Is it time to focus on capital preservation, rather than capital growth?

“I made a fortune getting out too soon” ~ J.P. Morgan

It’s important for investors to draw a few distinctions between the short-run and the full market cycle – which is commonly measured as the market peak to peak, or trough to trough.

In the short-run, market returns tend to be influenced most by a combination of investor sentiment, risk preferences and price momentum, all of which are interrelated.  Over the course of a full market cycle however, valuations are ultimately what matter. 

In the short-run, investors are often penalised for following the familiar approach of buying low and selling high.  Yet a full market cycle tends to be enormously forgiving to investors who decide to reduce their risk when markets are at or close to their high point. This is true even if investors do this a little bit too early, and miss out on the final stages of upside.

To emphasise this point, bear in mind that a five-year return profile of 10%, 10%, 5%, 5%, 0% beats returns of 20%, 20%, 10%, 10%, -25%.

The mathematics of compounding dictates that large losses have a disproportionate effect when it comes to amassing returns. Therefore, from a full-cycle perspective, avoiding them is critical. 

Investors always face the question of what to emphasise in their portfolios – capital growth or capital preservation. You can’t do both. In this note I want to deal with the challenge of emphasising the latter. 

This should not be mistaken as a forecast of an imminent market decline. It’s just we have always believed that successfully navigating the full market cycle is what matters most in the end, so we reflect upon the current conundrum quite a lot.

“Most investors are wired with every bone in their body to do the wrong thing” ~ Howard Marks, Oaktree Capital

The purpose of our comparison between the two return profiles above is not to advocate permanently taking a defensive stance. Far from it. The point is more that the avoidance of losses is generally worth pre-positioning for. 

In the post-war period, the average US equity bull market has lasted approximately 64 months, and generated a gain of 163%. Within about 15 months from the peak, more than 50% of this gain has typically been lost to the subsequent bear market[1].  So far, the current cycle has been both more profitable, and 50% longer than average, with gains in the order of 300% over 98 months[2].

Now, we have no special insight into when the bull market in equities will end or indeed what will eventually trigger its demise.  Recognising this limitation, in the later stages of a cycle our approach has always been to gradually shift emphasis from capital growth to capital preservation over a period of time as market risks build - the objective being to carry less risk as the market hits its peak, than we do as the market hits its bottom.

This transition phase (which is gradually underway) is invariably frustrating and requires discipline and patience, as while momentum pushes prices higher in the short term it feels as though almost every single thing you do is wrong.  From a full-cycle perspective though, it’s perfectly rational, even if it does risk sacrificing some short-term relative performance. 

“If everyone is thinking the same, then no-one is thinking” ~ Richard Russell, Founder of Dow Theory Letters

Judging by the avalanche of money currently pouring into passive investment strategies, we would submit that many investors today, consciously or not, are behaving with a higher degree of risk than normal.  We would contend that this makes some markets riskier than generally assumed. 

A false sense of security prevails over all financial markets at present due to low interest rates.  Many investors clearly believe the market environment is largely benign, safe and ostensibly primed for good future returns. We’re more guarded, particularly with the US.

It is true to say that today, the reward for taking risk has been extremely low for a prolonged period (or in other words, valuations have been high for some time).  It is the combined collapse in this (helped by low interest rates and quantitative easing) that has amplified returns during this bull market.  We suspect that neither of these will prove structural or permanent.

Similar to the late 1990s, today we have extreme capital concentration in the US markets.  Once again this has been partially driven by an innovation and technology boom.  Then, as now, the “value” part of the markets - a long-term investing approach which focuses on targeting companies which are valued at less than their true worth - are (relatively speaking) hugely unpopular.

So far in 2017, for the first time in a long time, US equities have started to underperform international markets.  From a value perspective, we believe this makes sense and may only be the beginning of a multi-year trend.  Outside of a brief episode in late 1929 and the period from February 1997 to August 2001, US equity valuations have never been higher than they are today.  From a full-cycle perspective they look unattractive and in time could prove far riskier than is presently assumed.

