David Buckle
 

‘Roger screws up’ 
There is a wonderful ‘Far side’ cartoon of an orchestra with a large man standing right at the back holding an enormous cymbal, poised to bash it. He has a thought bubble extending from his head saying ‘this time I won’t screw up’. The caption of the cartoon is ‘Roger screws up’.

This cartoon represents all of us trying to call a top in the equity market. There are of course three possible outcomes in that endeavour: too early, too late or just right. Some of us may be lucky and get it just right, but for financial planning purposes it’s best to assume you’ll be either too early or too late.

Erring either way is expensive. Our estimate of equilibrium P/E ratio for the S&P500 is 16, so it would have been very easy to have observed the PE ratio at 21 this time last year and viewed the market as expensive. Yet de-risk then and you’d have missed a 2017 return of 22%. If and when the equity downturn comes, I’d be surprised if it exceeds 20% - there have only been two such occurrences: 2000-2002 and 2007-2009.

As ever, investing is a risk-reward trade-off. It strikes me that investors have one of two choices: accept the risk of a downturn and stay invested in risky assets, or de-risk early and accept that return opportunities may be missed. It’s vital to be clear on that decision as the action required is quite different in each case. In not taking that explicit decision I fear many are implicitly assuming they’ll be able to exit at exactly the right time. That’s a brave assumption.

Let me take you through the two choices:

Stay invested
Regarding my personal portfolio positioning, I have a tolerance for risk and therefore I’m happy to remain invested. But I’ve taken that decision fully expecting to go over the cliff at some point. I’m explicit on that. 

I’ve assumed a bad case scenario is a 20% drop in equity prices. I have approximately a third of my assets in equities, so my portfolio could face a loss of 6%, that’s tolerable for me. Furthermore, in these two occasions when equities had downturns in excess of 20%, the bond market returned 30% and 17% respectively (as measured by the S&P 7-10 year Treasury index). Therefore, regardless of the valuation of fixed income, I’ve increased bond duration in my portfolio to help hedge against an equity downturn. To put numbers on this, my portfolio is 70% in a 10 year bond index, and 30% in equities. If I experience a 20% drop in equities and 1% drop in bond yield, I’ll still post a positive portfolio return. 

Whilst a lot of assets are expensive, there are pockets of value. European equity is one that attracts my eye, but the asset class I’m very drawn to are emerging index linked bonds. The event that gives me nightmares is a dropping equity market driven by higher yields. That unlikely scenario would presumably occur if inflation returns in force, and in that case EM index linked bonds would do well, and their real yields are attractively high.

De-risk early
My deputy is more risk averse. He’s already de-risked, arguing momentum has driven returns, fundamentals are only moderate, and the market has had a great run. He feels the drawdown could be bigger than 20%. Other than opportunity cost, the problem with de-risking, is that the lowest risk assets are the most expensive of all; they guarantee you a reduction in your purchasing power. Therefore, what’s important, and what my deputy has done, is to recognise that he’ll experience certain negative real returns all the while he has de-risked. 

I wouldn’t be happy with that, and it’s that difference which largely separates us. So, if you are going to de-risk, don’t overdo it, and make sure you de-risk in an even way ensuring you keep a balanced portfolio - that means diversifying across asset classes and regions. Pertinently to a de-risker, the Asian debt market is usually underexposed in global fixed income portfolios.

Good luck in 2018. If you make a new year’s resolutions, resolve to clearly decide: de-risk or not. Would you rather clash that cymbal too early or too late?

David Buckle
Head of Investment Solutions Design
 

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity International.

Investments in overseas markets can be affected by currency exchange and this may affect the value of your investment. Investments in small and emerging markets can be more volatile than investments in developed markets.

This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs. You should consider these matters before acting on the information.  You should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity Australia product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading it from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise. 

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