2013: Market conundrum

For many, 2013 is a year of great significance. For Christians, it is a year of new and hopefully great beginnings. For the Mayans, it is the year that was not to be.  

Unlike the start of 2012, 2013 appears to have started on much firmer footing. Inundated with a slew of negative economic headlines, markets ended the year on a high. It was a great year for investors all along the risk spectrum. Most developed equity markets experienced double digit returns with the German market up 32 per cent, Swiss market 21 per cent, France 22.6 per cent and MSCI World Total Return Index up 15.8 per cent.  

Fixed income markets fared the same. Global credits returned to investors double digit gains with Junk and High Yield returning 18.7 per cent and 10.9 per cent respectively, according to Bank of America Merrill Lynch Indices. With 2012 firmly behind us, will investors continue to ride the wave of optimism or be swept to sea on strong economic currents? 

Admittedly, there are a few proven investment strategies with strong returns in the not so distant past. Dogs of the Dow, an investment strategy that consists of buying the 10 stocks in the Dow Jones Industrial Average with the highest dividend yield at the beginning of the year, to CAN SLIM, developed by Bill O’Neil co-founder of Investor’s Business Daily, a philosophy for screening, purchasing and selling stocks, to simply indexing for specific market or sector exposures can be effective ways of investing over a long term horizon.  

Given the kaleidoscope of factors impacting today’s market participants, it may be prudent for investors to consider the additional to ensure a successful investment plan. 

Strategic asset allocation: Whether a seasoned investor or starter, it is important that the portfolio be aligned to its return objectives, risk budget and time horizon. Rebalancing the portfolio at least annually is necessary as markets move, time horizon or goals change or to take tactical steps based on short term misalignment or market mispricing. Whilst asset allocation decisions are normally longer term in nature, a rebalancing exercise may also be a great opportunity to add some needed diversification, volatility dampeners or alpha generating strategies to the portfolio. Commodities via precious metals, metal stocks, mutual or index funds are great ways to add this exposure. 

Economic cycle: With GDP forecasted at close to 1.8 per cent annualised, the US economy is still trending near the trough of its economic cycle. History has shown that performance differ between sectors at various phases of the cycle. For example, in an economic contraction, traditional defensive sectors such as Healthcare, Consumer Staples and Utilities tend to outperform other sectors. Similarly, in the early stages of an economic growth phase, early cyclical sectors such as financials, industrials, info tech and materials are notable historical outperformers. After identifying the phase of an economic cycle, entry and exit points for the sectors/securities should be established, with dollar cost averaging as the preferred method to establishing the exposure. 

Central bank actions: Given the widespread activity from global central bankers, one cannot discount the ability of policymakers to impact asset prices. Following adoption of a zero interest rate policy in December 2008, the Federal Reserve entered uncharted territory in adopting a very accommodative easy money policy. With inflation firmly anchored below its medium term target of 2 per cent, the Fed has now tied its interest rate policy decisions to an unemployment rate of 6.5 per cent at the risk of higher inflation. Whether or not you believe in the effectiveness of monetary policy to drive long-term economic growth prospects, global central bankers have been successful in providing synthetic support to risk assets, evident by the run up in equity prices last year. Given this significant move to back the economic recovery at any cost, it may not be prudent to ignore the power of monetary policy to impact a portfolio’s value. As such, monetary policy should be an important factor when considering a portfolio of risk assets. 

Risk premium: A successful investment is one where the investor is adequately compensated for the risk inherent in the asset. Compensation should, at a minimum, include the risk free rate of the currency of the asset. The risk premium, which is the return in excess of the risk free rate, is the additional return expected for investing in that specific asset. To ensure the investment provides a real return, a further measure, the inflation rate should also be captured. The total return can then be viewed on a risk adjusted basis. For example, if you choose to add High Yield or Emerging Market exposure to a USD intermediate duration portfolio of five years, an investor should expect to gain at a minimum the return on a 5 Year US Treasury bond, plus the inflation rate, plus an additional premium appropriate for that asset type. Achieving a nominal return in excess of the risk free rate may not necessarily be a good investment as that security may not offer enough compensate for the risks involved.  

 

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information. Statistics and Data Source: Bloomberg LP. Chart: www.peakwatch.typepad.com 

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