year to date, there have been instances when oil price declines, geo-political tensions and woes out of China have caused indices to post double-digit losses in 2016.
This has now been a relatively longer term trend, as those headwinds have caused the MSCI AC World index to fall 11 per cent (in price terms) since April last year. Its maximum drawdown, which calculates the most an investor would have lost if they had bought and sold at the worst possible times, is 15 per cent over that time.
Price performance of index since April 2015
Source: FE Analytics
Though this deteriorating sentiment towards risk assets has been attributed to macroeconomic headwinds, Lyon – who manages the £2.6bn Troy Trojan fund – says these mask the fact that some of the excesses of the recent bull market are now coming home to roost.
As such, he is maintaining his fund’s highly defensive positioning.
“The remarkable period of high return/low volatility ended in the middle of last year. Cash is precious once more and stock markets are running out of fuel,” Lyon (pictured) said.
Lyon has been one of the most notable sceptics of the rally in equities that began during the depths of the global financial crisis.
Though it has come at the expense of potential gains, the manager has a long-held belief that share prices have not reflected fundamentals as markets have been propped up by extraordinary monetary policies such as quantitative easing and ultra-low interest rates from the world’s central banks.
While Trojan has underperformed relative to the FTSE All Share by some 60 percentage points since the index bottomed after the crash in March 2009, it has come into its own of late.
FE data shows the fund has posted a 5 per cent return over 12 months compared to 9 per cent fall from the index. That includes a 2.97 per cent gain – the highest in the IA Flexible sector – in 2016. In fact, only 3.5 per cent of the 142-strong peer group have posted a positive return year to date.
Performance of fund versus sector and index over 1yr
Source: FE Analytics
Looking at the portfolio, and it is relatively easy to explain why Lyon’s fund has performed so well over the past two months or so.
The manager only has 41 per cent in equities but 24 per cent in index-linked bonds (which have benefited during the recent flight to safety thanks to their longer duration characteristics), 24 per cent in cash (which has dampened down volatility) and 11 per cent in gold bullion and gold miners (which have seen their prices rocket year to date as investors have begun to lose faith in central bankers).
However, though valuations have fallen, Lyon believes the situation for equities is only going to worsen from here.
“Corporate buybacks have been a major prop for equities as companies have utilised their free cash flow and borrowed more to reward (departing) shareholders. Balance sheets are considerably weaker. According to the Bank of International Settlements, the stock of corporate debt outstanding has risen by $4tn since 2009 to $11tn.”
“Evidence is emerging that many companies no longer have the cashflow to support their languishing share prices and are having to save, not spend.”
He uses the example of Exxon Mobil, which (according to Reuters) has spent more than any other company – $210bn – on buying back its own shares
“This month [Exxon Mobil] effectively suspended its buyback programme for the first time in 15 years (excluding buying back to offset share option dilution),” he said.
“Companies have a habit of buying high, but not buying low as necessity requires the preservation of cash. In the last cycle, share repurchases peaked at an annual rate of $589bn in September 2007, according to CLSA. The September 2015 level of $559bn may prove a high watermark for the current cycle.”
“Notwithstanding the recent falls in markets, we remain defensive as the buyback tide goes out.”
Of course, there are many who completely disagree with Lyon on this.
Numerous managers have told FE Trustnet recently that now is an attractive time to put money into the market as the falls have created significant value opportunities – especially as the China/oil price-induced selling has been well overdone.
These include the likes of FE Alpha Manager James Thomson, who heads up the Rathbone Global Opportunities fund.
“Earnings estimates have come down already, economic and growth estimates have come down already. Any upside to that would be a very positive sign for markets and investors aren’t positioned for it, so I think if anything, there’s the potential for a positive surprise coming through as a result of that,” Thomson said.
He added: “I still stay more on the positive tack, based on how the markets are overwhelmingly positioned.”
However, Lyon – whose fund has topped its sector for total returns, risk-adjusted returns, annualised volatility and has had the lowest maximum drawdown since its launch in May 2001 – says that valuations are by no means cheap enough to act as a catalyst for a strong rebound.
Performance of fund versus sector and index since launch
Source: FE Analytics
In fact, he believes most risk assets are still very over-valued given their – up until recently – prolonged bull run.
“Much of this shift [in markets] has been blamed on the weakening Chinese economy and currency and the (not unrelated) fall in the oil price. But there is more to it than that,” he said.
“The fall in oil has led to tighter monetary conditions for many, pushing the US dollar higher. World trade has collapsed to near 2008 levels and corporate profitability has fallen, which is evident from the pressure on cashflows.”
“Corporate bond yields have been rising, especially in high yield bonds, as financial conditions deteriorate. Valuations eventually matter.”
Lyon therefore thinks there is much more pain to come for equities.
“In his book, Irrational Exuberance, published presciently in 2000, Robert Shiller rang the bell at the market top identifying the ‘new economy’ bubble. Sixteen years later, reason has only returned very slowly.”
“The lesson learned from similar periods in history is that equities can get cheaper quickly, but they get cheap slowly. Professor Shiller would agree.”
