Investing when the markets are dysfunctional

It is no surprise that both investors and advisers are confused in what has become a dysfunctional economic and investment environment, according to Dominic McCormick.

The current investment environment is arguably the most challenging in the 27-year period I have been involved in the finance and investment industry.

This may surprise some.

After all, there have been times when market returns have been worse (1987 through to the early 1990s and more recently, 2007 through to early 2009), when market volatility has been more extreme (again, think 1987 or 2008) or when failures of investment products were more numerous (think early 1990s or again during and post 2007 to 2008). 

However, what is making things so challenging now is the extreme level of uncertainty and lack of conviction as to how investment portfolios should be positioned, especially with many frustrated investors taking an increasingly short-term view.

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Associated with this level of uncertainty and lack of conviction is an enormous degree of distrust and scepticism - of markets, investment products, the financial services industry, regulators and governments.

In many respects, the economic and investment world has become increasingly dysfunctional and traditional concepts of risk and return have become distorted.

At a recent conference a very well known academic highlighted this with the statement “I have no idea what a risk free asset is anymore”. 

It’s no surprise then, that the average retail investor (or adviser) is confused, and many are giving up on investing in many assets altogether, and instead, simply investing in cash/term deposits or paying off debt.

Why has this occurred and how should investors and advisers be responding? 

As discussed above, a key driver of the dysfunctional behaviour and mispricing of investments is uncertainty over the near-term investment outlook.

Very divergent views are prominently promoted in the media.

Some are suggesting that financial Armageddon is imminent and cash and bonds (or gold) are the only safe places to hide, while others suggest that sharemarkets are as cheap as they have been in decades and should be heavily weighted in portfolios.

Indeed, I can’t remember a time when professional fund managers themselves had such divergent views. Some prominent equity managers are nervously cashing up large proportions of their portfolios, while some others are salivating at the attractive value on offer in many markets.

This divergence is interesting, because while discerning the investment outlook is never easy, especially in the short-term, it is currently possible to clearly identify over and undervalued assets from a long-term perspective.

For example, the best nominal returns one can generally expect from government bonds in the long-term is their current 1-3 per cent per annum starting yields, while it is easy to build a case that supports various equity markets returning multiples of this in the long-term.

Further, one can be reasonably clear about some of the major themes likely to impact markets over that long-term time frame (eg, deleveraging of the developed world, growing wealth of the developing world, aging demographics, etc).

Thus, while the near-term outlook for markets is arguably as unpredictable as it has ever been, what makes sense from a longer term perspective is somewhat clearer. 

However, this greater long-term clarity (which suggests substantial weightings in global equities) is at odds with how frustrated investors are allocating capital in their portfolios, as they react to recent poor risk asset returns, deeply worried about the near-term outlook leading to large allocations to bonds, term deposits and cash.

Clearly, there is an accentuated focus on the short-term outlook, because of the major macro-economic concerns over Europe, China and the US, and the alternating ‘risk on, risk off’ environment that is giving investors plenty to lose sleep over.

Correlations across asset classes and strategies have increased markedly, decreasing the benefits – and increasing the scepticism – of portfolio diversification.

In this environment it has been difficult for even some of the best stockpickers to generate good returns, at least in the short-term.

Fundamentals are often being ignored, and portfolio ideas that may prove rewarding and/or risk-reducing over the next 3, 5 or 10 years may look quite wrong over shorter time frames. 

A range of other factors are contributing to this challenging and dysfunctional environment.

Global deleveraging is weighing on global economic/earnings growth and investors’ risk appetite, with any substantial market rallies widely seen as another chance to reduce exposure to growth assets.

Deleveraging is also leading to an environment of “financial repression” – where central banks are pushing interest rates lower across the yield curve and making commitments to keep them low for extended periods.

This is part of a greater degree of central bank and government intervention in markets more generally. For example, central banks (most notably in Switzerland and Japan) have become directly or indirectly active in currency intervention - with recent calls for Australia to join this club.

