Despite the gloomy economic backdrop, notable for significantly weaker manufacturing activity, equity markets have performed excellently in recent months. Is the time ripe for profit-taking?
Explanations from Damien Petit, Head of Private Banking Investments, in a financial article that appeared in the Luxemburger Wort newspaper.
Many investors are considering whether to withdraw from equity markets following sharp rises in recent quarters. Equity markets already seem to be pricing in the imminent signature of a partial agreement between the United States and China, as well as another pick-up in economic activity over the coming months following signs that the manufacturing sector is stabilising.
Is this the right time to be getting out?
We think that market timing – trying to predict short-term changes in the markets by making huge changes to a portfolio’s asset allocation – can be perilous for an investor. The opportunity cost of leaving the markets or not being invested can be great.
As an example, between January 2003 and September 2019, investors in the European equity market obtained an annualised return of 6.5%. However, if they had missed the top 10 (30) trading sessions – these 10 (30) sessions accounting for less than 1% of the period in question – their annualised return would have been much lower, at 2.4% (-1.8%) rather than 6.5%! Investors wanting to move out of equity markets should also consider the suitability of the alternatives.
Is holding a large percentage of a portfolio in cash a credible alternative to equities? The answer is clearly “no”: investors would suffer a loss of purchasing power due to the lack of a return on this cash. Doggedly negative real interest rates in Europe are inexorably penalising anyone holding cash.
Most segments of bond markets are not offering a satisfactory risk/reward ratio either. With sovereign debt yields unattractive – except in the case of US Treasuries, which are offering a spread of around 2% relative to German Bunds – many investors are opting for more risk. For example, they prefer bonds denominated in local currencies – especially in emerging countries – or even accept a steep decline in creditworthiness by looking to high yield corporate bonds (debt from issuers with a very fragile balance sheet structure). These different options contribute to a significant increase in the portfolio’s risk. They are therefore banished from our approach to constructing a portfolio. For our defensive holdings, we prefer US sovereign debt and gold, two assets that have shown a decorrelation in times of stock market crisis over the past 30 years.
In relative terms, equities therefore remain the asset class of choice. Risk premiums, which are still high, confirm that relative valuations still favour equities. The expected return on equity markets may have fallen considerably in recent years, but it remains well above the return on bonds. However, equity investors inevitably expose themselves to volatility. We suggest two ways of limiting this volatility. First, healthy diversification of the portfolio both regionally - based on the economic weight of the major regions rather than market capitalisation - and by company size. Secondly, investing in non-cyclical, quality companies to avoid any permanent capital loss (unlike with high yield debt in the event of default). Moreover, these companies will generally be able to pay a regularly increasing dividend.
However, investors must opt for an investment strategy suited to their risk profile. A more defensive asset allocation, with limited exposure to the riskiest assets, would logically reduce the expected return for investors, especially with interest rates being negative in the eurozone.