Keeping it liquid, diversified and simple

Market conditions over the last six months or so have been incredibly difficult and conditions don’t seem to have improved as we have moved through the first quarter of 2009.

The big problem is the very high level of uncertainty due to the total lack of visibility about the future. This lack of visibility, which has caused this uncertainty, has in turn created an unprecedented level of volatility amongst all the asset classes.

The crisis in the financial sector which was initially thought, naively in hindsight, to be relatively well contained, has more recently spread into the real economy with vengeance and changed peoples’ perception from one of taking on huge amounts of debt and leverage, and investing in risky assets, to a rush to deleverage at almost any cost and also a move to extreme risk aversion. This has created a total change in investors focus from the worrying about the return on their money, to now worrying about the return of their money.

My view is that a depression will be avoided but the slowdown in economic growth will be pretty brutal and we have already seen this in economic data coming out over the last few months. If one looks at GDP, industrial production, exports and also business and consumer confidence, these are all at multi-year if not multi-decade lows. However, the principal question is when and will the unprecedented stimulus by governments, both monetary, with interest rates falling to near zero in many areas, and also the fiscal stimulus, with money being pumped into the economies around the globe, stimulate economic growth? This is very important for the financial markets, because they are a discounting mechanism. Equity markets, for example, move three to eight months ahead of a low in the economy, so watching the action of the equity markets will be very important as they do tend to be one of the best predictors of an end to recession.

If one looks at the fourth quarter of 2008, it was epitomised by “a total collapse in confidence” given the worsening financial crisis and the effect that it was having on the real economy. All the major asset classes plunged downwards, with the major exception of government bonds, and also the perceived safe haven currencies of the yen and the Swiss franc.

When looking at sentiment in the equity markets, I use the VIX, or ‘the fear index’, which looks at the options and the premium that investors are willing to pay to hedge their exposure. When we get very sharp spikes in volatility like we last saw back in 1987, this is a good indicator that the market is near an important low.

Breadth is another important indicator. The New York Stock Exchange Composite Index, which has slightly less than 2000 stocks, has experienced a record number of new 52 week lows. Most noteworthy is the huge spike we saw in October; over 90% of the index made new 52 week lows, this indicates a very broad sell off, a capitulative type action. So in my view, October was a climactic low in the markets. Since then the markets have continued to weaken but the breadth of the market has improved, so things seem to be recuperating which is another positive sign.

Turning to the bond markets, there has been a huge flight to safety into government bonds. They were the only major asset class that moved higher in the October/November period. Investment grade and high yield bonds, or ‘non government bonds’, sold off very aggressively. They have recovered some composure as government bonds have moved higher, but the yield spread between the two still remains near record levels, signifying a high level of uncertainty.

Finally, looking at the currency markets we have seen a staggering move in the yen against sterling. The yen appreciated by almost 43% signifying that the currency carry trade, which was so popular in the past, has well and truly ended. Sterling has borne the brunt of the sell off, principally due to the UK economic outlook which has deteriorated quite markedly. The aggressive action by the MPC in cutting interest rates has also had its effects, causing the interest rate differentials to narrow sharply.

To conclude, I do not believe, given the current background, it is an environment to make incredibly bold statements or aggressive asset allocation calls, but I think until the visibility improves, volatility in the markets will remain very high.

It is also not a time to buy and hold, but to manage portfolios actively and take advantage of the extreme moves in the markets that we are experiencing, and when they present decent value, that is the time to buy. The main focus is keeping it liquid, diversified and simple.