Where to find value in volatile markets

published 25 January 2011

I haven't always seen eye to eye with Ken Fisher, the US market guru. But, in much of his material, he tends to make one very good point: that you almost never get what you might think of as a normal return in the stock markets.

In his latest book, Debunkery, Fisher lays out the numbers. He puts the average nominal annual return on the S&P 500 since 1926 at 10%-12%. He then notes that the market rarely returns this kind of number in any given year. It has ended the year up between 0% and 10% in 12 years and between 10% and 20% in another 16 years.

So, if you call a normal return something in this range, it has given normal returns just over 30% of the time. However, it has also made negative returns 30% of the time and super-good returns nearly 40% of the time. In 14 of the years since 1926, it has returned 20%-30% to investors. In 13 of the years, it has given them 30%-40%. And in five happy years, it returned 40%-plus.

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So, there you go: while it might, says Fisher, be hard to get people to accept the degree to which it is true, "average returns are not normal. Normal yearly returns are extreme".

The other point to remember about returns is that they depend more than anything on the price you pay when you buy. Buy near long-term average prices and you can expect to make average returns over a decade. Buy low and you'll probably make more. Buy high and you'll make less. Very high, and odds are you'll lose your shirt in one of the rare years in which the market falls more than 40%.

So, if we buy now what kind of returns can we expect?

Last week, I visited the flu-ridden strategy team at Socit Gnrale to find out. Their answer? Rubbish returns. Dylan Grice notes that if you look at the cyclically-adjusted price/earnings ratio (or Cape basically a ten-year moving average of the price/earnings ratio) for the S&P 500 today, you will find it is in the top quintile of its historical range.

Indeed, Andrew Smithers of Smithers & Co puts it so high that he considers the US market to be around 70% overvalued. This tells us on Grice's numbers at least that the ten-year returns from here are likely to average around 1.4% a year. Add in the charges that the likes of you and me have to pay when we invest and you might as well call it zero.

However, given that we know that markets don't tend to make steady returns, we also know that rather than a regular zero we are likely to see a parade of big ups and downs that eventually add up to zero. These numbers refer to the US, of course, but thanks to the correlation between it and us we can assume similar movements in the UK.

Back to Smithers. He doesn't expect a crash this year. Given the fact that quantitative easing (QE) cash is still flowing into the US market, "share prices will probably continue to rise". That said, the gross overvaluation of the market might lead "investors who are sceptical of their own and anyone else's ability to time markets" (which should be all of us) to prefer, "in these conditions, to hold cash".

That makes some sense. But holding cash seems even more unattractive this year than it did last year, what with rising inflation and low rates on deposits. And, of course, there is surely always value somewhere it is just a matter of finding it.

I've mentioned various value and defensive funds here before but I've recently come across a newish one that might be of interest: the Kennox Strategic Value Fund run by Charles Heenan. The managers agree with the bears on valuations ("risk is not adequately reflected in valuations") and on QE (they disapprove of the way in which central bankers are experimenting "with such disregard for history").

But they feel they own the things we all want to own: "solid companies at reasonable prices". They have around 17% of their assets in cash as "in readiness to pick up bargains when markets turn, as we firmly believe they will". And they work on what sounds like the finest of principles: if you can protect your capital when the markets fall, says Heenan, "longer term performance over the cycle will be good even if you give some ground up when the markets run".

Finally, over the short period since their launch, Heenan seems to be getting things right: in 2010, he produced a total return of 21%. The fund is small and as a result has a slightly higher total expense ratio than I would like (1.53%). However, that is coming down as the fund grows, you shouldn't have to pay an entrance fee, and there is no performance fee either.

If you want to buy value into a particularly volatile market, I suspect you could do a lot worse than with Kennox.

This article was first published in the Financial Times.

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast - but still writes for Moneyweek monthly.

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.