Further, the utterings of politicians, particularly in Europe, have become big drivers of day-to-day moves in global markets.

Indeed, there is a strong view that fiscally constrained governments will gradually become more anti-business as time goes on.

At the micro market level, controversy over high frequency trading has led to some valid questions from both professional and retail investors about the integrity of markets. 

It is not just retail investors.

Louis Bacon, head of global macro manager Moore Capital, recently returned a significant part of his funds under management to investors, citing the challenging “risk on/risk off environment” and “a caustic political environment and an anti-business administration” in the US. 

So how should investors respond to this challenging environment, particularly when many ‘safe haven’ assets that have benefited from central bank intervention and general risk aversion, producing good returns recently, are now priced such that they offer very poor prospective returns and may well have become higher risk investments?

Note that this is not just about fixed interest – the current move towards ‘defensive equities’ may well go too far - although they are likely to be supported while interest rates remain very low. 

In fact, many ‘low risk’ portfolios that have performed well in recent times could be poorly placed for the environment we may go through in coming years.

At the very least, investors should not be looking to the recent performance of their (or other) portfolios as a measure of their riskiness or their future appropriateness in the medium to long-term.

Investors need to be able to look through the current short-term noise buffeting portfolios and take a truly long-term view, which may require largely ignoring historical or current volatility as a measure of risk. 

The environment of recent years has helped to highlight the flaws of modern portfolio theory and strategic asset allocation (SAA) and encouraged the need to make portfolios more flexible and more diversified.

But this debate has yielded little in the way of specific guidelines to help build portfolios in the current environment. Indeed one of the major ‘outcomes’ of this debate - that most investors need more bonds and fewer equities - seems deeply misguided, given current valuations. 

Clearly, more dynamic asset allocation is appropriate in this environment because extended range trading is likely and extreme swings in sentiment will create opportunities and changing risks that need to be managed. 

Another focus should be on quality and sustainable income, because yield will be a bigger part of total return in a financially repressed environment – although, as noted above, I suspect this trend will eventually go too far.

It is probably also sensible – particularly at current valuation levels – to increase the skew of portfolios towards developing economies (or companies deriving significant revenue from them), given they have far lower debt levels, and therefore less of a need to deleverage, that will be more supportive of their growth assets.

Another focus should be some exposure to inflation protected/hard assets because the ultimate outcome of expansionary monetary and fiscal policies is likely to be inflationary, although this might not appear as a likely scenario right now.

Finally, one should consider a range of truly diversifying alternative investments – managed futures, volatility funds, gold, etc – even if their benefits are not always obvious in the short-term. 

The biggest risk is that investors give up on a sensibly diversified portfolio of assets, strategies and managers that are well placed for the medium to longer term but who may in some cases be performing poorly in the short-term.

That risk is much greater if the assets they move towards are the very ones that have performed well recently, yet whose outlook to a rational investor is very questionable (ie, bonds and cash). 

Convincing investors to stay the course in sensibly diversified portfolios with a bias towards attractively valued assets – rather than some backward looking SAA – is probably as hard as it ever has been.

Term deposits seem like an attractive option and for a proportion of many portfolios, they are.

However, giving up and going entirely to cash/term deposits may provide some near-term comfort, but it is a recipe for disappointment for long-term investors.

Communicating this in simple ways is the challenge.

This is not the time to give up on basic investment principles and good investment practice – value driven investing, contrarian approaches and a medium to long-term focus.

The near-term path of global economies and markets is highly uncertain, but there are some attractive longer term investment opportunities where a reasonable margin of safety currently exists.

The old ‘time in the market, not timing’ argument is flawed on many levels, but with some extreme valuation anomalies present in today’s markets, being willing to stay exposed to attractively valued investments should prove rewarding in the long-term.

Dominic McCormick is the chief investment officer of Select Asset Management.