Catching the stockmarket surge

The stockmarket boom looks set to continue, say private bankers. Nervous investors are going to have to take the plunge into equities, despite their memory of the traumatic events of 2008. They simply have no choice, as returns elsewhere will not offer a decent return.

“It’s a strange period, unique in many ways,” says Yves Bonzon, chief investment officer at Pictet Wealth Management in Geneva, summing up the mood of many. “Equities are probably not overly expensive on average, but they’re not cheap either by any standard. But when you look at the menu of investment options, they are probably at the top of the list given that many of the alternatives are extremely unattractive.”

It is, of course, resoundingly normal for any equity market boom to be accompanied by a large measure of fear that it will all come to an abrupt and sticky end. “The stockmarket always climbs a wall of worry,” says Keith Wade, chief economist at Schroders in London.

Much of the rally, suggest Swiss bankers, may have been driven by defensives. This is perhaps slightly atypical for traditional
rallies, which are based on high-beta stocks.

This indicates equity bulls are more than usually nervous – and reluctant to forget the past. Mr Wade at Schroders thinks the 2008 crash continues to affect the way equity investors play the market, giving them a bias towards income stocks. “People feel a little more secure if they can see the returns coming in terms of dividend income, without them having to bank so much on capital gains,” he explains.

The most compelling case for equities derives from a sober assessment of the alternatives, say private bankers and analysts.

“We think equities is probably the most attractive area at the moment,” adds Mr Wade. “In the search for yield, people have been driven out of cash, so they went into government bonds. Now they’re being driven out of government bonds.”

SEARCH FOR YIELD

Ultra-low interest rates in developed economies are leaving investors with negative real returns on their cash. Schroders says that although people have been shocked by the losses on bank accounts in Cyprus, holders of UK accounts have, in real terms, lost comparable amounts. Ten-year yields on US, UK and German government bonds are all below inflation.

Investors have responded by going into high-yield corporate bonds, and as a result even US corporate high-yield indices have dropped below 6 per cent to reach “virtually all-time lows”. Mr Wade believes this compares poorly with blue-chips offering dividend yields of 2.5 or 3 per cent, plus prospects for dividend and capital growth.

The wave of hybrid products being issued provides one of the best examples of an excessively aggressive search for yield in credit markets, according to Pictet’s Mr Bonzon. He cites contingent convertibles, also known as coco bonds, whose value is contingent on particular events. Private bankers have expressed surprise at the many times oversubscribed demand for Barclays’ November 2012 10-year cocos, which offer a high 7.625 per cent coupon but will lose their entire capital value if the lender’s common equity tier-1 ratio falls below 7 per cent. “The credit markets are the one area where I see a cyclically excessive build-up in pricing,” concludes Mr Bonzon.

Claudia Panseri, equity strategist at Société Générale Private Banking in Paris, sees “little upside for corporate bonds as rates cannot fall much further”. She notes that despite the pronounced move by investors into risk assets in the year to date, US investment-grade corporate bonds have produced a return of only about 1.5 per cent.

This is a fraction of the returns in US and some eurozone equities, though some emerging market bonds have produced a slightly higher return. “If clients want positive total returns by the end of the year, unfortunately they need to take more risk,” warns Ms Panseri. And that means going into equities.

POSITIVE OUTLOOK

Private bankers do, however, see some positive virtues in equities as well as negative vices in everything else. When it comes to stockmarkets, “systemic risk is now close to zero” says Ms Panseri. She cites the abscence of major events that would throw the entire global equity market boom into doubt, such as more hawkish policy by the Federal Reserve or European Central Bank, or a country exiting the eurozone. The latter is “always possible, but the risk is probably much lower than a year ago”.

Private bankers believe September’s impending German federal election will reduce systemic risk by casting a protective shield over equity markets, since the all-powerful German government will be anxious before then to avoid any policies, such as a more hawkish approach towards monetary policy, which could create volatile markets.

Many share the sense that systemic risk for equities has fallen. “The risk of tactical setbacks over the next few months is probably increasing, but we retain a very comfortable strategic view that we are in a secular bull market,” says Lars Kalbreier, global head of mutual funds at Credit Suisse in Zurich. This is founded on his confidence that concerted central bank action in developed countries “remains extremely supportive”.

In addition the tail risks from Europe seem to have receded somewhat, he believes. “That is something which bodes very well, overall, for risk asset allocations.”

Alan Higgins, chief investment officer at Coutts in London, thinks benchmark rates in major developed economies are likely to remain below 1 per cent until 2017, boosting equities for a while to come.

Even if systemic risk for equities has fallen, the opportunities for making decent returns on stocks will have evaporated if all investors have already moved into equities, thus eroding the opportunity for further price gains, in line with the old investing saying that it is time to buy stocks when everyone has become a bear, and time to sell them when everyone is a bull.

Wealth managers say we are still a long way from universal bullishness. After the “traumatic shocks” of the credit crunch, investors continue to be underweight equities, says Mr Kalbreier of Credit Suisse. “Risk appetite remains fairly low. It hasn’t really recovered as much as in previous cycles.”

The view at rival Swiss bank Pictet is that those with “a commitment to equities” are now “probably fairly well-invested”. However, this hides a second ring of investors who have deserted equities and gone into a variety of other asset classes, such as precious metals. There are therefore many investors left whose belated conversion to equities should continue to push the market higher.

The other way of measuring how much of the stockmarket boom is left to run is to consider valuations.

Jeremy Whitley, the Edinburgh-based head of UK and European equities at Aberdeen Asset Management, says that because of the doubling of stock prices since their troughs, attractive valuations for Aberdeen’s preferred companies – those with low fixed costs, low debt and strong business models – are now harder to find.

