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Time to leave the equity party?

January 2018

Gabriele Susinno, Senior Client Portfolio Manager

It might be getting very late but the global equity party appears very much in full swing.

Should I stay or should I go now?

The world economy is in good shape, inflation remains well-behaved and corporate profitability is improving. It's not surprising then that stocks are rising. But how long can the global equity party last?

Our US Equity Bubble Index1, for instance, produced by our multi-asset colleagues suggests the market might be approaching a 'danger zone', implying stock valuations are more a reflection of irrational exhuberance than underlying fundamentals.

FIG 1: Us STocks in bubble Territory?

Pictet Asset Management US Equity Bubble Index

Chart shows Pictet US bubble index is heading towards levels not seen since 2007.
Source: Datastream, Pictet Asset Management, 31.12.17.

How long can the momentum trade continue?

As Figure 2 below shows, the momentum trade (buying best performing stocks) has enjoyed its longest winning streak in 40 years - posting nine consecutive calendar years of gains. This looks unsustainable, particularly as central banks are reining in stimulus and raising rates.

FIG 2: RUNNING OUT OF MOMENTUM?

Annual returns of MSCI World Momentum Index since 1974 in US dollars

chart going back to 1974, shows the MSCI momentum index has been positive each year since 2009
Source: Bloomberg, January 2018
That said, despite the equity bull market looking very mature by these and many measures, we acknowledge it could still continue for a while longer.

Party on, with caution...

We believe that investors who want to remain invested must avoid complacency as any pick-up in volatility in an abrupt manner could throw markets into turmoil.

But how? Investing in just low volatility is, in our view, the equivalent of getting an early taxi home. As Figure 3 below shows, the low beta nature of these stocks means they captured very little of the rally over the past 18 months.

FIG 3: MINimum  VOLatility StOCKs have lagged the recent up-market
chart shows MSCI world minimum vol has outperformed MSCI world by 13% since June 2016
Source: Bloomberg, January 2018
Other strategies to insure portfolios such as long equity market puts (options to sell) or a short position in credit risk are also difficult to time and can become very costly. Gold, meanwhile, is not always a reliable hedge.

So what do you invest in?

We believe one of the most effective strategies is to balance your global equity allocation with stocks that have good participation when markets rise but also demonstrate sufficient resilience on the way down. This way you can stay in the equity party to the end, with less of a risk of a hangover.

Does this sound too good to be true?

We don’t think it is. As Figure 4 shows, since its inception in 2012, Pictet-Global Defensive Equities has offered this combination of resilience in down markets and good participation in up-markets.
FIG 4: An approach for all markets?
Pictet-Global Defensive Equities - beta capture since inception
table showing Pictet Global defensive has beta of 90% in upmarkets and 73% in downmarkets
Source: Pictet Asset Management January 2018. Inception of strategy was 30 November 2012. 

What kind of companies do we look for?

Currently, we are focusing on the companies that can take advantage of the strengthening in global growth. Using our proprietary 4P approach we favour businesses whose competitive advantage and underlying pricing power give them the ability to push through price increases (cash compounders), and those with strong cash generation to take advantage of new business growth opportunities (sustainable growers).

Crucially, when deciding whether to invest in these companies we always pay attention to valuations and debt levels. We avoid overcrowded market segments which are likely to be the first to suffer in the event of a trend reversal or companies with too much leverage that may suffer liquidity concerns in a rising rate environment.

Why aren't these stocks more widely sought?

We believe it comes down to persistent behavioural bias in the market of chasing glamour over dependability. Simply put, these conservatively-run companies are not as exciting as many of the pure growth stocks that dominate market headlines during a bull market.
The market chases glamour over dependability. This underpins our defensive approach.

Our investment ideas might not be the life and soul on the dance floor whilst the party is raging. However their more sustainable, dependable nature means you can be sure they will last the distance and perform as they are supposed to, year after year.