Investors should look to add a value position as a hedge for their portfolios because market returns from here could either be extremely positive or worryingly negative if history is anything to go by, according to Schroders fund manager Kevin Murphy. 
The FE Alpha Manager, who runs the Schroder Recovery fund alongside fellow FE Alpha Manager Nick Kirrage, said that valuations make now a difficult market to predict.
The FTSE 100 has been on a strong run since the financial crisis of 2008, early this month hitting a new closing high of 7,562.28 – eclipsing the previous record during the 2000 tech bubble.
“The question is are we due for another decade of lost returns or should we party like its 1999?” Murphy (pictured) said.
“Chartists would say that we have broken through support levels and there are no resistance levels in sight and therefore it is blue sky and bullish.
“Historians would say that we reached 7,000 in 1999 and had a bad outcome from there, we reached 7,000 in 2007 and had a bad outlook, and now we are through 7,000 so the outlook is very bearish indeed.”
Source: Schroders
However, as the above chart shows, not all bear markets are made equal. While the price of the market is the same, the profits that the market generates have risen over the years.
As such, investors that paid 7,000 in 1999 bought a market that was trading on 28.5x its cyclically adjusted price-to-earnings (CAPE).
“If we roll forward seven years, we had seven years of inflation, corporate growth, profit growth and the market valuation was different – the headline reading was the same but rather than being 28.5x we are now at 21.1x,” the manager said.
“Roll forwards another 10 years and whilst the market is higher the valuation is significantly lower (16.3x) because we have had profit growth.”
Murphy added that managers should have been wary of the valuation in 1999 as the average CAPE of 28.5x was more than double the market average of 11.4x.
Instead, investors at the time believed that it was only an average, that it didn’t take into account the rise of technology, and that this should lead to a positive outcome rather than an average outcome.
Below, Murphy has charted the returns over the subsequent decade in each year that the market has traded between 28x and 30x CAPE on a per annum basis.
Historic returns in the decade after market CAPE of 28-30x
Source: Schroders
“The green line is the best ever return from a starting point of 28x and you can see over one year you might have made a bit of money but as you continue to hold the market the returns you get over two and three years are negative,” the manager noted.
“Over seven years if you had waited and held on you would have made a little bit of money, but over 10 years your best possible historic outcome was zero.”
This, he said, is why the period after a strong bull run is known as the ‘decade of lost returns’ with the risk-reward balance poor for investors.
While the short term provided some positive performance, over the longer term returns were much more muted.
“Over the short term valuation isn’t a very good guide. It is a bit like a tennis match between Tim Henman and Roger Federer. You don’t know who is going to win the next point but you have a pretty good idea of who’s going to win the match,” Murphy said.
“That is the same as value investing. You don’t know what’s going to happen over the next quarter or the next year but if you are patient and long term and think about the markets over five years plus the outcome becomes much clearer.”
In the 10-year period following the tech bubble of 2000, returns were average to start with but quickly moved to the worst possible outcome and finished with minimal returns.
This is because the market was 34 per cent weighted to sectors like technology, media and telecoms, which were trading on CAPE multiples of more than 35x and performed very poorly during the period.
Looking to today, the market is valued at more than 7,000 but the CAPE is 16.3x – more than the average 11.4x but far below the highs of 2000 and the level of 2008.
The UK market has traded between 16x and 17x CAPE 54 times over the last 90 years and out of that the best possible outcome was a 40 per cent gain over the next year with a 12 per cent per annum return over the next decade.
Historic returns in the decade after market CAPE of 16-17x
Source: Schroders
“The worst however is pretty bad: the worst over one year is -44 per cent and that narrows the range again until it finishes at -3 per cent,” Murphy said.
Meanwhile, the average market return is about 5 per cent per annum for investors holding the market for between three and 10 years.
“That 5 per cent per annum is better than the bears would fear, not as good as the bulls would hope but is in the ballpark of a reasonable return and significantly better than other asset classes which are trading at higher valuation levels,” the manager noted.
However, those investors looking to mitigate the potential for the worst possible outcomes should consider value strategies as a hedge to the market, he added.
“Back in 2006, in the UK equity income sector, 40 per cent of funds had a value bias and 60 per cent had a growth bias,” Murphy said.
“Strategists are dining out on the underperformance of value and that has had the outcome that you would expect – because the strategy has underperformed money has left the sector and fund managers have changed what they do.
“Value managers have had style drift. That 40 per cent has become 14 per cent and when you run the same analysis in Europe only 5 per cent have a value bias and when you do it on a global basis only 11 per cent of managers have a value bias.”
However, he said this is extremely good news for value managers such as himself when things normalise – though he makes no attempt to forecast this.
“’When’ is something we can’t help you with but as and when markets return to a more normal pattern, that money is going to rotate into valuation-based strategies and the outperformance should be very significant indeed,” he said.
“We would suggest having an exposure to valuation-based strategies as a hedge is sensible.”