There is currently a mismatch between the strong performance of US equities and increased pessimism among investors. Since February, the S&P 500 has forged ahead fairly consistently, recently reaching record highs. Yet many investors distrust the rally. The indicators that we use on the OMGI Global Equity desk indicate that investor sentiment has worsened.
Why are investors pessimistic? They are painfully aware of multiple risks and sources of instability that could affect US equities. Worries about the outcome of the US election, worries about whether and when the US Federal Reserve will again raise interest rates, and worries about weakness in US corporate earnings are among the themes keeping investors awake at night. But the odd thing is, despite all these worries, equities have performed remarkably well. You could call the rally of the first half of 2016, the ‘guilty rally’: most believed that it ought not to happen, that it should not happen, that it was wrong for it to happen, but in the event … it happened anyway.
Source: Bloomberg, as of 23 August 2016
It would be easy to draw a rather obvious conclusion: that a correction in US equities is imminent, investors will come to their senses, abandon the rally for the ramshackle construction it has become, with a consequent sharp fall. But I do not draw this easy conclusion. Thinking back over market history, there are many occasions when markets have seemed difficult, intractable, and self-contradictory. In fact, complexity is rather normal.
It is all too easy to suppose that your current environment is the worst environment. But when you think back, it is usually the case that conditions are highly uncertain. It is not unusual, but quite normal, for investors to be confronted with looming events which could go either way, and whose outcome significantly impacts the course of markets.
So, how should investors cope in a contradictory and uncertain world? Some, faced with the inscrutability of markets, go passive: they buy a tracker fund or an ETF. And the fact that most active managers have historically underperformed the S&P 500 only appears to support them in this choice.
I believe it is possible to beat the S&P 500. But I also think that active managers often try to do so with one hand tied behind their backs. They buy too much of one kind of share. They build highly concentrated portfolios, which may perform well in some market conditions, but do badly in others.
Many fund managers have concentrated styles, such as a value style (preferring shares that are cheap in relation to their history), or a growth style (preferring shares in companies that appear to be growing faster than average). So the returns resulting from their portfolios naturally behave in an unstable manner, and they struggle over the long term to beat an index that is well diversified.
It is essential to successful investing to be diversified. It is also essential, in my view (though this is not often done) to be diversified across different investment styles. So we aim to use different styles that behave slightly differently as markets change. That way, we seek to build a portfolio that is flexible, robust, and resilient in the face of the market’s changes of mood.
The portfolios we build include shares aimed to perform well in a positive environment for equities, and also shares selected to backstop the portfolio in an environment of instability. At the moment we have a roughly 50-50% mix between the two.
I am not suggesting that sentiment within equity markets is deteriorating aggressively; but neither am I suggesting that the rally since February will continue for an extended period of time. Investors who avoid pinning their hopes too irrevocably to either possibility have the highest probability of outperforming over time.