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What to do in a Bear Market?
It's a nervous time in markets, so the following thoughts and analysis might help. Bear markets in equities are normal and no one knows their duration or extent in advance.
The sell-off in US equity markets on Wednesday (24th October) finally confirmed that we are in a global equity bear market. Dow Theory, the technical indicator on US equity markets, may have given a 'Buy' signal on 21st September last (as highlighted in that week's newsletter), but it reversed that signal on Wednesday last with a 'Sell' signal. As the US and global economies are in good shape and corporate earnings growth is healthy, this looks very much like a valuation correction in markets. The chart opposite highlights that well. Price-to-earnings ratios on markets have been falling all year.
The positive side of this is that valuations outside the key US equity market now look attractive so we doubt very much that Eurozone, Asia-Pacific and emerging equity markets have much further to fall. After all, interest rates remain extremely low. The table below highlights Eurozone equity markets trading on just 14.4 times 2018 estimated earnings. That's an earnings yield of 6.9% when European 10-year government bonds offer a fixed yield of below 1%. Trade tensions between the US and China in particular and a stronger dollar have weighed on Asia-pacific and emerging equity markets, so that they are even cheaper on 12-13 times 2018 earnings estimates.
The first thing we might reiterate is that while we keep an eye on some technical indicators to help tell us the likely direction of markets (Dow Theory, Coppock and the 30 & 50-Week Moving Average indicators), we do not make investment decisions based on such market timing tools. And this time around the 30 & 50-Week Moving Average Indicator has been a reasonably good guide, signaling for quite a while that the global equity markets x-US were in a defined downtrend.
We actually make investment decisions based on the quality and value on offer in individual companies and individual funds. This means that when markets decline, as they do reasonably regularly, assets we hold also decline in value. It's not comfortable seeing something you own decline by 20-25% in a few months. But, that is the nature of markets.
Short-term volatility, as we are experiencing now, means very little on a 5-year view. In terms of making investment decisions, the following are the relevant questions we ask:
- Has the long-term earnings power of the business you own deteriorated to the extent that business risks have increased and you might consider selling?
- Has the business taken on too much debt to the extent that management is in danger of imperiling shareholders' equity (like Aryzta)?
- Has the share price of the business you own risen to such an extent that future returns have been delivered already, which compromises the business's ability to deliver a decent return to you on a 5-year view from here (valuation risk)?
We only recommend actively managed funds (investment trusts and off-market investment funds) where we believe the fund manager pays attention to these same three core risks.
That being the case, if you are happy that the business, financial and valuation risks are low in all your holdings, then such weakness in markets as we are experiencing now is not a threat; it's an opportunity. You must always remember that volatility in markets is not risk. It's easy to forget that core investment fact. Your job, and the job of this website and your advisor, is to figure out what you want to do about it.
What you do about periods of weakness in markets depends hugely on whether you are a 'Lump-sum Investor' or a 'Regular Investor'. We define the lump-sum investor as one that has capital but cannot add to that capital in any meaningful way. The lump-sum investor has to sit out such weakness in markets with patience. To get unnerved by market weakness and to sell out of otherwise sound holdings is to risk taking a permanent loss, when none needs to be taken. A quick look back at the deep 2007-09 global equity bear market will help reinforce the point.
Kerry Group's shares peaked at circa €23 in early 2007, but fell to under €14 by early 2009 despite earnings resilience at the group. That was a near 40% share price decline. Kerry's shares are near €90 today, as, like gravity, the share price eventually had to follow earnings upwards. Kerry is not a cheap stock today, but it remains a quality long-term hold. DCC, the business services group, had a similar experience. Like Kerry, DCC's earnings remained on an upward path during the Global Credit Crisis, yet it's share price also suffered a 40% plus decline from a peak in early 2007 of near £17.50 to a low of near £9.50 in early 2009. Today, DCC's share price is over £60.
