Are you getting the right advice?

met with a number of large private investors around the Asian region last week. What I heard concerned me, as many are still sitting with significant exposure to Corp debt and Equities.

Why the concern? Neither corp debt or equities are ‘cheap’. Indeed, if anything they are somewhat overvalued at current levels, as the search for yield has driven prices up. Also holding both gives too much exposure to market or beta risk, given their high correlation. We have just witnessed how abruptly markets can move in times of stress and many investors are unknowingly leaving themselves too exposed to potential shifts in the market.

There are likely two key factors, for investors not to be adequately diversified: a) they may not be getting the proper advise and/or b) they may be too short term orientated and focussed on yield and playing the market’s momentum.

Much of the current ‘advice’ given to private investors is often very conflicted. Many private banks, for example, look to make at least 1% from a client, usually substantially higher, and these fees are not always transparent. To make the desired revenue on a client’s portfolio, the private banker may be incentivised to offer the highest earning products, such as structured products and equity funds, rather than well thought out holistic advice in the client’s best interests.

While in Europe there has been a very clear shift towards providing more holistic and transparent advice, such as from specialist private banks or multi-family offices, there is still a long way to go in this regard in Asia. This is primarily due to the wealth being predominantly first generation and principals are not well versed in the practice of ‘wealth management’. Also, they tend to have large deposits with the banks and wish to maintain these relationships. Overtime though, I would envisage they will get savvy and start to demand more longer term, non-conflicted, advice.

So why am I not advocating equities at this point? As I highlighted in an earlier post a properly diversified portfolio can have far lower levels of volatility and potential drawdown, while still producing close to equity like returns.

Given the current market environment, private investors would be well advised to check the weighting of equity and corporate debt exposure in their portfolios, to ensure it is not too high. In aggregate, for the average 40+er anything over 50% should raise a red flag. Indeed, a number of multi-strategy managers that I track and which are typically long, have cut back exposure and in some cases are now short the market.

When deciding appropriate allocation, it may be worth considering the following:

The US equity market is not cheap: whether one looks at P/E forward, P/E10 or the Q ratio, the market looks relatively expensive. Using the P/E10 may be a better measure than P/E forward, given corporate margins are close to record highs. On the P/E 10 measure the markets is c.50% overvalued.

Equities in EM, Europe and Japan offer relative better value but aren’t without risk. In the emerging markets, one needs to be alert to the currency risks and, in the case of Europe, risks around the periphery. Greece’s debt issues are not resolved and will resurface again.

In the US, earnings growth has disappointed for a number of years and continues to do so this year. Expected improvement in capex spend has not materialised as companies hold back cash for share buybacks instead.

US corporate margins are still close to record highs: should these start to normalise, earnings will come under pressure and market valuations will increase accordingly.

The strong USD will impact earnings for US companies: c.30% of S&P earnings are attributable to exports. Similarly, the strong USD is hurting emerging markets as many of them have loaded up with dollar denominated debt.

Economic growth in the US, even after QE1-3, is still not strong and a lot of economic data is mixed. The diffusion index in New York, for example, was far weaker than expected due to weakness in exports and the energy sector.

The velocity of money remains subdued: The low velocity reduces the impact of QE and indicates less willingness of consumers to borrow to spend. The argument can be made that this will reverse, but so far it’s been trending lower since 2000. This fits with Dalio’s concern that we may be at the end of the debt super cycle.

Total public debt across much of the developed world has increased significantly:In the US, government debt to GDP is well over 100%. This can of course continue to increase, aka Japan, but restricts the usage of fiscal policy somewhat and is simply borrowing from the future.

Yields in the credit markets have increased on average, but there is still little value here.

Inflation expectations have declined significantly due to weaker energy: a weaker RMB will likely reduce US inflation further. While this will reduce the pressure on the Fed, it also gives some reflection that inflationary growth is not expected any time soon.

Heavy duty truck demand peaking?: This is not a chart I often look at, but seems to be a leading indicator given it peaks a few months before a recession. With the slowdown in commodities, I would envisage heavy duty truck orders will start trending down.

Low oil will hurt many emerging markets: while low oil prices will be a boon for the US consumer, they are having a significant impact on the exporters of the commodity. Also, the US’s shale gas industry has come under severe pressure, which will hurt various US communities.

China and other Asian markets are visibly slowing: China’s recent PMI reading was negative and electricity production and retail sales are weak and declining. The recent equity market volatility will also dampen the economy.

In summary, investors need to be cognisant of the risks when investing in the equities and corporate debt and should ensure their exposure is suitable for their risk tolerance. Volatility has been low for many years now and many are lulled by the sense that the Fed has your back covered. Their policies may prove less than effective at some point or they may be unwilling to do more.

Other assets include cash, government debt, commodities, gold, private equity, hedge funds and real estate, to name a few.

Cash is good to hold during periods of market uncertainty and gives dry powder should there be a market sell off.

While no debt is without risk, holding highly rated government debt, such as US treasuries, provides some yield and will perform well if deflationary fears escalate. Gold can be used as a good hedge this exposure in case inflation surprises on the upside.

Hedge funds can be a useful way to diversify some of the beta risk. Many hedge fund managers can play in both a rising and falling market and macro managers may be well positioned to take advantage of market events and dislocations.

In conclusion:

In almost every walk of life, people buy more at lower prices; in the stock market they seem to buy more at higher prices.
(James Grant)
Successful investing is anticipating the anticipation of others.
(John Maynard Keynes)
Diversify your investments.
(John Templeton)

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