Market briefing – 27th May 2020
Last week saw the FTSE 100 break back through the psychological 6,000 figure. At the time of writing it remains just under 20% lower than the beginning of the year. (1)
Meanwhile in the US, the S&P 500 has virtually returned to its figure at the start of 2020.
It seems remarkable that markets are operating back at such elevated levels.
If markets did, indeed, bottom out towards the end of March, this will have been one of the shortest and shallowest bear markets of all time. However, there are several reasons why investors should remain cautious about equity markets.
Within the world’s largest economy, 15% of the US workforce is now unemployed, with more than 20 million jobs being lost in April alone. This sees the US economy operating at its worst unemployment rate since 1948 and skyrocketing from the previous lows of 3.5% leading into the pandemic. Furthermore, the US market’s recovery is being led by a very narrow number of names, which is a dangerous signal. The top five stocks in the S&P 500 now make up 20% of the index(3) which is not representative of the wider US economy. These stocks are the well-known technology names such as Apple, Alphabet (Google), Amazon and Microsoft.
Whilst the Chinese economy appears to be more operational, returns have been even more astounding with it being just a couple of per cent off where it started the year. However, the wider emerging markets region must surely be in a more challenged position. Destabilisation of trade networks and the unwinding of globalisation is likely to see the global economy operating on a smaller scale in the future. In fact, the World Trade Organisation estimates between a 13% and 32% reduction in world trade(4) .
In the opinion of many, trade wars are likely to become a problem again in the future. The trade wars between China and the US in 2019 created challenges and it has been mooted that this situation might rise again in 2020 and beyond.
So, whilst volatility remains high and sentiment is in a sensitive state, equity markets will continue to react on the back of good or bad news. For all these reasons, caution towards equities is appropriate whilst there are opportunities within the bond market.
Which brings us onto …
There is no risk without reward
As an investor, sooner or later you will need to accept one truth, there are no meaningful investment returns without investment risk. Investors who own volatile investments are rewarded by what’s called a ‘risk premium’; that is, the excess investment return they receive over what are known as ‘risk-free assets’, historically usually government backed bonds, such as US treasuries or UK gilts.
This means that caution should be adopted with the cash you need now; it would be unwise to invest this money in the stock market, as there is roughly a 50% chance the stock market will go down, rather than up.
Although past performance is no guide to future returns, history does teach us that the further you look back in time, the likelihood that the same stock market will go up increases.
The importance of diversification
Nobel Prize winning economist Harry Markowitz is known for developing something called Modern Portfolio Theory. This theory is behind many investment plans.
This briefing won’t discuss the theory in any detail, except to mention Markowitz’s update of the economists’ belief that “there’s no such thing as a free lunch.” Markowitz said, “the only free lunch is diversification.” And by this he meant an investor can reduce their risk without reducing returns, simply by diversifying their investments.
Since Markowitz wrote his PhD thesis in 1952, it has become far easier and cheaper to invest in a diversified portfolio that includes investments from around the world and within different investment types.
To illustrate the value of this sort of diversification, let’s review the events of this year from both a risk and reward standpoint. However, before we do that, it should be noted that any past performance is no guide to future returns, and also reviewing a period of time less than 5 years is not a long enough period of time to draw sensible conclusions. That said, if diversification operates properly, even over such a short period of time, reward should be increased whilst risk (as measured by volatility(7)), is reduced.
The above graph of the FTSE 100 total return for this year, (invested 100% in equities), shows it has dropped by 19.36% during 2020.
In terms of risk, the other side of the coin from reward, as shown by the bar chart, the FTSE 100 during 2020 had 38.92% volatility(7) for the same period.
At this point, it’s important to remember that headline stock market falls do not mean that investors’ individual portfolios will have fallen by the amounts reported by graphs such as this.
Which brings us back to diversification. Most investors are not 100% invested in the FTSE 100; indeed, most investors are not 100% in equities.
Most investors should be invested across a wider range of asset classes in addition to equities, usually via multi-asset funds or portfolios; so, they would not have experienced the -19.36% loss with 38.92% volatility. The Investment Association helps with this analysis by pooling multi-asset funds into sectors with the percentage amount indicating the amount invested in equities.
As this chart shows …
… the collection of 227 multi-asset funds across 91 fund manager groups investing between 40% and 85% in equities, has dropped by 8.16%, less than a half of the FTSE 100, over the same time period.
And what about the level of risk taken?
Clearly any drop is not pleasant. However, -8.16% is significantly less painful than -19.36%. This was achieved by diversifying across non-equity type assets, such as bonds and cash, and as the bar chart shows resulted in a much lower volatility of 24.48%.
What should this tell you?
That investors should continue to keep calm and diversify.
While risk and reward do typically go hand in hand, smart diversification can help investors minimise their risks.
Although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimising risk.
However, remember that no matter how diversified a portfolio is, risk can never be eliminated completely.
It is true that the short-term horizon is extremely uncertain due to the unpredictability of this situation. However, it is important to remember that we very often have a long- term investment time horizon.
We will continue to monitor the current financial situation and keep you notified of any changes that are made. Please seek professional financial advice if you wish to discuss your financial situation further.
(1) Based upon information supplied by Square Mile Investment Services Limited
(2) FE Analytics
(5) Helen Keller (1880-1968) – Despite being deaf and blind since she was 19 months old, Helen Keller became one of the 20th century’s leading humanitarians and co-founder of the American Civil Liberties Union (ACLU) – Biography.com
(6) Harry Markowitz (1927) – A Nobel Prize winning economist who devised the Modern Portfolio Theory, introduced to academic circles in his article, “Portfolio Selection,” which appeared in the Journal of Finance in 1952. Markowitz’s theories emphasised the importance of portfolios, risk, the correlations between securities, and diversification – Investopedia.com
(7) Volatility “often refers to the amount of uncertainty or risk related to the size of changes in a [stock] value” … “for example “in the [stock] markets, volatility is often associated with big swings in either direction” – Investopedia.com
(8) Sir John Templeton (1912-2008) – Sir John Templeton was a legendary investor and mutual fund manager who founded the Templeton Growth Fund. He was an early innovator in global value investing, and his family of funds held more than $13 billion in assets when he sold the firm in 1992. Following this sale, he spent the rest of his life focusing on philanthropic pursuits – Investopedia.com
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