Are you being rewarded for your exposure to choppy markets?

Local investors saw the JSE All Share Index lose most of last year’s gains when it tumbled after global markets earlier this week. According to market commentators the global volatility this week took markets close to the carnage experienced around 9/11.

John Kinsley, Chief Operating Officer of Prudential Portfolio Managers (SA), says the bulk of the bad news impacting negatively on world stock markets is being generated by the US. The main concerns appear to be a looming US recession and further fall-out from the sub prime turmoil, which is causing turmoil in world credit markets.

Kinsley says in addition to the current market volatility, further possible interest rate increases and political uncertainty are also weighing heavily on South African investors.

“We expect markets to remain bumpy for a while, but this is not what influences our investment decisions. Key to our strategy is the valuation of the market.”

“In other words, are our investors being rewarded for the risks we are taking on their behalf by being in the market? If the stock market is cheap, we are being rewarded. If not, the potential for losses increases.”

Kinsley says Prudential considers the current pricing of all asset classes as fair, with equities still leaning towards the cheap side.

“The JSE is currently priced at a forward P/E of around 10, which means it is on the cheaper side of what we consider fair value.”

He says the biggest risks to the current market valuation would be a slump in earnings growth. But as long as earnings are keeping pace with the growth in the stock market, valuations will remain fair and there is nothing to worry about.

Earnings growth could be negatively impacted by the following:

1. An unexpected surge in the inflation rate, which would force interest rates up a lot further.

2. A decline in global demand for commodities, particularly from China.

Kinsley is confident, however, that the risk of the above scenarios occurring is not very high.

“The South African Reserve Bank has been hawkish in controlling inflation through interest rates, and although CPIX is above the upper target band at the moment, reasonable market expectations are for it to fall back towards the target band later this year. The possible looming recession in the US should not have a significant impact on demand for SA commodities given that the growth in demand for commodities is mainly generated out of China and other industrialising emerging markets.”

He adds that the risk of political instability and the impact on the currency is ever present, as is the case for many emerging markets. But while the issues facing the ANC this year have increased the political risks, at the end of the day it is the economy that drives the markets, rather than politics.

Kinsley says volatile times are always a reminder for investors to ensure that their long-term strategies are firmly in place and their portfolios appropriately diversified.

The bottom line, according to Kinsley, is that investors with a well diversified basket of funds have no need to panic. While diversification will not shield you from market volatility, it makes the inevitable movement of the markets much more palatable.

“This is therefore a good time to ensure that your long-term strategies are firmly in place, taking account of factors such as your age, draw-down requirements and amount of debt.”

But above all, says Kinsley, don’t try and time the market. “We may well be in for a bumpy ride for a while, but those financial portfolios that are properly structured are far more likely to weather the storm.”

Kinsley says risk averse investors unsure of how best to manage volatility should consider absolute or target return funds, which are unit trust funds managed towards achieving a predetermined benchmark (for example, inflation plus 4%) at below average short-term volatility. These funds invest in a combination of equity, bond, money market, property or derivative instruments.

Kinsley’s survival kit for investors:

• Ensure that your portfolio is well diversified.

• Consider balanced funds where qualified asset managers watch the markets for you and take care of the asset allocation.

• It is never too late to diversify – if you are feeling pain now, take action to prevent it from happening again.

• If your investment portfolio was constructed with proper long-term asset allocation according to your needs and circumstances, you have nothing to worry about.

• Never invest borrowed money.