“If everyone is going left, look right” ~ Sam Zell, Founder and Chairman of Equity International

US equities aren’t the only market we believe investors have overpriced.  Importantly, the US dollar has also enjoyed a bull market since 2011, which we believe may now be in the process of topping out.  And, of course, bonds have been in a bull market since 1981, leading to valuation levels today that are hard to comprehend.

If our observations on these three major asset classes prove to be reasonable, then it highlights some potential opportunities. It also underlines why some traditional solutions to our capital preservation conundrum may no longer be helpful:

• 10 year government bonds – their yield has fallen from a peak in 2007 of 5.5%, to just shy of 3% in early 2009.  This move generated a total return of c.30% in 18 months, which was a big help in counterbalancing equity market losses of an even greater magnitude. The problem today is that since 2009, yields have fallen a further 80%, bottoming at 0.5% last summer. It is worth remembering that the yield and price of a bond are negatively correlated, so as the yield falls, the value of the bond rises, and vice versa.

In theory, the yield on a bond cannot drop below 0%. However, for bonds to provide a similar level of return as they did during the last equity bear market described above, yields would have to fall to approximately minus 2%.  On the basis that such an outcome would probably bankrupt the financial sector, we doubt it’ll ever occur so must seek protection elsewhere.

• Foreign currency exposure – Sterling fell a little over 30% from late 2007 to the end of 2008.  Once again, this provided a considerable offset to losses in overseas assets held by UK investors.  The problem today is that following the post-Brexit devaluation, sterling is back in the vicinity of its multi-decade lows, and no longer appears overvalued.  So here too, we think it’s tricky to rely on a further drop in the currency to generate much of a boost from holding overseas assets.

Although there are no guarantees, below are a few assets that we think, in combination, have the potential to not only help preserve capital in the present environment, but hopefully continue to grow it in a good risk-adjusted manner:

• Equities in relatively depressed markets – “value” investing  which is the art of buying stocks which trade at a significant discount to their true value, has been in the doldrums, relatively speaking, for about a decade now.  Below is a chart showing a ratio of US growth stocks against the MSCI World Value index, which recently surpassed its ‘tech bubble’ highs.  Although of course past performance is not a guide to future performance, you’ll note from the chart that from a similar extreme in 2000, value went on to radically outperform for many years.  What equity exposure we have remains tilted in favour of the value style, in part for this reason.
• Alternative strategies - It's fair to say that from a full-cycle perspective we think there’s probably more risk to the growth style presently than there is absolute upside with the value style.  We think a good way to supplement this bias is therefore in strategies that have the ability to generate positive returns when markets are falling.  It is however important to note that such strategies involve additional risk as should markets rise instead of fall, large losses may be incurred.
• Gold – during the phase of an economic expansion when earnings and profit margins are expanding, you’d expect assets with growing cashflows to outperform gold.  But in an environment where profit margins are already very high, bond yields are close to all time lows and the dollar is close to its peaking, we think gold becomes a more interesting proposition as part of a diversisfied proposition, with potentially good upside.
• Cash – otherwise known as “dry powder”, has considerable value here, not because of the return it currently generates, but because of the opportunity it affords investors to establish more constructive positions as forward-looking returns improve. Being fully-invested in a bull market feels great. Being fully-invested in a bear market feels awful. For now, cash could be one way of lowering portfolio risk.

Many of the trends we’ve briefly discussed in this note have been going on for a long time: the outperformance of US equities; the relentless decline in bond yields; the bull market in the dollar; the relative bear market of active management, particularly with a value bias.  As such, investors get used to them and become almost resigned to their persistence.

We believe this is exactly the time when being active, patient and disciplined could add most value from a full-cycle perspective. We remain alert to profiting from the opportunities that may present themselves as these trends begin to tire.

Please remember that past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.  Alternative investments, including commodities, involve a higher degree of risk and can be more volatile and less liquid than shares and bonds. They should only be considered as a long term investment.