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What 2016 has taught us about investing in equities

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What 2016 has taught us about investing in equities

I was recently asked why investors should allocate any money right now to equities. In the mind of the questioner, equity prices are heading for a fall due to rising interest rates, stretched valuations, and Australian property markets in bubble territory. This is a great question and I’d like to answer it using the lessons we learned during the past 12 months.

The answer? If you know for sure that equities are heading for a fall, then you should not own equities today. But the problem is, you cannot know for sure where equity prices are headed. No one does.

We observed a great example of this dynamic in the global equity markets this year. Cast your mind back to the first three weeks of January: global equity prices had fallen by more than 11 percent in three weeks. The Federal Reserve had just hiked interest rates in the US for the first time since 2006; and there were renewed concerns over a financial crisis in China. Given the global equity index had tripled since the depths of the GFC in 2009, there were very real concerns that we were heading into another significant equity market downturn.

And how did the remainder of the year play out? Global equities rallied by more than 22 percent from the lows achieved in February. This is an astronomical rally which stemmed from coordinated Chinese, Japanese and European stimulus. Meanwhile, the Fed placed its monetary tightening bias on hold. And finally, the surprise Trump and Republican victory in the US general election doused an already hot market with further fuel in recent weeks.

The probability of the global market returning anything above a flat result this year was low after the start it had in January. And yet, at the writing of this article, the global market has delivered 8 percent year-to-date with only two weeks remaining until year end. Similarly, the ASX200 started the year by falling 10 percent by February. And yet its year-to-date return is 9.5 percent.

Imagine we played a game in which you pay me $3 to roll a die once, and I repay you the number of dollars equivalent to the number shown by the die. Obviously, you want a six but the chances are low at only 16.7 percent. In effect, the equity markets this year rolled a six. There was a low chance of it happening but it still happened.

And this is why investors need to allocate some of their portfolio to equities. No one knows what the market will deliver year to year. Staying on the sidelines feels safer and ensures that a negative return will not be sustained. But staying on the sidelines ensures you will not participate in the upside when the market rolls a six. And we know that over very long periods of time, equities will deliver positive returns above most other asset classes.

Standing here today, there are plenty of headwinds on the horizon for average equity returns. Interest rates, demographics, valuations, geopolitical risks. Making money in equities will very likely be more difficult in the future than it has been in the past. But there will still be plenty to be made over long periods of time; or said another way, remaining on the sidelines will prove very costly – as it always has. This has been the lesson of calendar 2016. And it is a lesson investors should never forget.

Andrew Macken is a Portfolio Manager at Montgomery Global Investment Management. Andrew joined Montgomery in March 2014 after spending four years as a Research Analyst under Jim Chanos at Kynikos Associates in New York.

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This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564) and may contain general financial advice that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking advice from a financial advisor if necessary.

8 Comments

  1. Hi Andrew, I’m a seed investor in Montaka and recently the alpha plus fund and to be honest it seems as though investing today is more about guessing which way the fed will go next month or will the EU blow up tomorrow or will china implode next week or will Japan drop trillions in helicopter money this quarter and traditional value investing is getting less relavent with each passing day .The world seems quite insane and extremely risky these days ,and when I read that Montaka has recently taken a more bullish view after assessing things I’m left wondering how can one possibly take a bullish view with bubbles as far as the eye can see in almost every asset class and the world economy on life support with printed money and negative or extremely low interest rates and to top it off the fed looking to raise rates ?

    • Hi Andrew,
      Thank you very much for your comments and question.
      I agree with you completely that the world seems risky these days. And that is why we are approximately only 55% net long in Montaka; and we hold approximately 13% cash in the Montgomery Global Fund.
      But we do believe it is true that the probability of a much more bullish equity-return scenario over the next 12-24 months has increased following the result of the US general election. This is not to say that we believe the bullish scenario will happen, it is to say that the probability of it happening has increased from low to less-low. Does this make sense?
      On this basis we ratcheted up our long exposure in both funds (very slightly) immediately following the US election. Already this has been helpful: since the November lows, the global market has put on +7.5% in US dollar terms. This is an annualized rate of return of over 50%!
      We very much wish we did not have to worry about global macro and geopolitical events – but the reality is that we very much need to if we are going to do our absolute best to maximize returns for clients.
      All the best
      AM

      • Hi Andrew, Happy New Year to you and wishing you a very good year for the Global Funds.
        But surely the lesson from 2016, contrary to the opinions above, is to stick to traditional value investing, building a portfolio of great businesses that are undervalued, setting cash levels based on the abundance or lack thereof of bargains in the market, and not make any forecasts about the direction of equity prices or indeed commodity prices?
        Here’s the latest from Howard Marks offering a different view about macro calls:
        https://www.oaktreecapital.com/insights/howard-marks-memos
        Thanks.
        Kelvin

    • Interesting question, John.
      By my estimation, the global market has delivered two consecutive years of at least +20% annual returns 19 times over the last 143 years. So if we define “the market rolling a six” as at least a +20% annual return, then perhaps a sensible estimate for the probability of it happening two years in a row is 19/143 = 13.3%.
      All the best,
      AM

  2. Thanks Andrew for your piece on ‘what 2016 has taught us about investing in equities’. I was wondering if any lessons were learned on shorting the market, considering the relative performance difference between the Global and Montaka funds in 2016.

    • David,
      Thanks for your question.
      2016 has been a difficult year on the short side for sure. In the last 10 months, the global markets have rallied +22%. Short selling is particularly difficult during highly-stimulated periods in which low quality (“junk”) businesses rally hard. This year has certainly been characterized by this dynamic.
      That said, the opportunity on the short side from here is looking highly attractive. As we start to lap the onset of the Chinese/US/EU/Japanese stimulus from the beginning of 2016, look for low quality, overvalued businesses to suffer hard. It will be during this period that owning some “insurance” pays off.
      I understand that owning insurance in a very strong equity market – like the one we have seen over the last 10 months – can feel like a waste. But that is the nature of insurance: you don’t know when you are going to need it.
      Wishing you a safe and happy year-end holiday period.
      AM

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