Twelve months ago, in early March 2009, markets hit their nadir for the current economic cycle. The world did not end, as some pessimists were predicting. In fact, most markets throughout the world have rebounded aggressively from these lows. This pattern of behaviour has been observed in previous recessions, though the magnitude of change in these latest bear and bull market phases was huge. The exact path from here, of course, remains unknown, but so far markets have not deviated significantly from their past habits.
Returns in several major asset classes have been significant over the past year, but markets have made little progress in the last four months (or, as the analysts like to say, they have been moving sideways). The S&P 500 index, for example, ended February at approximately the same level it had reached in mid-October last year, and investors, in addition to poor performance, have had to suffer significant volatility along the way, with swings of 5 per cent up and down. This has occurred despite generally strong economic data during the period, as well as impressive corporate earnings.
One reason for investors to be positive, however, is this: if the markets were comfortable with equity valuations in October, there should be greater confidence now, as the price has stayed more or less stable. However, as 2010 unfolds, investors should remain alert, since historical data for the S&P 500 suggests that the 12-month return following such a strong rally is usually slightly negative. Investors should also never forget the benefits of diversification, especially in an environment of high uncertainty, and also consider positions in other types of assets - in addition to equities - in order to provide a degree of protection.
In previous financial cycles Western governments were not as financially stretched as they are today. The size of the credit-related boom and the subsequent bust required such massive fiscal and monetary stimuli from national governments that many countries have reached their financial limit and are now having to rein in expenditures. It is apparent that these gigantic initiatives, which began more than a year ago, have succeeded in stabilising the world's financial systems, but concern remains. Sovereign risk - the failure of governments to honour their loan repayments - is a real issue. For the past few months Greece has been stuck in the spotlight, due to the sheer size of its fiscal deficit and refinancing requirements. However, the Athens government has announced several measures to reduce its fiscal deficit, such as public-sector wage cuts and a 2 per cent increase in VAT, and the market has responded well.
Although Greece is a relatively small economy, other EU countries are facing similar issues. Spain, Portugal and the UK are all under the credit-analysis microscope. Keeping the uncertainty in equity markets and serious sovereign debt issues in mind, what is the average investor to do? Government bonds in mature economies are the normal refuge in times of uncertainty, but with interest rates likely to rise in the next few years, this asset class is unlikely to deliver much of a return. Investment-grade bonds may perform much better, and higher-risk bonds, such as high-yield (or junk) bonds and emerging-market debt, could do even better than that.
Gold is also a traditional refuge in times of turmoil, especially when high inflation is expected. The problem with gold is that it is one of the few asset classes that generates no income. Cash in the bank generates interest, shares generate dividends, bonds generate yield, and property generates rental income, but gold gives you nothing except capital growth (or loss). With no generated income to help determine value, the price of the metal is very sensitive to external economic and emotional factors, including fear.
Gold can play an important part in stabilising performance in a portfolio, but unless you are prepared to watch its price daily you would be better off investing in the asset through a general commodity fund where the managers can shift from one product to another as conditions change. Hedge funds are definitely worth a look. These products use a variety of strategies to produce growth independent of what is happening in equity or bond markets. This feature is often referred to using the mathematical terminology of "absolute" performance.
Man Investments is one of the main suppliers of hedge funds at the retail level, and has been extremely successful with its range of capital-guaranteed hedge funds. Its most recent offering, Man Directional Series 2 Ltd, combines several different types of hedge strategies across 10 different managers. This approach seeks to reduce undue risk, and in the past six years has produced an average return of 10.2 per cent per year.
Investors who are uneasy about the lack of regulation in the hedge fund world might prefer a capital-guaranteed index bond. The returns of these products are linked to a basket of indices, such as the S&P 500 or the price of oil. With these bonds, you participate in some, but not all, of the growth, and in return your investment value receives some form of guarantee. In financial-speak, you sacrifice upside gain to reduce downside loss.
You are usually obliged to leave your money invested in these vehicles for at least five years. On the other hand, you can avoid having to share your growth with the guarantee-issuing bank and take it all for yourself by investing directly, without the guarantee. But since the guarantee is only as good as the bank issuing it, you should make sure that the institution is solid. Lehman Brothers specialised in these kind of guarantees, and we all know what happened to that firm.
Bill Davey is a financial adviser at Mondial-Financial Partners, Dubai. Write to him at bill.davey@mondialdubai.com
