US housing market key to improved sentiment
John-Paul Smith is the London-based chief strategist in the balanced and quantitative investment team of Pictet Asset Management (PAM). He is also chairman of the PAM strategy unit and responsible for strategic guidance for all equity teams, including both developed and emerging markets. He joined Pictet Asset Management in 2001 as head of global emerging markets. He shares with AsianInvestor his views about the global financial crisis and market sentiment.
What are your expectations for this year?
At some point this year, investors will become more confident. But the timing is very, very difficult to predict because of the pessimism we are seeing. Just to step back a minute, one of the important things to bear in mind is each market cycle is partly determined by the investors that are in it and their expectations. We had the Y2K technology bubble in 1999 because the market was dominated by index investors who didn't really look at value investments and didn't really care what they paid for a stock. And what we have seen more recently is that the biggest marginal players in the market have been hedge funds. Hedge fund assets as a percentage of global assets are not huge, but as a percentage of turnover in markets they are very significant indeed.
What were the expectations of investors of hedge funds? What they were sold, broadly speaking, is that in good years in the market they would in broad terms keep some pace with the index and produce good absolute returns; and then in bad years, they would produce a reasonable absolute return; and then in terrible years, they wouldn't lose money at all. And that was the problem last year. It was a very unrealistic expectation to begin with. Very few of us expected a year as terrible as last year. But one of the reasons it was so bad was when things started to go wrong, hedge fund investors just pulled their money out because they had been sold a different story than what was really going on in the market.
Actually, the reality is while some hedge funds performed poorly, they mostly as a group have done okay relative to the equity market. But that's not what they promised investors, they promised absolute returns.
What could bring confidence back to investors?
The key for sentiment improving is when this wave of deleveraging of hedge funds burns itself out. Each market cycle is comprised of money passing out of bad hands into good hands. Money has to pass from people who have a very short-term time horizon with very unrealistic expectations of what markets can do to investors who are prepared to absorb losses and stick with shares for the long-term, like Warren Buffet. I don't think Warren Buffet believed he was buying at the bottom when he bought into the market, but he was buying at a reasonable valuation. For sentiment to improve, we need those types of investors and not investors who mark their positions to market every day, every week or every month.
Is liquidity still a major issue among investors?
A lot of the value investors who were invested last year saw very poor returns; Bill Miller of Legg Mason is a very good example. A lot of those fund managers saw big redemptions from investors. With pension funds, you are supposed to set long-term prices. They have a problem because they probably think shares are very cheap at this level, but they have contingent liabilities to think of and they also have solvency position of some of the funds are under question. Some pension funds may even be forced to buy bonds even at these low yields but those will rebalance. Things will become so cheap that investors will come back to the market. Corporate debt is a good example of that. Maybe when investors see returns from cash and government borrowings at low levels, they will perhaps go and buy corporate debt and to some extent equities.
The thing that will probably determine investors coming back to the market is sentiment towards the US economy. And what is the biggest determinant of sentiment in the US economy? It is where people think the housing market is going. People are incredibly pessimistic. If you are looking at the futures market, they are predicting another 15% to 20% downside in the US housing market. When I look at the affordability of US housing, I think naively that property in the US is at reasonable levels. But then again it's a question of confidence. Nobody wants to buy. But hopefully you will see a bottoming out of sentiment this year.
Will investors want to see some kind of recovery in the US housing market -- and not just a bottoming out of sentiment -- before they actually put their money back into the markets?
Historically, markets have always discounted and have always gone up way before the end of recessions. But as you have alluded to, maybe there are some investors who are too scared. But in general, I don't think so.
When you talk about corporate credit, do you have a specific market in mind?
The US and to an extent Europe both offer reasonable opportunities.
Where should investors put their money now?
I'm a value investor so I would take at least a three-year horizon. But even for retail investors who need to mark their investments to market and if they need the money within a fairly short time-scale, they have no business being in equities at all.
Where should they be?
