From Seneca Investment Managers' public marketing material. Seneca is now part of Momentum Global Investment Management.
Our analysis suggests that the global economy moved into expansion phase around the turn of the year and will move into peak phase towards the end of 2019. If we are correct about this then we are looking at low but positive returns from equities for the next year and a half followed by negative returns (a bear market) in 2020 and possibly 2021 too.
"Investors must ask themselves is they would prefer to miss out now, or crash at high speed"
It would be nice to think that we could remain overweight equities until the day equity markets peaked then very rapidly move underweight so as to benefit from the ensuing bear market. In reality, this of course would be impossible. What is possible is to see the peak ahead of us and to start preparing in advance.
The problem is that it is hard to know for sure whether the peak is close or far away. If one was driving a car and saw some deceptive obstacle in the road ahead, it would be prudent to assume it was close and to start braking immediately, if gently. This is what we started doing recently when we moved portfolios to an underweight position in equities. Moreover, our plan is gently to move portfolios further underweight over the next 1-2 years.
The problem is that by slowing down before others do, there is a tendency to think one is missing out. Yes, it is very possible that the obstacle in the road is not that close, and that those not braking will continue to enjoy the thrill of driving fast. The question that investors must ask themselves is whether they would prefer to miss out now, or crash, sooner or later, at high speed.
To continue with the driving analogy, changing speed at the appropriate moments is the equivalent of tactical asset allocation. There are times when one should not hesitate to go full throttle – the obstacle is behind us and the road ahead is straight and clear. Then at some point the next obstacle begins to come into view and it is time to ease off a bit. The alternative is to drive at an average speed the whole time, which would be the equivalent of not implementing any tactical asset allocation at all, instead keeping exposure to asset classes such as equities and bonds the same at all times throughout the cycle.
Let us call these two cars TAA and SAA (for the avoidance of doubt, these refer to funds that on the one hand employ active tactical asset allocation and on the other just stick to a fixed, or strategic, asset allocation) and pit them against each other in a race, agreeing that the objective of the race is to be ahead over the long haul. If we start the race with the obstacle right behind the cars, TAA is likely to build up a nice lead, given that it going full tilt. Even when TAA starts to slow down it will continue to extend its lead, as it is still driving faster than SAA. Only when TAA starts driving slower than SAA, having seen an obstacle ahead, will its lead start to shrink.
Although TAA car is driving more slowly, it hopes that it can actually maintain its lead over SAA until the next obstacle is reached. However, it is not the end of the world if it cannot do this. It is possible it will be overtaken, in which case it is tempting to think it would have been better to follow SAA’s approach. Then SAA smashes into the obstacle, while TAA drives around it. SAA is stuck at the roadside for repairs, and TAA is once again putting its foot down. This lap he’s able to build up an even bigger lead, given SAA’s troubles.
For ‘lap’, read ‘investment cycle’. For ‘obstacle’, read ‘bear market’. Then of course, the car’s speed is the equivalent of the equity weight. TAA driving faster than SAA means overweight, etc.
Being able to add value through tactical asset allocation in relation to a static weight approach relies on having a sound framework for predicting markets. This does not mean predicting short-term market movements, including the precise timing of peaks and troughs. I have yet to come across any credible research that suggests this is possible. What I have come across however is credible, empirically driven research that finds linkages – patterns – between such things as interest rates and dividend yields on the one hand, and the medium-term performance of financial markets, whether equities or bonds, on the other.
Putting such research to use however is hard. While the aforementioned research has identified patterns in them, financial markets are still dominated by uncertainty. This means building multiple scenarios around a central scenario and putting them into an asset allocation framework. Just as importantly, the approach requires discipline.
While it is possible that the next bear market will start tomorrow, it is more likely that it will not. This means that in the near term we will in all probability underperform those funds adopting a static approach to asset allocation (TAA car is driving more slowly than SAA car). However, I do not believe the opportunity loss will be significant. If I am correct that we are now in expansion phase, returns from equities for the next 1-2 years are not likely to be that much more than those from cash. Furthermore, any underperformance will most likely be in the form of lower positive returns rather than negative returns.
The chart below sets out how we expect the equity target in our funds over the next 5 or so years to progress. It will no doubt change as the macro backdrop changes. Although I have a central scenario, the downturn will almost certainly start earlier or later than that suggested in this scenario.
Published in Investment Letter, July 2018
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.