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News » Financial Market Updates » A Correction is Coming

The value of investments can fall as well as rise and past performance is not a guide to the future.  The information contained within this document is for guidance only and is not a recommendation of any investment or a financial promotion.

Skerritts View - September 2016

A Correction Is Coming:

These are not our words, but those of BCA Research who have issued a report with that title. After a tremendous rally in markets across the world since Brexit, and with US equities in particular being virtually priced for perfection, trading at average P/E ratios well above the post-1980s average, it will come as no surprise that a correction of sorts is on the cards. If words don’t do it for you, maybe pictures do. The graph below shows very clearly why, if a correction is due, the month of September is the most likely to herald its arrival.

This is all very dramatic and scary stuff, but what does the average investor actually DO about it?

What Does Risk Off Actually Mean?:

People in the investment industry will often speak very earnestly on TV or in the Press about how we are in a risk on or a risk off environment, and interviewers will nod sagely in agreement without asking the killer question – for those who remember the head to head discussions in Alas Smith and Jones, a Griff Rhys-Jones voice should be inserted at this point – “so, risk off…..what’s that then?”

In its basest form, risk off means sitting in cash. Cash is the most commonly used gauge of risk free assets, except of course we all know that if one sits in cash for too long this in itself creates risk in terms of inflation and opportunity. It would be very interesting to find out how many private investors went to cash prior to the Referendum in June for fear of exactly the kind of short term sell off that we saw immediately afterwards, yet failed to get back into the markets within the next couple of days to benefit from the massive rally that we have witnessed which has taken a number of indices to near all-time highs. Of course we’ll never hear about it because very few will actually own up in public.

If you are a private investor, or indeed a discretionary portfolio manager or fund manager, there is not much that you can really do to dodge a short term correction other than brace yourself as if you’re in a dodgem, knowing that the imminent impact is coming, but being prepared to pay again for the thrill of the overall ride and experience that is the bumper cars. What is low risk anyway?  Gilts have delivered equity-style returns in both the last three months and two years, which is behaviour inequitable with a low risk asset. We’ve seen suspensions in property funds and the gold price has gyrated, and a high number of so called absolute return funds were seen to be absolute rubbish in offering protection from falling markets earlier in the year. Yes, a good manager will include diversification within a portfolio to try to protect it, but when all’s said and done, if you can’t stomach the ups and downs of the roller coaster, it’s best to stay away from the Theme Park in the first place. No gains are made in a straight line, and increasingly in recent years as volatility has spiked, much of the annual gain (if there is one) has been concentrated into just a few trading days in the year. If, as we expect, a correction is due, one has to think that once the US election is out of the way in November, we could see a “Brexit-type” rally as a major source of uncertainty is removed from the equation. Whether we like the answer to the equation is another matter entirely.

Why Your Water Tank Is The Most Important Part Of Your Retirement Kit:

Our regular readers will know that we’ve been banging on about our water tank method of income provision since 2006. It’s become more appropriate by the year. In short, our water tank refers to the total return nature of a retirement pot as being essential to the longevity and success of providing a required level of sustainable income. If you concentrate only on what an asset is yielding in terms of income, the other concentration that is virtually inevitable is within the asset classes that form your portfolio. This is a highly dangerous situation.

It has become ever-more dangerous as yields have all but dried up from the more traditional safe sources such as gilts and cash, and so income seekers have been herded into equities and high yield bonds that they would not have dreamed of owning in the past, because of the risk that these offered. The risk premium on many of these equities has shrunk due to the demand, and so there is a case for arguing that higher yielding equities are at even more risk of snapping back to their previous risk premium levels, taking investors’ capital with them.

Psychologically, investors in retirement see an investment’s yield as their spending money, whereas its capital is savings money.  This is why retirees have a bias to yielders, while accumulators have a bias towards growth assets. It is a far less risky approach to providing income if it is seen as a total return concept, rather than simply yield or growth. We mentioned earlier about the importance of diversification and this applies just as vigorously to those in retirement.

A growing risk is in the yielders themselves. In the financials and utilities sectors, profits have been declining and yet dividends have been increasing. In the energy sector the profits and dividends have already been slashed. What the financials and utilities are doing is, in the long run, unsustainable but if you look closely at the portfolios of many of the equity income funds that are on the market, you will see financials, energy and utilities sitting very close to the top of the sector allocations. Telecoms, on the other hand had their issues back in 2012-13 and look to have a more sustainable dividend policy as their profits have generally risen recently. If you are dependent upon the dividend for your income, then a dividend cut can be disastrous, and history tells us that when a dividend is cut, it can be cut pretty sharply. And, of course, if a stock cuts its dividend, its share price falls out of favour pretty quickly too.

We’re not saying that a raft of cuts is imminent, but we would recommend that you look quite closely at where your income is actually coming from. With our water tank method, you are not dependent upon just one source of income at all, and it is the total return of your portfolio that is the most important factor.

Sources: BCA Research August 2016

Please note that these are our opinions and for information only. The content should not be taken as a recommendation of any investment and does not constitute advice.

 

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