Following a nearly comatose 2017, 2018 has witnessed a resurgence of volatility for risk assets. So, how do we decide when to cut, and when to stay in?
Ideally, long-term investors should seek to stay invested through the bumps– the “noise” – but to sit out of equities during painful sell-offs, for example the Dot Com bust. Those are of course more than worth avoiding.
Our view is not based on ”noise”. History shows making knee-jerk reactions due to short-term noise is a poor strategy. We are long-term, well-diversified investors, and have no intention of making any sudden, emotional moves in reaction to short, sharp drawdowns: they are almost always wrong.
On the contrary, we rely on a process. At its simplest, when an asset is unloved, and cheap, we look kindly upon it. History shows the best returns are to be harvested from undervalued and unloved positions, particularly as momentum starts to trend upwards.
The opposite is equally true: even quality assets can be bid to the point where they offer poor prospective returns, often a precursor to momentum turning. Ironically, at these times, many investors are too complacent, oblivious to the actual levels of risk. Of course, none of this happens in a vacuum: the economic scenario is of critical importance, and we dispassionately gauge if the stage of the business cycle is fruitful for risk taking.
At present, the global macroeconomic environment remains supportive of risk assets and is bolstering corporate profits. This is particularly true for the US, where corporate earnings should grow by over 20 per cent in 2018 due to a confluence of positive factors, including highly stimulative fiscal policy (for example lower taxes slashed taxes) and a slow, predictable pace of rate hikes by the US Federal Reserve which does not threaten risk-assets at present.
Driven by bumper earnings, the price-to-earnings ratio for US equities is significantly cheaper than at the beginning of the year. All other global regions remain cheaper than the US. Admittedly, while momentum is not giving a clear positive trend at present, sentiment remains oversold – a positive signal for us - on a number of measures following October’s spike in volatility.
Therefore, we don’t think October was the canary in a deep drawdown coalmine. Indeed, while this October will have hurt portfolios exposed to equity risk given the sudden, sharp drawdown, we have chosen to use the opportunity to increase our weight to equities taking us from “neutral” to marginally “risk-on”.
Of course, risks to equity markets are ever present, such as escalating global trade wars and possibly tighter-than-expected US monetary policy to name but a few. Nevertheless, we continue to focus on implementing our disciplined investment strategy.
It is deliberately long-term. It aims to eschew the “noise” which inevitably surrounds October-like months, and look to what we consider indelible, longstanding drivers of asset returns: valuation, momentum and sentiment. To the degree that the
fundamentals change, we pay attention.
To the degree the “noise” fills the air, we remain positioned to take advantage of any excessively bearish sentiment.