Fears about a September correction are not deterring bullish fund managers from dipping into equities.
A survey by Bank of America Merrill Lynch reveals that the level of cash balances of the 204 equity fund managers polled plunged to 3.5 per cent in the second week of August, hitting their lowest level since July 2007. “This is the strongest market sentiment in two years and it represents a big turnaround from the apocalyptic bearishness of March,” wrote the survey’s authors Gary Baker and Michael Hartnett.
The results look reassuring, but the optimism of many in this focus group is “skin deep”, Baker and Hartnett say.
Indeed, evidence of the weakness of the market rally came this week with the release of a report from US regulators showing that the number of “problem banks” jumped to 416 in the second quarter and the banking industry lost $3.7bn over the same period. Then came revelations that businesses cut investment spending at the fastest pace since records began in 1966 in the year to the end of the second quarter.
“Despite the current euphoria, any recovery is still fragile and risk is still very much in the system,” claims Bob Swarup, senior analyst with Pension Corporation. “Many of the earnings surprises on the upside we have recently seen were more due to cost cutting than to actual revenues being better.”
The consensus among bulls and bears alike is that the market is overbought and a pullback is likely. But a correction would only result in a 6 to 8 per cent fall-off in valuations, predicts Ted Scott, F&C’s strategy director for UK equities. Given improving macroeconomic conditions and fundamentals, the argument for investing in equities is still a cogent one, claim the bulls. And a “dramatic” correction would only occur, according to F&C’s Scott, if another meltdown of the magnitude of the Lehman Brothers collapse were to take place.
“Equities as an asset class look relatively attractive compared to other asset classes,” says Scott. “In some cases, bond yields are down to 2 per cent in the US. And you’ve seen quite substantial upgrades since March. But as the market is overbought, it’s reasonable that it might come back a bit.”
Mark Harris, director of funds of funds with Henderson, adheres to a similar view, claiming that while valuations are “no longer cheap”, there is still “a lot of” cash on the sidelines and in corporate bonds. Oversupply and the possibility of a bubble poses concern for buyers of corporate debt, Harris warns.
The rally since March has forced institutional investors to shift out of defensive positions and buy “risk assets”, points out Colin Graham, manager of BlackRock’s Balanced Growth portfolio fund.
“The key point is that since the fourth quarter of last year and moving into this year, there have been a wider range of assets available to investors than ever before and, in most cases, they have been trading at discounted levels,” Graham says. “Managers were able to create a portfolio of different types of assets that would capture this mean reversion from distressed levels back to more normal valuations.”
But rising markets are capping opportunities. Graham admits to being “incredibly nervous” about next year’s outlook. “I’m beginning to buy protection, like put options and changing equity exposure by buying call options to cap any downside movement,” he says. “This has become a momentum and liquidity-driven rally and valuations and fundamentals don’t matter.”
If demand shrinks due to uncertainty and more investors add to their cash holdings, a “double-dip” recession or some sort of deflationary shock is likely, in Graham’s view.
Private investors appear to be even more cautious. Sally Tennant, UK chief executive of the private bank Lombard Odier, reports that many of her clients are far more interested in hard assets, such as commercial property, than they are in equities.
“Very few want to pile in,” Tennant says. “Low volumes are still being traded in equities, so I think all this chatter about cash levels dropping is a bit exaggerated. There’s a nervousness and a cautiousness among my clients. They realise that it’s not Armageddon, but people think it’s going to be a long time before it gets better.”
Justin Urquhart Stewart, director of Seven Investment Management, says a number of his clients favour “dripping” cash back into the markets.
New money is making its way into index-funds, as investors steer clear of actively-managed funds with higher fees.
“There is still a pervading suspicion of the markets by private investors but, to a great extent, it is also a suspicion over the quality and effectiveness of their advisers,” claims Urquhart Stewart.
While private investors may choose to watch from the sidelines in the coming weeks, the most bullish fund managers are opting to remain almost fully-invested in equities. They insist that even if a correction occurs, it will be short-lived and not derail their portfolios’ prospects in the long-term.
“Taking a 12-month view from here, I think you’ll make money from equities,” argues Graham Duce, co-head of multi-manager funds with Aberdeen Asset Management. “And really, what’s the alternative? Cash is yielding virtually nothing at the moment.
“We’ve stuck to our guns in Asia, for example, and have enjoyed the rebound. Just over a year ago, its market value was trading on seven times forward earnings and it’s now up to 14 to 15 times next year’s earnings.”
