Peace of mind, despite challenging market conditions
RECORD-LOW interest rates continue to inflate the price of global equity assets. The JSE All-Share index breached 54,000 last week despite many asset managers claiming that the market is expensive. Should investors be concerned?
Equity investors pay a price today for an uncertain stream of future earnings. These earnings are worth more today if investors discount them at a lower discount rate.
Because interest rates globally are close to all-time lows, investors are placing a very high present value on these future earnings.
Many asset managers are saying that if you use a normal interest rate (rather than the current low interest rate) then the future earnings of stocks don’t look so good today, and the market consequently is paying an unjustifiably high price for these earnings.
That doesn’t necessarily mean investors should be worried. Investors that think interest rates will stay low forever don’t need to discount future earnings at a higher discount rate. For them, the new normal is the low rate.
Unfortunately, theories that justify high prices by claiming this time things are different tend to be wishful thinking strategies rather than investment ideas based on solid evidence, says David Crosoer, Executive: Research & Investments at PPS Investments.
Nevertheless, managers that have accepted that low interest rates are here to stay are generating strong performance by buying momentum stocks and listed property counters.
“At PPS Investments, we would be underexposed to these sorts of strategies,” says Crosoer. “The managers we chose to invest with, in contrast, all have a value or valuation bias to how they think about equities, and we’d be very nervous if their investment case required abnormally low interest rates to make sense.
“The biggest risk investors could take on now is to buy expensive shares thinking they will be able to time their exit. The kind of investor we’d worry about the most is the one who thinks interest rates will go up, but he can still get out in time.
“The appropriate strategy, we believe, is firstly not to take on too extreme a position in expensive shares, and secondly to lower one’s future return expectation given the current valuation starting point.”
How does one build a ‘sleep easy at night’ portfolio rather than an extreme portfolio, and have peace of mind? “We try to reduce investor worry by combining more than one manager in an investment portfolio. This strategy is aimed to reduce extreme positions a portfolio might take.
“So, example, single manager portfolios in this environment have often ended up holding lots of platinum and other resource shares because it’s very difficult to see value elsewhere.
“Our multi-managed portfolios would be more diversified, because we deliberately combine managers who think differently, so not all our managers would end up holding these counters.”
That’s only half the story. In this frothy environment, investors also need to scale back their return expectations.
This too has been said for many years now while the market steams ahead, says Crosoer, but given they’re expensive and continuing to rise on the back of artificial stimulus, the risks are significantly rising.
“Returns over the past five years have been higher than the historical average and this means we’re effectively borrowing those returns from the future – so it’s impossible they remain so high.
“We encourage investors to have a sober discussion with their financial adviser and if necessary, look at increasing their savings so as to make up any shortfall in their retirement or financial planning to cover likely reduced earnings in future.
“We understand this is a difficult conversation as we’ve been saying it for some time and markets have powered ahead. But investors need to diversify the risk that returns will be insufficient to meet their needs.
“Better forsake some consumption now for capital later, than find out later you don’t have enough capital.
The catalyst for a correction in markets, says Crosoer, may well be a move by the US Federal Reserve to finally start hiking rates, and Fed governor Janet Yellen recently made an ominous statement that markets looked frothy.
The world can’t really stomach higher interest rates at the moment, but that doesn’t mean they’re not going to happen.
He admits to the danger of going too underweight equities in a market that simply powers ahead indefinitely: the more expensive it gets the harder it is to buy back in.
“For the investor, a multi-manager approach takes away some of those risks because we’re investing in multiple managers who have different styles and philosophies each of which are appropriate to a different stage in the investment cycle.
“That’s why we’re quite happy to surrender some of the current upside knowing we will get it back later.
‘The current performance is coming primarily from the momentum inherent in the market, and when a revaluation occurs we believe a lot of the outperformance will come from the ability of our strategically combined managers rather than the market,” says Crosoer.