Even the corporate debt market is too risky for them. They should have their money in cash, with reliable counter-parties. The key thing for any investor is to ask themselves what is their benchmark. Is it the return or a fixed hurdle rate? And what is their time horizon? For any younger retail investor who is prepared to take risk and who is prepared to lose money, then now is a good time to go into equities. That will not have an impact over the medium-term. But over the long-term -- three to five years -- value begins to matter.
Do you think investors have actually learned their lesson from this crisis?
I think most investors -- whether they are institutional, retail, private -- are momentum investors and they invest largely based on instinct and psychology. The next cycle that we get on the upturn -- this one is so vicious on the down cycle -- whether it's next month, next year or beyond, it will be much more dramatic because people haven't changed. When prices start rising and people can see some sign of the economic situation getting better, then people will put money back. There are a lot of very good private investors and institutional investors but most people are momentum-driven.
What do you advise an investor who is looking at a three-year horizon?
The first thing the investor should do is have an under-benchmark position in government bonds. They should certainly have a very good exposure to corporate debt and to equities. The core of the corporate debt investments should be investment grade. If they are very adventurous, they may consider some exposure to high-yield debt. If you don't have the specialist capacity to allocate, the best thing to do is to find yourself a good manager.
The bulk of their exposure should be in equities. They don't necessarily have to put it all in at once. They can have a compounded cost average.
Should investors enter the market now or sit on their cash a little bit longer?
If they don't have exposure to equities, they should certainly put their money in at the moment. When the rally happens, it could be quite dramatic. I would certainly put a portion of that money to work now. There are so many cheap stocks out there.
In terms of specific equity markets, do you have any favoured markets?
When we get the initial rally, I think all markets will rise together and there won't be a huge differentiation in returns. On a three-year view, however, that's when value should start to have an impact. Japan is perhaps the cheapest major market in the world. Russia is cheaper but it's not a major market and I wouldn't necessarily advise people to buy Russia on a three-year view. Japan would be my number one pick, followed by the US. But there probably won't be a huge difference in performance between the Japanese and US markets. And Japan being a smaller market, investors should probably have a greater exposure to the US.
Some fund managers say Asia is the place to be, particularly China. What are your thoughts about that?
Longer-term, Asia will be in an important position in the global economy. But with China, there are a number of issues. First of all, there's a lack of economic transparency. We don't know anybody who has a full understanding of the Chinese banking sector. There are a number of things that could go wrong. One is clearly the Chinese banks and something nasty happening. China is a bit of a blackbox. Corporate governance in China has never been that fantastic. On the other hand, the economy does have the potential to grow at a very high rate.
Our emerging market team currently likes China. On a three-year level, I personally think China will underperform compared to the US and Japan.
People tend to be very manic about China - it's either fantastic or its terrible. And you know what, I suspect the truth is somewhere in between.
If you look at academic findings, you'll see that emerging stock markets tend not to correlate with GDP. So just because the Chinese economy is going to grow at a good rate does not mean that the Chinese stock market will do well. Looking back, returns from the Chinese stock market are way below economic growth.
But China doesn't look expensive at the moment. There is no great valuation issue. And I think people just feel that the Chinese economy will grow over the medium-term. I think it's the mirror-image of people's position in the US. People are pessimistic about the US but are optimistic that China's position in the world will grow.
Most fund managers are saying they are looking for companies with good balance sheets, healthy cash flows, little or no leverage. How can there be over-performance, in terms of equities, at a time when fund managers are looking for the same things?
One key thing is if you have an approach, you have to stick to it. A lot of managers can tend to get blown of course. They say one thing but they end up playing the same momentum games as everybody else. What I would ask a manager is, if you are so stock-focused and stock-specific then what's your level of turnover in your portfolio? That's a key indicator. If people have high rates of turnover within their portfolio then they are not necessarily doing what they set out to do.
I think you can outperform by having a consistent focused approach. It's not a matter of having the same approach, it's a matter of defining your investment approach and sticking to it.