Bear markets, it is said, are defined both by their depth and their duration. Although certain global equity indices have fallen by around 20% or more from their 52-week peak, developed market benchmark indices have not yet fallen to levels that would naturally categorise the latest set-back as plunging us into a traditional bear market.
However, the continued absence of any lasting recovery is beginning, at last, to wear investor confidence down. Attempted rallies have been crushed, to be replaced with further weakness and volatility.
Whilst we anticipated such an eventuality we have long advocated a more defensive approach to equity investing. The combination of slowing economic growth, coupled with increased pressure on company profits justifies a cautious investment approach for the time being. This will not always be the case. Our end-2008 FTSE 100 forecast is 6,800 and we believe that a better long-term buying opportunity will present itself during the second quarter of the year. At that point equity investors will be looking closely for signs that the economic slowdown, pronounced in the US and to a lesser (but still significant extent) in the UK and Western Europe, is bottoming out.
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Although we do not expect the ensuing upturn to be particularly aggressive, investors will naturally attempt to anticipate the trough before official data confirms it as such. At that point and with the likelihood of much easier comparable earnings periods, especially for the financials, from Q3 2008 we would expect a more sustained equity recovery, particularly from this heavy weight industry grouping.
The importance of the global profit cycle
We reproduce the highly stylised earnings cycle chart (above) to illustrate the point that the single most important determining factor behind the relative performance of various asset classes is the global profit cycle. Not only does the profit cycle inform which geographic destinations investors should be favouring, but which investment styles and sectors too. When the earnings cycle is accelerating, as it was from 2003-2006 investors naturally have plenty of options to choose from. Profit growth is abundant and in such circumstances the successful call is to buy lower quality, value orientated investments with greater cyclical exposure. Put simply, why pay up for quality growth when one can buy growth much more cheaply elsewhere?
By contrast, when the earnings cycle turns down profit growth becomes increasingly hard to find. In such circumstances investors inevitably pay up for reliability. Inevitably, with fewer investments fitting the bill, market leadership (which often becomes a relative thing as all sectors are adversely impacted by indiscriminate selling) becomes much more concentrated. Perversely, active investors can generate "pure alpha" (see Week in Previews passim) much more easily in the prevailing environment because a much greater emphasis is placed on getting the strategy absolutely right and those who don't tend to be punished disproportionately.
Without wishing to sound too much like a cracked record we continue to favour those companies which have a proven ability to generate superior top line growth (i.e. in excess of the market) across the economic cycle, not just at its peak. We are wary of operational gearing (sales, less cost of sales / EBIT) and supportive of low levels of financial gearing and reliable cash generation. If such a strategy results in an increased emphasis on specific higher yielding equities, so much the better. In prevailing circumstances the merits of investing for total return are magnified.
Judging by conversations we have had we are unconvinced that investors are truly aware of the downturn in the global profit cycle, preferring to look at equity market weakness either as part of the inevitable cut and thrust of stock market investing or as an opportunity to buy into apparently bombed out sectors and stocks. To some extent this view is the natural human response to what has, after all, been a decade long period of economic prosperity, an explosion of credit and a powerful profit surge taking the latter to a record share of national income and margins to all-time peaks. The view that, after a such a long period, typically cyclical investments such as commodities and emerging markets gain traction with investors, particularly those following momentumbased strategies. We are less convinced.
The sectors to watch
One of the key similarities between the financial market experience of 1999 2000 and 2006-07 is that although sector leadership narrowed during the former period to Tech, Telecom and Media stocks the profit cycle was still rising. An environment characterised by narrow market leadership during generally rising profit growth is a clear sign of unsustainable bubble conditions in play. The Mining sector enjoyed market leadership for much of the 2003-07 equity market bull run a period when, again, profit growth was generally rising. This too, with the benefit of hindsight proved to be a period of broad profit growth built on a transient credit bubble. The end of the period of cheap money has brought about marked weakness from those sectors which had hitherto enjoyed cheap and easy access to credit.
Our expectation for an anodyne recovery is built on our belief that cheap and easily available credit will be significantly harder to access in the future than it was in the past, creating the conditions for a marked rotation in equity market performance and sectoral performance within those markets.
