Tactical Asset Allocator: After the ‘santa rally’ markets may run out of steam

With equity market valuations stretched and volatility unusually low, is it prud

Oh dear. I write this in the Silly Season, in all senses of the phrase – when financial firms are trying to whip up news stories with festive-related themes; and, more perniciously silly, when investors remain convinced that stock markets can maintain their inexorable bull run. Crikey, the markets continue to rise despite the guilty plea of former NSA director Michael Flynn that potentially implicates president Trump in backroom deals with Russia!

Schroders, for example, has been peddling the idea of a Santa Rally, based on analysis of three decades of data which suggests shares surge in the run-up to Christmas. It claims that the FTSE 100 index is more likely to rise in December than any other month, and with a larger than average magnitude. The FTSE 100 has climbed by an average of 2.4 per cent in Decembers since 1987, the highest average gain of any month, while the worst month is June, when the index has slipped by an average of 1 per cent. In fact Schroders found that this phenomenon held up across world stock markets, as measured by the S&P 500, MSCI World and Eurostoxx 50 indices.

But just because the FTSE 100 has risen 83.3 per cent of the time in past December does not mean it will do so again this year. As with any technical analysis, what counts is not the pattern per se, but the economic or business story behind it.

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One theory is that the Christmas holiday feel-good factor injects goodwill in investors, who then make optimistic decisions, while another is that fund managers are rebalancing portfolios ahead of the year-end. But neither of these would result in increased share purchase and holdings if at the time investors believed that stock markets were peaking, as seems likely this Christmas.

As readers of this column know, the cyclically adjusted price/earnings (Cape) ratio valuation measure, which compares the price of a market with its annual earnings over 10 years, is now up at levels not seen since 1929 and 2000.

Until now, you could argue that lower interest rates justify the current exorbitant price/ earnings ratios, because investors are happy to pay more for £1 of earnings if the alternative is getting near zero from a government bond or bank account. However, central bank policy is about to reverse, albeit slowly. 

One outcome that could surprise investors is if not only the stock markets but also the bond markets fall sharply, in tandem. For the past 15 years, holding both bonds and equities has produced a wonderful diversified effect on portfolios; but the historical reality is that stocks and bonds tend to head in the same direction.   

Stocks and bonds in sync

Arguably, when stocks and bonds move together, that is a good thing, as it means profits are increasing, which leads to a higher valuation for stocks. But rising profits produce inflation, which encourages central banks to hike rates. This in turn raises borrowing costs for companies. As long as profits are increasing, stocks could keep climbing, but if the market is worried that the economy might slow down, then bond prices usually go up because investors flee stocks and buy bonds – a safe haven that in future will be more attractive owing to that central bank intervention.

In recent times, investors have increasingly purchased long-dated sovereign debt as a hedge against inflation – a strategy that proved highly successful immediately after Brexit, which has led to further widescale implementation.  This helps to explain why the market has experienced lower volatility over the last year – because this strategy requires less portfolio rebalancing (note that the Santa Rally theory depends on an intense year-end period of rebalancing) – and it also explains why low yields have been compatible with higher equity prices. 

The risk to the market arises if a shift occurs in the correlation between Treasuries and equities, and there has already been evidence of this. In the US, for example, stocks and Treasuries moved in opposite directions most days in the spring, but they have started moving in the same direction more often in recent months, and typically downwards.

In addition to the risk that higher yields drag down equities, investors could begin to offload their long-dated sovereign debt when they discover that the hedge no longer works, and move back into traditional hedges that have the effect of lifting volatility.

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When valuations are this stretched, even small snippets of negative news can have a big chain reaction on markets, so the risk of overheating lingers – especially in the US, which is late in the cycle. The bond markets are equally tricky because large chunks of Europe’s and Japan’s bond markets offer pitiful returns.   

In December, the Bank of Japan’s governor Haruhiko Kuroda put an additional cat amongst the pigeons by signalling the possibility of a ‘reversal interest rate’, a vicious cycle where if the central bank lowers interest rates too far, banks’ capital constraints tighten through narrower margins, impairing their ability to lend and prompting a contraction in the market. 

For now, fortunately, Japanese stocks are defying this scenario, helped by factors such as the influx of foreign workers as well as the unprecedented fiscal stimulus. But all in all, 2018 looks set to be a challenging time. 

Diversify with gold

Another way to add some diversification into your portfolio is through gold and quasi gold-linked emerging market currencies, which will benefit from dollar weakness, a slowdown in developed nation growth and emerging markets playing catch-up. The last currency to decouple from gold was the Swiss franc in 2000; however, India for example has issued sovereign gold bonds linked to the bullion price, to reduce bullion imports that push up the trade deficit, and these might be worth considering. As well as increasing in line with physical gold, these bonds pay interest of 2.5 per cent a year, half-yearly. 

Neil Woodford’s recent and much-publicised warning on the market alluded to European junk bonds yielding less than Treasuries, low levels of volatility and triple-leveraged exchange traded funds attracting gigantic inflows. He still has a huge following, capable of influencing the market. At any rate, it’s a timely reminder not to be complacent – the FTSE 100 bounced below 7300 on 1 December for the first time for two months, and largely recovered only as president Trump’s tax reforms lifted firms with exposure to the US, such as Ferguson and Ashtead Group.

We are therefore taking more profits off the table this month by sellling 200 shares in iShares Euro Stoxx Total Market Growth Large in an attempt to protect the portfolio should the Santa Rally indeed prove illusory.   

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