June 23, 2024
If you are an investment professional, you will know that there are always many things to complain about in markets. In fact, there is always an excuse NOT to invest:
(·) "stocks seem too expensive"
(·) "geopolitical risk is high and you never know what can happen tomorrow"
(·) "inflation remains too low/too high"
(·) "markets are moody these days and sentiment is too positive/negative"
(·) "look at that yield curve: a recession is coming"
etc etc
What is a better bias: fear vs overconfidence
Some of the above complaints are reasonable. And from time to time, they happen to be true. Think about the bloodbath experience in 2022 in government bonds (considered a safe investment) when rising inflation killed the asset class. But in many other instances markets move higher without paying too much attention to those generic issues.
Buying assets at any price can be a costly error. Staying out of the market because of continuous concerns is also a costly error.
So what is a smart way to invest regularly then while being squeezed between fears and opportunities?
Some recent conversations
In May and June I have been talking about markets (or meeting in person) with a number of expert investors (friends, colleagues, clients) working in Italy, Switzerland, Hong Kong, London. I understand that not many have turned around their portfolios in 2024 to enjoy the ongoing, unexpected equity rally.
In fact, many of them still have too much fixed income - maintained after a disappointing 2022 with rising inflation and increased in 2023 as yields seemed "cheap" and interest rate cuts were coming on the table - and not enough stocks.
They wisely followed the main market narrative of finding value in cheap bonds while waiting for the announced rate cuts (typically prompting a bond rally) and avoiding equity markets over-excited by the AI paranoia. The strategy was logical. But the resulting portfolio performance has been disappointing.
Market narrative
What would you do if government bonds are cheap and inflation goes down? It would be the time to buy bonds. And what would you do if you see the news like the ones below? You would try to avoid the general euphoria and sell/avoid expensive stocks before a possible fall, right?
Yes, it would be the right decision-making process.
But it has been wrong this year.
Incongruences
Take a look at the S&P 500 (= US equities), as a proxy for stocks behavior. It is going higher and higher.
We can look at the PE (price-on-earnings) ratio (on "reported" earnings) at 28.4x to confirm that US stocks are very expensive right now.
What happens if we plug-in future earnings expectations? Well, the forward PE ratio goes down quite a lot. The answer here is the opposite than before: assuming future earnings expectations are correct (company earnings going higher in the US on strong consumption and a growing economy), the S&P PE is dropping to 22.6x landing on its historical past-30-year average => not expensive.
In our model portfolio, our equity position sits around 73% right now, well above the neutral 50%.
It might well be that earnings will fall and stocks will prove to be expensive. We believe the trick is in the ability to fine-tune stock exposure to safer if still-performing bets (think about Quality stocks) or cycle-tilted bets (think about Momentum) to ride the best segments of the market at the right point in time.
To do this, it is mandatory the ability to tactically move to change if conditions change.
And bonds?
To cut a long story short, bonds could continue to struggle if inflation is not tamed (something we do not know about) or could soon rally if economic growth slows down (or more rate cuts will be confirmed across the US and EU).
We have less than 20% of our portfolio in bonds, much lower than our neutral 50%. Instead of deciding how many bonds to add or remove to our portfolio, the focus should be about what can work in this environment or in this phase of the cycle.
With a beautiful income stream offered by ultra-short bonds without sensitivity to inflation or rates - at 5.5% in US and almost 4% in Europe - it is easy and safe to add/keep cash proxy fixed income into our portfolios. But these assets would not protect in case of economic meltdowns.
So we are adding long-duration instruments (less than 5% of the portfolio) to enjoy cheap valuations, to add protection to the portfolio in case of unexpected issues, but still limiting the exposure to higher inflation.
Conclusion
I have always been a fan of market narratives as it allows to exploit human feelings and portfolio positioning.
But since 2022 the narrative has been too focused on issues and too little on facts. Disciplined decision making, eventually supported (not run) by machines and AI, can help smart investors reduce the weight given to feelings and narratives and increase the ability to focus on the right pockets of the market.
Happy week-end all!
