WAITING FOR THE LIGHTS TO CHANGE

Reuben Beelders – Chief Investment Officer

October 2019

“I don’t make predictions, and I never will”
Paul Gascoigne

Our multi-asset funds were launched just over 5 years ago on the 1st of May 2014. Absolute and relative performances over this period have proven our fund design to be effective and the results achieved have been in line with our expectations. For the 12 months ended 31 August 2019, the Gryphon’s Flexible and Prudential Fund of Funds have returned 5.78% and 5.39% respectively.

While our funds may have behaved as we’d expected, what was not expected was the market’s reaction to our dynamic asset allocation. Being fully invested in either equities or cash has been challenging for most investors to grasp.

We are currently fully invested in cash and have been for the past year. The question we are repeatedly faced with now, is when will we move back into equities?

This is understandable in that equities have, over time, been the asset class of choice and the asset class that has most effectively preserved the wealth of investors against inflation.

Like Paul Gascoigne, we don’t choose to make predictions. However, transparency in the management of these products compels us to consider various scenarios.

What are our expectations of the future, and what signals from our proprietary indicators would announce a return to equities?

Based on our assessment of financial history, we believe that there are a few scenarios that should be considered as to how financial markets will evolve over the near to medium term. For example, markets could trend sideways for an extended period. Or, as has often been the case in the past, there could be a dramatic sell-off in markets which, while traumatic for investors, achieves the purpose of restoring value quickly. Then again, markets could continue to trend higher…

We consider each of these scenarios in more detail below:

1. Trending sideways for the near to medium term:

We assign a 40% probability to this eventuality. Why so high? Unlike in the past, Central Bankers are desperate to keep asset prices elevated as they have very little armoury at their disposal to keep inflation from going negative. Central Bankers could therefore cut interest rates more aggressively than has been discounted by markets.

So, while we may be in exactly the same position on major global equity indices in five to ten years’ time, the volatility over these periods is likely to be significant.

Historical precedent for this projection is the Japanese market post 1980, and then the U.S. market post the dot-com bubble in 1999. Also worth considering is that the U.S. market displayed very similar characteristics from 1969 for the subsequent 10 year period.

As can be seen from the chart below the Nikkei 225 Index has still not recovered its peak which was reached in 1989.

After the frothy conditions of global markets in 1969, U.S. markets trended sideways, with lots of volatility for a 10-year period:

While a single period of no capital return could be considered an aberration, this was not the only time this occurred in U.S. markets, as the graph of the S&P500 index below shows. Subsequent to the Nasdaq bubble in 2000, markets delivered no capital return to investors for the next 12 years:

South African investors endured a similar experience during the 1970’s; the graph below shows that very little capital return was generated by equities during that time.

While there are any number of reasons to explain these ‘flat’ or ‘no-return’ periods, we believe this is chiefly due to valuation.

In a seminal paper produced in 1998, Campbell and Shiller consider prospective long-run stock market returns to the Cyclically Adjusted Price Earnings (CAPE) ratio.

There is a clear inverse relationship between valuations at the beginning of a 10-year period and the returns over the subsequent 10-year period. As such, when markets are reflecting high valuations, investors should be aware that lower returns into the future are more than likely.

We have deliberately used a graphic from this paper which is now more than 20 years old.

While this graph will not assist in determining short-term investment returns, its record over the long-term cannot be ignored.

Based on our assessment of markets currently, lower returns from equities are more than likely into the future.

2. A dramatic sell-off in markets:

Financial market returns have ostensibly been stellar over the past 30 years.

As such, advice is generally that “it’s not timing the markets, but time in the markets” that adds value to portfolios. We would contend, however, that there is also “a time to not be in the markets”.

We are of the view that the former statement excuses financial professionals from having to make asset allocation decisions.

Our own research, and that of countless others, indicates that most portfolio value comes from asset allocation. How much value are investors assured of then if no asset allocation decisions are being made?

Why would there be a market sell-off? Let’s consider a few reasons, and while lengthy tomes could be written in respect of each of these, we will simply mention a few pertinent points for each:

2.1. Valuation and underlying earnings growth:

Markets that are not cheap may be discounting strong earnings growth into the future.

We believe that the following factors will impact the ability of corporations to continue to grow their profits at the levels of recent years. We are cautious about the forecasts of bottom-up analysts who continue to forecast 15% earnings growth. We don’t believe these numbers are achievable. Two reasons for this are mentioned below:

2.1.1. The tightness of the U.S. labour market:

With the U.S. unemployment rate currently at very low levels, many economists are perplexed by the failure of inflation to show signs of picking up.

We are less concerned as about the “Why?” as we are about the “When?”

2.1.2. Populism, regulation and returns to non-shareholders:

While many view these as unrelated, we see them as part of a secular trend and a headwind against future corporate profitability.

2.2. The length of the current U.S. economic expansion:

While this may seem an obvious statement, it is worth remembering that the risks of an economic downturn increase as the length of the current expansion increases.

2.3. Inversion of the yield curve:

While very few indicators are infallible, the recent inversion of the yield curve in the U.S. is one we choose not to ignore.

In addition to it having a very good track record we believe that, combined with the above factors, it increases the risk of a drawdown in equities.

Taking these factors into account we suggest the likelihood of a dramatic sell-off in markets to be a 50% probability in our forward scenario planning.

3. Markets continue to grind higher:

Despite the fact that markets are “expensive”, they can become “more expensive’. As John Maynard Keynes is alleged to have said:

“The market can remain irrational longer than you can remain solvent”

While we assign the probability of 10% to this future scenario, it is nevertheless a scenario that cannot be ignored.

Ironically, we are very comfortable with this scenario because the current position of our funds exposes us to a cash return of around 6% currently.

In conclusion, investors often confuse absolute returns and relative returns. However, we have no confusion in this regard. We only appear to “lose” relative to other funds. On an absolute basis, our investors not only enjoy strong returns, they also do so without having to stomach the extreme volatility currently being experienced in financial markets, as illustrated in the graph below.