Five investment trust legends preparing for a market crash
22nd November 2013 18:15
by Esther Armstrong from interactive investor
Here it comes: a fresh bout of uncertainty in stockmarkets based on the Federal Reserve's intention to cut back stimulus in "the coming months".
Will it be in December, January or March? The guessing has already begun.
Meanwhile, equity investors grapple with whether the tapering of quantitative easing (QE) will be good for stocks because it presumes a stronger US (and therefore global) recovery, or if it will be bad because the rug of artificial liquidity will be pulled from under investors' feet.
This is not a new debate, people have been querying the longer-term impact of QE, and its subsequent withdrawal, since it was first implemented in the wake of the financial crisis.
But the rumblings of the bears over the past couple of months have started to get louder.
To find out the impact of the US Federal Reserve's decision to maintain its asset-purchase programme at existing levels, read:What does the US Fed's QE-tapering delay mean for markets?
Jeremy Grantham, co-founder and chief investment strategist of GMO, which runs closed and open-ended funds in the US, has long been cautious on equities, predicting low to negative annual returns over the next seven years.
He believes the Alan Greenspan and Ben Bernanke (former and current chairmen of the Federal Reserve) regime of excessive stimulus, soon to be administered by Janet Yellen as the next chair, will proceed as usual and that markets will head higher.
Be prudent and you'll probably forego gains, be risky and you'll probably make some more money, but you may be bushwhacked and, if you are, your excuses will look thin."Jeremy Grantham
In his quarterly letter, released earlier this week, he says: "I believe it would take a severe economic shock to outweigh the effect of the Fed's relentless pushing of the market.
"Look at the market's continued advance despite almost universal disappointment in economic growth. Only Japan was a modest pleasant surprise at 0.7% ahead of forecast and the UK and Switzerland scraped home by the skin of their teeth. Everyone else fell short.
"There have been a few occasions when such broad disappointment with economic growth still allowed the US and most other major economies to make material upward moves in their stockmarkets. It is yet another testimonial to the global reach of the Fed's stimulus of equities - as was the very substantial decline in emerging market equities on just talk of tapering."
Blue-chip companies
Grantham predicts US blue chips will move between 20% and 30% higher in the next couple of years, with the rest of the world covering even more ground in at least a partial catch-up.
"Then we will have the third in the series of market busts since 1999 and presumably Greenspan, Bernanke, Yellen, et al. will rest happy, for surely they must expect something like this outcome given their experience," he says.
Clearly this scenario presents an even greater conundrum for investors who will want to reap as much of the rewards as possible without suffering the inevitable fall out.
Grantham does not recommend timing the market, however: "Be prudent and you'll probably forego gains," he warns, "be risky and you'll probably make some more money, but you may be bushwhacked and, if you are, your excuses will look thin."
Defensive
Aberdeen Asset Management's Bruce Stout is another investment trust manager who has been warning of the perils of unwinding QE, which he terms "economic vandalism", for some time.
His bearish stance has seen the he manages suffer some marked underperformance in the past year as he has missed out on a great deal of the market's gains.
The portfolio has been positioned defensively since 2010 because of his concerns, and has languished in the bottom quartile of the global growth and income sector this year because of this.
Have they reached the point where they are continually printing money because they are terrified of what might happen if they don't?"Bruce Stout
His longer-term track record is much stronger, with the trust producing top-quartile returns in five of the six years previously.
When the Federal Reserve failed to start tapering in September, having prepared financial markets for such an event, Stout said: "Addicted to debt and with no political will to change, perhaps central bankers are becoming increasingly impotent.
"Have they reached the point where they are continually printing money because they are terrified of what might happen if they don't? Against such an uncertain backdrop, in which sentiment likely dominates fundamentals, focus on capital preservation remains key."
He subscribes to the view that being invested in good-quality equities with strong sustainable profit growth is more defensive than holding cash or bonds because dividend growth can provide inflation protection.
Volatility
Elswhere, Sebastion Lyon from Troy Asset Management, who runs the has also lagged the market this year.
Robin Angus, executive director of the trust, says in its quarterly report: "In frothy and volatile markets like these it is usual for us to underperform the FTSE All Share, sometimes very substantially so, and it would be a surprise not only to ourselves but also to many of our shareholders if we didn't.
"As a matter of principle we do not invest in what we believe to be seriously overpriced assets which carry a risk of serious and perhaps permanent capital loss."
The trust currently has 8% held in cash, which the Association of Investment Companies (AIC) says is actually on the lower end of the spectrum compared with its historical average.
Yet, as Angus explains: "To be fully invested in equities today would, we believe, be too great a risk. Forecasts of corporate earnings, having peaked in late 2011, are beginning to come under pressure and we fell sure that the profit cycle has turned.
"We can find no compelling reasons to take a positive view on stocks and have therefore been gradually reducing our equity holdings."
Insurance
Yet another investment trust manager worried about equity markets retracing is Miton's Gervais Williams, who runs the . Rather than taking profits and holding money in cash he favours an alternative way to protect his portfolio from a market setback.
In the trust's October factsheet, Williams says: "With markets near new highs, and volatility costs close to absolute lows, we do feel the Put Option 'insurance' costs have become low enough for us to consider buying a FTSE 100 (UKX) Put to cover approximately one third of the fund's capital base.
The results of the great financial experiment, which we are only part way through, remain inconclusive and monetary authorities do not have the power to support equity markets indefinitely."Alastair Mundy
"With a Put Option in place the trust can remain fully invested, collecting the dividends on the portfolio, with less need to hold precautionary cash against a market setback."
Williams purchased the Put Option with an index strike level of 5,800, according to the AIC, 13% lower than the blue-chip index's close of 6,686 on Thursday.
The Diverse Income Trust has been the absolute best performance by net asset value in the UK Growth & Income sector over the past year, returning 45% compared with an average of 29.5% from its peer group.
The great financial experiment
Finally, Investec's Alastair Mundy, who runs the , is holding 12% in cash currently.
He says of the market sentiment just now: "In general, investors prefer strong, simple narratives and shy away from uncomfortable arguments. However, that often results in investment decisions based more on hope than objectivity.
"Our views remain the same - the results of the great financial experiment, which we are only part way through, remain inconclusive and monetary authorities do not have the power to support equity markets indefinitely. The unintended consequences and disadvantages of their adventurous policy are in all likelihood still to come."
With five lauded managers predicting rocky times ahead, it makes sense for equity investors to bank some of the gains they have made.
If they don't and the correction comes they will have only their greed to blame.