While gazing at screens bathed in red may not be the most conducive condition for considering outperforming investment strategies, it is our belief that such conditions make it harder for more generalist strategies to work and easier for more focused strategies to generate pure alpha. Clearly narrowing equity market leadership, coupled with narrowing sector leadership makes it harder to pick winners but the relative success of winning strategies is significantly greater than when conditions are much more benign. This gives rise to three potential strategies to survive bear market conditions.
Bear market strategies
1. Individual stock selection
Those investors opting for a stock by stock approach to investing have a better chance of outperforming broader indices, with the proviso that that stock selection remains focused. A broadly based portfolio comprising a large number of stocks across a range of industries stands less chance of achieving outperformance than a more focused portfolio. Whilst this may fly in the face of the generally accepted wisdom that, through diversification investors can reduce the specific risk associated with disproportionate exposure to just a few stocks, current market conditions augur in favour of a more focused approach.
Naturally, achieving that focus becomes more difficult and is potentially costly in terms of reshuffling ones portfolio, however, careful stock selection can offset the costs associated with so doingor doing nothing. Getting things absolutely right may matter less to private investors than it does to hedge funds etc but to the latter it matters hugely. As more entrants have entered the playing field, so returns for everybody have reduced. Broad-based equity market strength may allow broadly diversified investors to make money the crowding of hedge funds around a limited number of differing strategies has made relative outperformance extremely difficult. By contrast, narrower market conditions return the emphasis to much more detailed analysis and consequently greater rewards for those who get it right.
2. Passive investing plus
The second possible option for investors is simply to index portfolios and augment performance by including structured products, carefully researched hedge funds and exchange traded funds (ETF's). Our colleague John Fletcher has worked hard to campaign for increased use of ETF's here at Charles Stanley and those investors who have adopted these products could have added incrementally to their portfolio's performance. ETF's increasingly cover a wide range of asset alternatives and provide investors with the opportunity to buy into non or poorly correlated investments such as fixed income and commodity markets with relative ease.
Indexing might strike many investors as anathema given the desire to achieve supranormal returns, however, in conditions such as those prevailing passive investing becomes an active alternative. Clearly during periods of narrow market leadership in an environment of generally falling profitability, the probability associated with outperforming using an active approach to investing declines markedly. The past five years have been very good to active investors, reflecting broadly-based profit growth and such conditions will inevitably return in the future. Until such time as a broadbased recovery takes place a more passive approach to investing should bear fruit.
3. Stick to larger companies
Narrowing market leadership has important implications for thematic investing too. A company's size and geographical spread of operations has become more significant to investors during this period of slowing profit growth and heightened risk aversion. Although the small company index appears to be outperforming its larger counterpart over the past few weeks, this merely reflects the fact that investor interest in small cap stocks has virtually dried up. Larger companies have the advantage of greater liquidity and are thus perceived as more defensive, even if they can suffer from time to time on fears relating to forced fund liquidations.
It is to larger companies that we have for some time indicated that investors should be focusing. Periods of increased volatility tend to augur in favour of larger companies. Large company quality growth is also one of the largest style orientated investment categories, thus providing investors with a relatively larger universe from which to pick stocks and larger companies tend to have greater international focus. Whilst Western economic activity is slowing, Asian activity remains relatively robust. This, coupled with the likelihood that sterling could suffer disproportionately on the world's foreign exchanges, increases the likelihood that larger companies will benefit more from the benefits of financial translation.
Within quality growth styles one can differentiate between the more momentum-based investor with a marked preference for sectors such as energy and those favouring stability and higher quality such as consumer staples and to some extent healthcare although we accept that that sector has its own distinct issues at present.
Conclusion
Many investors are waiting for the macro economic environment to recover and for the profit environment to improve. Unfortunately confirmation of the former may take another six months at the earliest and confirmation of the latter possibly as long as a year. Investors will inevitably attempt to anticipate the trough before it is confirmed by backward looking data, however, such strategies can and do often end in tears.
As equity market volatility increases (both on the up and downside) and sector leadership rotates away from those areas previously benefiting from access to cheap and easily available credit, so investors should reconsider their portfolios, away from value and towards our marked preference for quality growth.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley
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