ARE WE THERE YET?
REUBEN BEELDERS – Chief Investment Officer
ABRI DU PLESSIS – Portfolio Manager
Equities, both global and local, have enjoyed a strong run over the past six months. Our multi asset funds exited equities in August 2018 and have remained equity-free since. We are increasingly facing questions from our investors as to when we foresee a move into equities.
THE SHORT ANSWER
These are some of the considerations that support us being comfortable with our indicators keeping us from equity exposure currently:
- Equity markets have run ahead of fundamentals and are already discounting far more than just a full recovery from the COVID hit.
- The stimulus packages, while useful, lack substance; they do not auger recurring or productive growth as an income/salary would. i.e., it will create a high base effect that markets should look through.
- It seems that a significant portion of the various stimulus packages may end up in savings accounts rather than being spent.
- The global economy was already struggling to grow before COVID.
- The Chinese economy is showing signs of having matured.
- The US FED failed to deflate its huge balance sheet or normalise interest rates after the GFC. Every time it tried to implement measures to do so, markets would start falling or consumption weakened. What/why would it be different this time?
- While many investors are euphoric about the US FED “promising” not to raise interest rates until 2024, we are less sanguine: whenever the FED has adopted for this approach in the past it has been due to the economy being in need of the support of lower interest rates – not an environment conducive to strong profit growth.
- The market currently has a fixation with inflation. A pickup in inflation would not necessarily mean real growth or demand picking up…stagflation?
- Commodity prices are currently being driven by supply issues rather than by demand (catch up from COVID’s effect on productivity).
- Markets still seem to run on FOMO and this euphoria is reflected in very low cash levels in portfolios; the Bank of America Fund Manager Survey has fund manager cash levels at low levels last seen in 2013. If all the cash is already invested, who is going to do more buying?
- When retail investors start to play an increasingly prominent role in markets, it is usually an indicator of the end of a cycle e.g. Gamestop, Bitcoin, etc.
THE LONGER ANSWER
A quick refresh on the nature of our multi asset funds:
- Asset allocation decisions are made as a result of signals from our data-based fundamental indicators.
- No forecasting is taken into consideration by the investment team. They adhere very strictly to these indicators when implementing any changes to asset allocation in the multi asset funds.
- While equities are expected to be the best long-term performing asset class, there have been times when they have not offered adequate risk-adjusted value. Buying equities at these points in the cycle could in fact result in negative returns for the investor.
- Sell/Bear Indicator: Economic activity moves in cycles, commonly called the business cycle. Company earnings follow this cycle closely. In turn, company earnings drive share prices. And this is what drives the ‘Gryphon Sell Indicator’.
- Buy/Bull Indicator: Interest rates reveal a lot of information about the business cycle and inflation expectations. It is commonly accepted that the interest rate yield curve, long term rates minus short term rates, follows the same cycle as the economy. A positive yield curve indicates positive economic and company earnings growth. This is what triggers the ‘Gryphon Bull Market Indicator’. Our yield curve indicator is not yet seeing real underlying growth.
- More insight to the mechanics of the fund can be found ..
THEN & NOW
Late in August 2018, local indicators signaled a bear market in equities. Based on this, the Gryphon Prudential Fund (Reg 28 compliant) sold down from 75% in equities to 0% in equities. The Gryphon Flexible Fund moved from a 100% allocation in equities to 0%.
So, to the burning question; how are equities “valued” today compared to our equity exit point, 28th August 2018?
A common valuation metric used for equity markets is the Price Earnings Ratio. The price-to-earnings ratio (P/E) is the ratio used to value an equity investment (individual company or index) by measuring its current share price relative to its earnings-per-share. The table below provides a snapshot comparison:
The index is therefore more than 10% higher (or more expensive), while earnings are lower than they were when we exited equities.
An alternative view would be to consider that the price of the index is equal to the P/E ratio multiplied by the earnings, lower earnings should result in a lower index price. As can be seen above, the combination of lower earnings and a higher price results in a higher P/E ratio, i.e. we are paying more for each unit of earnings.
The chart below reflects the average Price Earnings Ratio of the JSE All Share Index from the inception of the index in mid-1995. Over this period, the average of the ratio has been 15.8x. This means that investors have, on average, been prepared to pay 15.8x the earnings of the index to invest in equities.
This graph also clearly illustrates that investors buying equities at ‘cheaper’ levels, i.e. lower P/E levels in 2003 and 2009 would have performed very well over subsequent periods.
Why does this matter?
It is our view that for equities to trade at the long-term average Price Earnings Ratio, earnings would have to grow by more than 50% to merely offer “average” value, let alone exceptional value.
The only rationale for buying equities right now would be if a strong recovery in underlying earnings was expected; not just a recovery to levels of before the exogneous event of COVID, but to at least significantly higher levels than pre-COVID earnings.
Underlying economic growth is likely to remain muted. Although a large component of the earnings of the All Share Index is earned offshore, we do not believe that a sufficiently strong earnings recovery will occur to justify an investment in equities at current levels.
MULTI-ASSET FUNDS VS EQUITIES
The purpose of any effective multi-asset strategy should be to generate returns in excess of the underlying asset classes; a fund manager has the opportunity to move between asset classes and thus optimise returns.
The graph below illustrates the performance of our multi asset funds from the time we sold equities, i.e. 28th of August 2018, versus equities to date.
It is useful from a number of perspectives:
- Despite the current euphoria around equities, it’s worth noting that an investor in our funds would have returned 33% while and investor in local equities would have returned 22%.
- The significant volatility experienced by equity investors over the period has been avoided by investors in our multi-asset funds.
- Cognisance of downside risk has generally resulted in our investors preserving their net asset value.
Given that these funds make asset allocation decisions based on signals from data-based indicators, the challenge for any investor is to have the discipline and fortitude necessary to sit and patiently allow events to unfold, and to wait for the indicators to do what they do. When invested in a strategy such as Gryphon’s multi asset strategy, the temptation is to second guess the indicators, to watch wide-eyed while you feel like you’re missing out opportunities in the market. And that’s all the ‘risk’ is…opportunity cost! Bear in mind that regardless of which way the market goes, there is minimal risk to an investor’s capital. This is the mainstay of these funds – while they may be aggressive in their asset allocation, they are constantly cognisant of protecting investor’s capital…and this ultimately results in inflation-beating returns.
Finally, from the doyen of discipline, Charlie Munger:
“Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Systematically you get ahead, but not necessarily in fast spurts. Nevertheless, you build discipline by preparing for fast spurts. Slug it out one inch at a time, day by day. At the end of the day – if you live long enough – most people get what they deserve.”