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23 Apr 2018

PROTECTING AGAINST RISK OF LOSS IN THE LATE STAGES OF A BULL MARKET

We’ve written before how business cycles drive market cycles. WILLIAM FRASER explains why Foord underperforms during the late stages of a bull market

Since the 2009 global financial crisis market lows, share investors worldwide have benefited from the aftereffects of the Bernanke Put. Massive American, European, British and Japanese central bank stimulus found its way into markets, lowering volatility and boosting share and bond prices.

Central banks also lowered interest rates to near or below zero percent. Negative real rates forced savers to seek capital growth elsewhere. Share and high-yielding corporate debt markets became the default asset class for investors.

Consequently, real earnings’ yields fell over the now almost nine-year bull market as prices rose. Market valuations, measured by price-earnings ratios, surged above their long-term means. Sectors geared to faster economic growth experienced outsized gains and companies exposed to the knowledge economy ballooned. Old economy stocks, with more predictable, but slower, earnings growth, lagged.

But it wasn’t all about prices. As the economic cycle progressed, lower interest rates and steady employment gains augmented company earnings. As sentiment and consumer demand recovered, manufacturers boosted output, increasing demand for commodities. Soon, capacity became constrained and companies borrowed cheaply to build more factories or invest in new machines. Wages finally rose as skill shortages became endemic. Investor confidence improved and more capital became available for business and stock markets.

The economic cycle found a natural rhythm not unlike those that came before. It is typical for share prices to lag the cycle in the early stages when investor sentiment is low. This provides a good entry point for long-term investors. But it is also common for excessive share market exuberance at the end of the cycle, particularly as investors chase returns in specific sectors or themes.

In our view, we are slowly nearing the end of the second-longest economic expansion in living memory. But despite the rich valuations, markets may continue to advance as investors extrapolate favourable conditions, increasing the risk of permanent capital loss.

Given current valuations, global share market returns should be muted over the next five years (on some metrics, the US S&P500 Index is the third most expensive in its 120-year history). The bull market in developed market bonds is already over.

Foord’s international portfolios are accordingly becoming increasingly conservatively structured. Share weightings within portfolios have begun to decline, while cash holdings have increased. Within equities, the portfolios are tilted in preference of companies with more stable earnings’ prospects and much lower risk of loss.

This investment strategy will underperform in the late stages of an economic cycle when investor exuberance is highest. Long-term Foord investors will recognise the current relative underperformance patterns and approve the strategy.

The long-term returns of Foord’s international equity portfolios provide evidence of its’ success: despite lagging during the late stages of three previous economic cycles, performance of the Foord International Fund over the past twenty years has surpassed inflation, the peer group, global bonds, and global equities.

 

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