SocGen’s Ms Panseri concedes that for her preferred types of stock – companies with strong and regular free cashflow, stable sales, and relatively low debt – “valuations are not cheap”. L’Oreal, one of the candidates she cites, is on a forward price earnings ratio of 24, for example.

Ms Panseri adds, that higher than normal historical valuations can be justified by the very low interest rate environment, with strong companies able to borrow in the bond market for as little as 1 per cent for a five-year note. For her, this, squares the circle. “Valuations are expensive but appealing.”

These companies can be found in, among other sectors, personal care and technology in the US, and food and pharmaceuticals in the eurozone.

LOOKING STATESIDE

Many private bankers continue to see value in US stocks, despite the rise of the S&P 500 to record highs in April. Lim Say Boon, chief investment officer, group wealth management and private bank at DBS in Singapore, notes that in January 2000, when the index was not far off today’s levels, operating earnings per share were only about half what it is today. The market is, in other words, only paying about the same nominal price for almost double the earnings of early 2000. “Valuations are mid cycle, not late cycle,” he concludes.

Credit Suisse also favours the US, citing its highly accommodative monetary policy and strong housing market, which is buoying the US consumer. However, the virtue of emerging market stocks that can benefit from the “secular trend” for economies previously highly reliant on exports to refocus on domestic consumption is also highlighted. This creates investment opportunities in Chinese retailers, home-grown luxury brands, and Chinese pharmaceuticals companies.

This is, however, a view at odds with the continuing nervousness of many wealth managers about emerging market stocks, which fell even more than developed markets at the peak of the credit crunch, and then had a torrid time when the eurozone crisis erupted in 2011.

Within developed markets, wealth managers are responding to the rise in defensive stocks such as utilities and consumer staples by looking – albeit tentatively, in many cases – at cyclical stocks.

High-dividend stocks in defensive sectors “provide a degree of downside protection”, says Mr Kalbreier at Credit Suisse. In light of their high valuations, however, he recommends overweight positions in cyclicals such as capital goods and industrials. These will form, he says, “the next stage of the rally”. Schroders’ Mr Wade explains how he has begun looking at “value plays” such as US banks.

However, while seeing the value opportunities in the low share prices of banks such as the UK’s Lloyds and Royal Bank of Scotland, Coutts remains wary of many classic cyclical stocks because of the still uncertain global economic environment.

“Cyclical stocks tend to be worth buying if there’s a global boom,” explains Mr Higgins. “We do not have that, though we do not have a global recession either.” Commodity producers such as Rio Tinto and BHP Billiton “need the oxygen of stronger global economic growth”, he adds.

Schroders concurs that “the thing that’s holding back” the stockmarket from further sharp price rises is growth. “Growth in profits is not going to be particularly good, partly because gross domestic product growth is not that great, and also because profit margins are pretty high,” believes Mr Wade.

But such worries simply provide opportunities to buy equities at appealing values, says Eric Verleyen, chief investment officer of Société Générale Private Banking Hambros in London. “Month after month we ask: is there still time to buy equities? Because last year was good, and then the first quarter of this year was good. Are we too late? The answer is that there is time to buy equities.”

He adds that if share price volatility returns, temporary falls in stock values could “constitute a big buying opportunity”. The Chicago Board Options Exchange Volatility Index, or Vix, which tracks expectations of US stock volatility, surged in mid-April. For Mr Verleyen the wall of worry may have dips and hollows, but is still a wall that takes equity investors from the ground to the sky.  

ONCE BITTEN, TWICE SHY

The global stockmarket boom is under way, and wealth managers are trying to persuade private clients that they need to join it now to avoid being left behind. What can you say when they enquire warily how they can protect themselves against it all going wrong once more, leaving them as bruised as in 2008?

Asked what investors can buy to hedge against another crash in equities, Yves Bonzon, chief investment officer at Pictet Wealth Management, replies in two blunt words: “Not much.” The cheapest hedge is, he says, to buy 30-year safe-haven government bonds, notably treasuries, bunds and gilts. Another solution is a cheap, heavily out-of-the-money call on the dollar – the classic currency play for risk-averse investors.

However, private bankers assert that buying safe-haven sovereigns at current yields offers little downside protection – because prices are so high that it is mathematically difficult for them to rise much further, even in a disaster. This gives them little room to compensate investors for huge losses in equities and other risk assets.

Schroders’ chief economist Keith Wade thinks there “has been a bit of a reversal” in the dollar’s behaviour. Recently it has risen and fallen in line with risk assets, because bets on strong economic growth have centred largely on the recovering US economy.

That still leaves gold, the world’s oldest safe-haven asset. The yellow metal has, however, not performed well recently – dropping to a two-year low in April, below $1,400 an ounce. It has, moreover, shown itself to be insensitive to recent crises, including the botched Cyprus bailout and tensions over North Korea.

Put options on equity indices form an alternative hedge – but Eric Verleyen, chief investment officer of Société Générale Private Banking Hambros, notes that the cost of at-the-money put option protection on a global equity portfolio for the remainder of the year is about 6 percent – “pretty expensive when you consider the low interest rate environment we’re in”.

One solution to this conundrum is to distinguish between hedges against volatility and against disaster. “The utmost tail risk hedge is still gold,” says Lars Kalbreier, global head of mutual funds and ETFs at Credit Suisse in Zurich – despite, he notes, its non-reaction to recent crises. He also sees virtues in deep out-of-the-money put options on equities, such as a cheap hedge against a calamitous 30 or 40 percent fall in the S&P.