When in doubt...

History proves time and time again that the stocks with the most upside priced in, likely fall the farthest. We see this effect in every market, including real estate and commodities.

In markets today, we are seeing some lofty valuations, as investors chase prices up, in the search for yield. With interest rates drifting lower, what premium will markets require to secure diminishing returns? At some point, the fundamental ability of a business to sustain and grow its earnings has to underpin the price we pay for these future earnings. Right now, the fluff in the market is all about the return differential to the risk free rate. So, what happens when interest rates just can’t fall any more?

It is impossible to know when markets will correct. Their fall from grace is as inevitable, as their long term rise, so should we even worry about what can happen to the paper value of our investments?

We know that if we hold through the good and bad, that we win the race, but to finish first, you must first finish. So we need strategies to be over or underweight. We must keep a quality focus, and we should question everything. In that regard, I see a lot of debate at the moment regarding active or passive investing.

We are in the mature stages of a prolonged bull market. To be fair, this market came off a very low base (the GFC); and it has been expanding on unconventional monetary policies, as Central Banks have pushed and pulled every lever to avoid a recession. But recessions are actually a necessary part of the economic cycle. They provide a cleansing fire to get rid of inefficient businesses, to open the door to new ideas and new talent. Increasingly, I hear more and more about “zombie firms” (they’re dead, but they don’t know it).

As the market grinds to new heights, it gains more support from passive index funds. You see, in a passive fund, the weight of money that pushes into the market, will find its way to the stocks that are at the time being bid to what may be illogical levels. More money pushes prices higher, the stock becomes a bigger part of the index, and more capital is thus directed toward it – it’s a virtuous circle.

Active managers will try to avoid this phenomenon, but by doing so, they appear to underperform the market. By working to steer clear of the over-inflated prices, they dwell in stocks less loved, and so their performance lags. Ironically, this leads to more money moving to passive funds, bidding higher irrational pricing, and the demise of those active managers who struggle for scale. In some ways, it too is a cleansing, as the remaining active managers are the better managers. Their opportunities amplify when the indices do finally fall, causing widespread havoc. Just as passive indices push prices higher in a bull market, they will also drag prices lower in a bear market, indiscriminately selling stocks, irrespective of their underlying fundamentals simply to reallocate their weight in those stocks to a new (lower) benchmark. It becomes the proverbial tail chase.

So – what’s the answer?

There isn’t one. Diversification is one solution. Having active and passive components and ideally the best of each. Time and fortitude are important ingredients and importantly the capacity to be brave when prices are falling. Make sure your portfolio reflects your position, one size seldom fits all. Tailoring is the solution.

Tony Munro CFPCM, Post Grad Dip. Bus.Studies (PFP), AFA, FSP 5501

The views and opinions expressed in this article are intended to be of a general nature and do not constitute personalised advice for an individual client.

A disclosure statement is available on request and free of charge.

#getgoodadvice #buyqualityinvestments #independentadvice #longterminvesting #diversify #financialgoals #financialplanning

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