Bearish investors need to beware – the strength of the upcoming market rally is likely to catch everybody by surprise. I see returns in the region of 15% to 20% over the next 6 or 12 months.
There are a number of concerns currently, which is why investors are so demonstrably bearish, holding elevated cash levels and are overexposed to defensive shares and bond proxies. While this strategy has worked very well for a lengthy period of time, there are already signs of change in the air – most notably the gradual lift in global bond yields.
However, there are two near-term headwinds we need to overcome before markets can move higher – November’s US elections and another likely hike in US interest rates in December. As always, markets dislike uncertainty and this election is alarming for all observers. While, any outcome is better than the present confusion, a likely win for Hillary Clinton will enable investors to overcome this uncertainty and once again concentrate on other things. Recent Purchasing Managers Indices are all pointing to better times ahead and labour markets continue to generate jobs, albeit in a slightly sub-par fashion. This should be sufficient to allow the Fed to raise rates by a quarter of a point in December, likely accompanied by a dovish message.
So, come December, we will have two major uncertainties out of the way – at a seasonally strong period for equity markets. This powerful combination is likely to lead to strong performance for many global equity markets.
What about valuations? While US valuations are 10% to 15% above ten-year averages, almost all other markets are cheap by the same comparison. This means returns are likely to be strong globally, with the most powerful gains outside of the US.
Much more important than all this, is portfolio composition. It is very common for investors to have significant positions in stable companies displaying strong cash flows, high dividend payouts and subsequent low volatility of earnings and share price movement. However, with a continued economic recovery and gently lifting interest rates, this could well be a disastrous strategy. The generally elevated valuations displayed by these sectors are a big risk. It is striking that there have been significant inflows into low volatility funds for much the same reasons. Paradoxically, it is this very investor focus that will eventually cause these sectors to overinflate and fall. It is really a question of when, not if.
After years of poor or patchy performance, financial sector shares have started to do well in recent weeks across a number of geographies. Of course slightly higher rates help, but there are hints of an easing of the regulatory burden – primarily in the US – that could allow more to be returned to shareholders. This is potentially another powerful combination. We are mindful of the fears surrounding Deutsche Bank and are keeping a watchful eye for any contagion, but do not see this as a repeat of the 2008 Global Financial Crisis.
I firmly believe the outperformance by defensive shares and bond proxies is over and the baton will be passed to value and interest rate sensitive stocks in coming months. This could be a real issue for portfolio managers still hiding out in ‘safe haven’ names.
The value of investments may fall as well as rise and investors may not get back the amount invested.
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