The Lump-sum investor has to decide at the outset what proportion of his/her assets should be in risk assets in pursuit of the higher returns they have always delivered. In contrast, the Regular Investor is someone who is investing over time, in good market conditions and bad. The risks of poor timing in equity markets for the regular investor are much lower because he/she is not investing at just one point in time, but over time. At times, the regular investor may be overpaying (when markets are richly valued) and at other times, when markets are depressed, they will be getting great value. Over time, things will average out and an investment programme that invests in equities (real businesses), where the returns have always been higher than in bank deposits in the past, should work out fine.
A good investment advisor, we believe, is there to ensure that emotions don't make decisions. The media is often critical of the investment advisory community saying that they don't beat markets so why do you need them. In our view, this misses the point. We believe that a sound advisor is not there to beat markets, but rather to get the returns on offer for clients and to have a strategy in place for individual clients that is not derailed by market volatility.
Translating this into practice for regular investors in the members' area of our website is the Regular Investor's Subjective Growth Portfolio. Translating this into practice for the Lump-sum Investor is The GM Fund. As many subscribers will know, the fund is not a pure equity fund, but has a balanced mandate. However, as traditional risk-free assets offer no return (bank deposits and government bonds), the fund currently has no allocation to either bank deposits or government bonds, but instead has chosen to take added risk by having a 20% weighting in US & European Defensive Global Consumer Franchise stocks in place of long-dated government bonds (Coca-Cola, Diageo, Unilever, Colgate, Mondelez, Heineken etc). And these stocks have acted defensively in the current market sell-off as you would expect. The fund has a further 22% in 'Alternative Assets' that have little correlation to equities (or to the general economy) and that can provide returns of 5-6% per annum with minimal risk.
In The GM Fund, within equities, we are using the current weakness in markets to top up stocks we believe offer good value and have strong business models. With new cash coming into the fund along the sale of some defensive positions, we have been topping up the holdings in Berkshire Hathaway, DCC, Ryanair and Applegreen in particular. We have bought a new holding in Associated British Foods (the owner of Primark) as we believe the Primark retail business has a competitive advantage and years of predictable growth ahead of it, and the shares offer good value. We have bought a new holding in the AVI Japan Opportunities Trust last week and we are averaging into the TR European Growth Trust, whose share price is off over 30% this year. The managers of both these investment trusts presented at our recent conference.
As outlined at our Annual Investment Conference in the Shelbourne Hotel on 10th October last, we believe US equity markets are priced to deliver returns of 5-6% per annum on a 5-10 year view. Berkshire Hathaway, as we outlined, is leveraged through its massive insurance float so that we would expect Berkshire Hathaway to deliver returns in the order of 7-8% per annum over the same 5-10 year timeline. Recall that Berkshire is actually paid to be leveraged. That's right! Most companies pay to borrow, but Berkshire earns a positive return on its insurance underwriting. So, Berkshire gets to use its insurance float to buy additional assets and the returns from those additional assets go to shareholders.
With that understanding of Berkshire Hathaway (and Markel has a similar business model), investing these two stocks appears to be a more sensible way of investing in US equity markets compared to just tracking the US equity market via an exchange-traded fund!
GillenMarkets exists to assist private investors to develop a sound savings and investment plan. That includes the person just starting out who can save and invest regularly over his/her lifetime to the person with pension assets to the person with a lump-sum to invest. We can assist in the following ways:
- We hold 1-day investment training seminars that empower you to become a successful investor. You don't need to be Einstein to understand investing and to start a sound investment plan. Our next seminar is in Dublin on Saturday, 1st December, 2018.
- We publish Ireland's only subscription-based investment newsletter that allows you to access impartial investment advice and sound investment suggestions along the way so that you can do the investing for yourself, cheaply.
- We provide wealth management services for those who don't wish to do any of the investing for themselves. Many people are time poor, don't have the interest in investing for themselves or simply recognise that they get too emotional when market conditions deteriorate.
If you have an interest in any of our three services just contact the office by telephone (01 2871400) or by email to email@example.com and we would be delighted to hear from you.
14th November 2018