Tackling the greatest equity return myth!

Gareth Stokes, FAnews Online Editor

How do you maximise return in equity markets? You’ll probably get as many answers to this question as there are fund managers. If a consistent reply emerges it might be something like: It’s time in the market – not timing the markets – that counts! In other words, the longer you remain invested in equities (an index tracker for example), the greater your chance of achieving the long-term average equity market return. Not everyone agrees.

Without detracting from the discipline of a long-term investment approach, Alwyn van der Merwe, director of investments at Sanlam Private Investments, observes: “You tend to make money for your clients when you get the big calls right!” He believes the biggest ‘mistake’ a portfolio manager can make is to delay acting on a strong market view. If you think resources are going to collapse then you have to lighten your exposure to that equity class. And if you think cyclical shares are going to run hard you cannot afford to remain underweight the sector... The real challenge is in correctly identifying these ‘big’ calls!

The problem with economic forecasting

Although economists base their predictions on long-term trends they don’t always go back far enough. Van der Merwe uses a graph of G7 quarter-on-quarter GDP stretching from 1961 to early 2007 to demonstrate. The average GDP growth dips below zero on two occasions over this period – but only slightly. There’s not even the vaguest hint that things can get as bad as they do. From mid-June 2007 the G7 economies went into freefall. Average growth in the latest quarters plummeted to -6%!

This inability to correctly forecast growth exhibits in the consensus views for 2009 GDP growth in developed economies. In September 2008 the consensus was for moderate growth in the US, UK, Euro-zone and Japan. By December 2008 the consensus forecast was for a slight contraction in the UK, with zero rates everywhere else. But by May 2009 there was red ink everywhere. The experts predicted -3% for the US, -3.5% for UK, a 3.5% contraction from the Euro-zone countries and a staggering -6.5% GDP growth for Japan. Despite a global economy in tatters, the experts waited until “May 2009 before they started to downgrade the forecasts significantly,” says Van der Merwe.

Even Federal Reserve chairman Ben Bernanke got things horribly wrong. When the crisis first emerged Bernanke suggested the US was looking at $100m of banking system write-offs. At 2 October 2009 we know the US banking system credit losses and write-downs tops $1trn… Globally the IMF estimates the total at $2.8tn. Nobody could have predicted the extent and depth of the recession we’ve just lived through. “The US economy as a whole shed 7.3m jobs through this recession,” said Van der Merwe. Why bother with forecasts? Professionals across the financial services industry need context to go about their daily work. The forecasts act as points of reference to anchor market expectations…

Comparing yesterday with today

Knowing what we do about economic forecasting let’s compare the SPI September 2008 view on domestic equities with the group’s latest thinking. At the time SPI found six underpins for equity prices. Local share valuations were reasonable, inflation and interest rates were trending lower, poor 2009 earnings would improve dramatically in 2010 and there was plenty of cash sitting on the sidelines.

Today’s picture is very different. Domestic equities are fairly priced, if not a trifle on the expensive side. The real problem is earnings. If corporate earnings don’t recover strongly through 2010 there’s simply no way recent share price improvements will prove sustainable.

The road/market analogy

Investors must always remember the subtle difference between financial markets and the ‘real’ economy. “Financial markets discount in advance what we expect from the real economy,” says Van der Merwe. Shares hit lows in March 2009 – at a time when expectations for real economic performance were extremely poor. Now markets have re-priced shares for an earnings recovery in 2010.

What do you do if you’re travelling along a road with a poor surface? Do you stop your motor vehicle and proceed on foot – or do you simply reduce speed. Van der Merwe believes investors made mistakes through the recent crisis. They became totally risk averse and moved out of equities in favour of cash and near cash assets. Instead – they should have reduced risk (speed) in their equity portfolios. The same advice holds today… Although equity returns will be ‘soft’ compared with previous years – investors will probably find this remains the best vehicle to reach their long-term destination.

Editor’s thoughts: Just when we though some sense was returning to the markets we got bad news from the Middle East – with government owned Dubai World asking creditors to back off until they can sort their finances out. South African equities suffered a hit as international investors reassessed their risk appetites. Are you concerned with recent developments in the Middle East – or are you confident the global economy will recover despite this hiccup? Add your comments below, or send them to gareth@fanews.co.za