Seek protection or stay fully invested? That is the question. However you look at it, the nine-year bull market has many investors thinking. It is at these moments of inflection that behavioural biases can have their greatest influence on markets.
Left unchecked, investors’ behavioural biases lead them to make irrational decisions, especially buying when a market is expensive and selling when it’s cheap. Investors are often fooled by strong recent returns, thinking they’ll continue. Similarly, investors frequently forget about their innate loss aversion; humans are inclined to dwell on further declines as downturns worsen, leading to pro-cyclical behaviour that often breeds poor financial outcomes. Supporting this rhetoric, empirical evidence implies that cheap assets have a far wider margin of safety than their most popular equivalents, with valuations directly influencing longer-term outcomes.
It is important to acknowledge that cheap assets rarely have fundamentals that are perfect (think of Russia, the UK and the telecommunication’s sector), as they often carry significant uncertainty and are thus punished by negative investor sentiment. At the other end of the spectrum, expensive asset prices regularly surpass what fundamentals justify. The latter is the challenge we face now. Specifically, the US and Australian equity markets sit in the fourth quartile of valuations. This leaves much of the equity market universe vulnerable to sluggish returns at best, or a major downturn at worst, a development of which every investor should be wary.
Let’s reflect on what this means. When the majority of assets are this expensive, should we simply fill portfolios with those few assets that are least popular? Or can a multi-asset approach help deliver better outcomes?
In answering, it is critical to remember that asset allocation is the primary driver of long-term returns. Therefore, factors such as the equity/bond split, geographic allocation and duration levels will have a meaningful impact on outcomes. Related to this is knowing the limitations of our shorter-term predictive abilities. The reality is that financial markets carry significant levels of uncertainty at all times in the cycle and sound portfolio management is being positioned for a variety of outcomes, not just one.
This is one advantage of a multi-asset approach over, say, an equity-only portfolio. While fixed income is similarly (if not more) expensive, a multi-asset portfolio provides a better hedge against various potential economic and market outcomes. There are simply more levers to pull, including better risk controls and an ability to secure cash flows over a full market cycle.
The last point to iterate is the concept of a margin of safety. When markets are unanimously expensive, we must appreciate that the margin of safety is lower than it would ordinarily be. This is problematic in an absolute sense, as the range of outcomes (reward for risk) becomes skewed to the downside. Therefore, when faced with such probabilities, it can become prudent to seek protection in cash, as it will help control our own behaviour and become effective ammunition against the increasing likelihood of an adverse outcome.
Turning to local market nuances, the same challenges apply. In fact, things could be considered even harder, given
the concentration risks in Australia.
It is important to establish the essentials. First, the Australian sharemarket represents only about 2.5 per cent
of global markets. Second, while it faces valuation pressures similar to many of its Western peers, the range of outcomes tends to be quite wide due to the concentration issues. This is most prevalent among financials (inclusive of real estate) and materials, as these dominate the index exposure. The high level of cyclicality inherent in most of these sectors further exacerbates the nature of the risks.
There are two ways to think about this underlying exposure. First, at an index level, the risks can become heightened
and this reinforces the importance of sound behaviour. One thing we know for sure is that chasing past performance is a dangerous path. However, by being contrarian, an investor can use the concentration risk as a platform for valuation-driven opportunity. In this regard, the Australian market remains unappealing compared with some investment opportunities available globally. By positioning a portfolio in those areas displaying the most attractive reward for risk; a valuation-driven investor can reduce the cyclical bias and thereby add a cushioning effect on returns in down markets. This is a tool we are advocating to reduce the impact of any valuation shock.
What does this mean practically? Well, in our multi-asset portfolios, we retain some exposure to Australian shares despite the fact they rank poorly based on our valuation and risk models. This is also the case for US shares. However, we adhere to a bottom-up approach that considers markets on a more granular basis, with exposure to unloved countries and sectors, like UK equities and global telecommunications, that have become more attractive on an absolute and relative basis. Opportunities have similarly presented themselves in cyclical areas, such as emerging markets across both equities and debt; although we note the recent strong returns have tempered our conviction in both of these asset classes – especially on a risk-adjusted basis.
When considering the opportunities holistically, the last point to address is the home-country bias. This phenomenon is commonplace in many markets around the world, and while there are arguments for it (for example, capturing franking credits from equities), the reduction of this bias in Australia is a positive step towards managing risk.
Experience has taught us to see the investing world through the lens of absolute and relative valuation, to cautiously but positively await opportunities to buy great quality assets at times when their price is below the intrinsic value. Said another way, human predispositions can lead to poor collective behaviour – creating market cycles and an evolving reward for risk.
We expect 2018 and beyond to be no exception, requiring a guarded stance when most assets look expensive.
Phil Straehl is head of capital markets and asset allocation at Morningstar Investment Management, based in Chicago.
James Foot is director of capital markets and asset allocation at Morningstar Australia.