One odd thing about this nasty market is how little it seems to bother most investors. Global equity markets are down 15% so far this year – and many parts of the market are off very much more – yes, I am looking at you, US technology stocks.
But while data from the online investment platforms shows investors looking at more conservative investments than in the past (a good thing), Scottish Mortgage is still the most popular investment trust on buy lists (an odd thing given that it is at the epicentre of the market meltdown).
However, the lack of obvious stress amid private investors makes a certain kind of sense. After all, most of us have still made a little money in nominal terms over the past two years, and quite a lot over five.
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The latest numbers from Interactive Investor show that, while their average DIY investor is down 11% this year, they are up 13.2% over the past two years and 2.6% over the past two and a half – that is, since just before the lockdown-induced crash of March 2020.
The past two years have been so unreal in so many ways that having the same amount of money as you did then seems sort of all right. A lucky escape even.
Valuations could fall further
The problem is that we cannot be sure we have yet escaped. Valuations are not as bad as they were – the cyclically adjusted price/earnings (CAPE) ratio of the US market is back down to 28 times from a high of 38, for example – that’s only about 15% higher than the 15-year average.
The UK market is on a CAPE ratio of 14.6 times on numbers from Cambria Investment Management – that’s only a few percent off its long-term average.
This might all sound reassuring – comforting, even – but it probably shouldn’t. The truth is that in markets such as these merely reverting to long-term averages is not enough. It makes sense, says Matt Kadnar, portfolio manager at asset manager GMO, that price/earnings ratios should be higher than their long-term averages when things look good. If profits are high, economic growth is good and inflation is low, investors feel comfortable and “they are more likely to pay a higher multiple on the market”.
It makes sense then that in the pre-Covid years, when all this was true, valuations were “substantially higher” than their long-term averages. Things are clearly rather less comfortable now – very uncomfortable, in fact.
So valuations should now not be at their long-term averages, but rather below. How much below? GMO has a model for that – one that Kadnar says has historically shown “incredibly high” explanatory power.
Unfortunately, this model – the Comfort Model – is not telling us anything reassuring: the CAPE should be knocking around 19 times, rather than 28 times as it is now.
To get back to average would require a fall of 15% – more if the earnings bit of the equation gets nasty. If investors eventually react to current circumstances as they have to similar events in the past, that 15% might be just the beginning. Feeling less comfortable? You should be.
Investment trusts could help
You should also now turn your mind to getting a little insurance against valuations falling not to, but well below, their long-term averages.
One place is in the investment trust sector. Most analysts keep a close eye on the discount at which their shares trade to their net asset value (NAV) to get a sense of when it might be time to buy.
In June, the average discount across the sector widened to 9.5%, says Winterflood Securities – that means you can buy the shares in the average trust for 9.5% less than the actual value of the assets it holds. That number was 2.2% at the start of the year – which should have been a danger signal, by the way. That’s against an average of 4.4% over the past year and 4.7% over the past decade.
There’s a huge range here of course – huge discounts in sectors such as property, private equity and technology, something that reflects the expectation that the prices of the underlying assets they hold will soon fall further, and smaller discounts in the likes of UK equity income.
But the key is that the discount is wider than usual, which is good, but it’s probably not quite wide enough to be a screaming buy signal. It’s clearly not if we think of it in terms of the Comfort Model – there have been times in the past when the average discount in the sector has been 20%.
That said, any discount over a couple of percent offers you some insurance, as the expectation of falling prices of the underlying holdings is already in the price. And there are some trusts that seem to offer very significant levels of long-term insurance.
Look to the private equity sector, says Nick Greenwood, manager of the MIGO Opportunities Trust, a trust of investment trusts.
Many trusts in the sector deserve to be on whopping discounts, the average being currently well over 30%. The value of a lot of the holdings will soon be written down in line with price falls in the listed markets.
But not all private equity trusts invest in the kind of early-stage growth businesses that are collapsing in value. Some have long focused on mature businesses and on profits and cash flows. They will not see the same writedowns – so might be genuinely cheap and provide you with built-in insurance. Look at Oakley Capital Investments (LSE: OCI) – on a discount of 30% – and NB Private Equity Partners (LSE: NBPU) on 36%, says Greenwood.
Look for dividends
The other place to look for insurance, in the UK at least, is in dividends. Those invested in the FTSE 100 this year will have lost about 3%. But this will for now at least be compensated for by the dividends they will receive along the way – the yield on the UK market is forecast to be 4.2% this year – a total payout of £85bn, up from £78.5bn in 2021.
This is not a one off: the payments are well covered by corporate profits, notes AJ Bell, and while there is some concentration risk here, as over half the total payout comes from only ten stocks, more companies are paying dividends this year than last year.
These dividend payments matter. The FTSE 100 may fall 20% from here – who knows? But if it goes down and stays down, dividend investors will at least know they have an excellent chance of being evens in nominal terms at least in five years, thanks to getting 4%-plus in dividend payments every year.
You might even go for a double bite of cover – and buy one of the UK’s income trusts. They don’t come with much of a discount these days, but you can get 2% off NAV at Murray International (LSE: MYI) (yielding 4.5%) and JPMorgan Claverhouse (LSE: JCH) (4.7%). And 10% at the Lowland Investment Company (LSE: LWI) (5.4%). There’s got to be some comfort in that.
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.
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