Paul Killik: A market perspective
13th March 2020
It is a brave and probably a foolish man who tries to predict the short-term direction of equity
markets, particularly when we are in the midst of something as unpredictable as a pandemic, so I
am not going to do that. However, I will try to bring some logic to the current situation and off the
back of that lead to a more distanced prediction.
Fear is a powerful emotion, the more so when you are unsure of what you are fearful. As Roosevelt
famously said, “the only thing that we have to fear is fear itself”.
There was more logic behind the market falls surrounding the Global Financial Crisis in 2007/09,
when the global banking system was on the point of collapse, or the tech boom and bust of 2001/03,
when all tech companies were significantly overvalued, than there is for this latest and more
dramatic decline, which is event driven, centering around a pandemic.
We know and understand that the pandemic will pass although we recognise that there will be a
price to pay in loss of life and passing economic disruption. However, and without wishing to
minimise the human cost, economically this is likely to be collateral damage rather than structural.
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Unfortunately, since 2009 we have seen an explosion of indexed or passive investment, which
essentially represents computers taking over stock market investment. It is now generally accepted
that passive investing currently represents about 50% of the US stockmarket.
The essence of passive investing is that it is quantitative rather than qualitative, the selection of
securities for a given passive portfolio is simply determined by reference to their inclusion in a
predetermined group such as an index. The securities are not selected by referencing their qualities
one to the other, which is otherwise known as active investing.
The purpose arose as investors sought ways to match the performance of an index considered to be
their benchmark, on the grounds that it is difficult to criticise a performance that is more or less in
line with their benchmark. The portfolio of investments held in a passive portfolio therefore
technically mirror the benchmark against which it is measured.
Unfortunately, in as much as it is created to mimic the herd instinct, it is just as susceptible as wild
animals are to a stampede driven by an unknown fear.
THE IMPORTANCE OF ACTIVE INVESTING
As touched on above, active investing is driven by the comparison of one business to another.
Securities are therefore selected on their qualitative merits. This subjective approach to investing
leads to multiple different portfolios and a bear market scenario doesn’t lead to everyone selling an exact replicator of a small number of indices/portfolios, which becomes impossible for the market to absorb.
I sincerely hope that this episode will convince the regulators that they need to control or phase out this style of passive investing, as it leads to an unacceptable level of volatility.
In the meantime, we have been steering our clients toward quality long-term growth businesses that will have been sucked into passive portfolios because they happen to be represented in one or more of these indices. I believe that once markets stabilise, as I shortly expect that they will, active portfolio managers will quickly start to acquire these good quality businesses that have been indiscriminately dragged down with everything else in the same index.
As a final sanity check, in these days of ever lower interest rates, one should keep an eye on equity dividend yields. They rise in inverse correlation to the fall in share prices. In the UK the yield on the FTSE All Share has now risen to 6.1% whilst the 10 year gilt yields only 0.35%. In the US the yield on the S&P 500 approaches 2.4% whilst the 10 year US Treasury offers only 0.88%. Even the MSCI World Index has risen to around 3.1%.
I recognise that a recession is doubtless on the way as a consequence of the virus-induced global shut downs that are taking place, and dividends are likely to be lower in the near future. However, even in the Global Financial Crisis they fell by only 25% in the UK and I would be surprised if the pandemic brought about anything quite as severe. In the US, companies are more likely to see through this uncertain period and their lower yield gives them the head room to reduce share buybacks to maintain dividends, which I would expect.
When markets settle down, these yields will appear increasingly attractive to Lifetime Savers.
I would also remind clients of the work that we have been carrying out on the length of bear
markets. In our list of ten since WW2 we have what we would consider four event driven bear
markets, as opposed to either structural or cyclical. They are listed below and as you will see their length is around one to two years. This is measured from the highest point before the start of the decline, through the trough, to the recovery to that original level:
1956 – Combination of communist-driven geopolitical events and Suez Canal crisis – 26 months
1961 – Kennedy battles US Steel over price hikes – 21 months
1966 – Escalation of Vietnam War – 14 months
1987 – Black Monday – 23 months
This is not a prediction per se, but it is helpful to remind ourselves that we do come out of these
depressing episodes and in the scale of things, it need not take that long.
I conclude with my reminder not to try not trade these volatile markets. Continue to hold good
quality long term investments, over time they will continue to deliver the growth that we are all