Bulls against bears

Ashutosh Kumar says that for every voice of optimism in the UK All Companies sector, there is a counter-balancing note of pessimism

Fund managers in the IMA UK All Companies sector are itching to claw back returns they have given up during the current economic downturn. Of late, the managers seem to have turned cautiously optimistic. This move has helped their performance immensely over the very short term as markets have rallied strongly since early March; it has also improved their otherwise dire medium- and long-term returns to April 2009. But what should investors make of this? Can they expect an end to the incessant losses incurred over the past couple of years?
There is no doubt the synchronised freefall in global markets has been painful, much worse than the dot.com fiasco. The FTSE All Share index fell by nearly 37% over August 2007 to February 2009 (this excludes the sharp recovery we have seen since the beginning of March 2009), according to Lipper. The indiscriminate destruction of wealth this time around is notably high compared with the 19% decline recorded during the previous bear market, January 2001-2003. To put the recent market falls into perspective, take a look at the performance deterioration among the sector's funds. They are down by a painful 39% over the same period, according to Lipper.
Laggards and leaders
So what explains the underperformance of laggards during this extreme period? Market timing had a lot to do with it. Factors that set apart the laggards from the leaders (who have also suffered in absolute terms) include a markedly lower level of exposure to real estate in 2007 and a strong underweight in financials around the time the sub-prime mortgage crisis surfaced in August 2007. Then, as the crisis unfolded, the relative outperformers turned out to be those who had pulled back en masse from the commodities space during the second quarter of 2008.
In fact, funds that posted the strongest relative results during this undeniably difficult period were those that had moved the proceeds from the above into defensive areas such as healthcare, telecoms and utilities. Another attribute of the outperforming funds related to the cap structure; the leaders tended to own much more in large caps given their relatively resilient and broadly diversified earnings.
But, these poor recent results do not reflect in the sector's three-year returns to April 2009, which at -8.6% annualised (cumulatively about -25%) are not as ominous as one would expect, according to data from Morningstar. The same is true for returns over five years which, at +2% annualised look fairly benign. That is mainly due to the rally we have seen since the beginning of March this year, with the FTSE All Share index up an impressive 29.1% and the peer group up a praiseworthy 26.4% over 9 March to 20 May. This huge leap has bolstered the funds' average three- and five-year track records.
Funds have rallied strongly since early March due to additions cautiously optimistic managers have made in beaten-up areas such as commodities, banks and retail, at the expense of defensive plays such as healthcare, telecoms and utilities, which have had an incredibly good run, according to portfolio data from Morningstar. For instance, the sector's top-quartile funds during the recent market upsurge have run higher than average exposure to the de-rated materials, financials and lower than average exposure to stalwart healthcare, telecoms and utilities. This decision proved extremely benign to returns as the FTSE sector indices clearly show the top-performing sectors over the three months to April included basic materials, retailers and financials. Needless to say, the laggard indices during this short period included the defensive sectors.
Ben Whitmore, manager of the Jupiter UK Special Situations fund, says: "For much of 2008, being underweight the banking sector proved positive for performance as questions remained over the sector's capital adequacy and earnings' prospects. In recent weeks, however, we have taken advantage of bombed-out valuations to increase our exposure."
Paul Spencer, manager of the Renburg UK Mid Cap Growth fund, adds: "A timely reduction in our exposure to property companies, as well as other consumer-facing areas, helped our returns during the downturn. Our extensive experience in UK equities also helped us to separate the wheat from the chaff."
Cautiously optimistic
So apart from rock-bottom valuations, what other reasons are fuelling the fund managers' cautious optimism? Well, several. For starters, the response to the crisis from governments around the world has been synchronised and unprecedented. Hundreds of billions of dollars were secured to prop up the ailing banks and save the global financial system from a total collapse. Central banks across the world also weighed in by loosening their respective monetary policies; interest rates in the UK, Europe and US are at historic lows.
In some countries such as UK and US, central banks have also resorted to quantitative easing to increase the total money supply and improve liquidity. The UK and US governments also conducted stress tests to gauge a select number of banks' resilience should the economic environment deteriorates further; the aim was to alleviate any concerns over the financial health of the banking industry and to prove that large banks operating in the country were indeed fit for purpose.
Although it is too early to say that the steps taken by the governments and central banks have rekindled global demand and resurrected the weak consumer, the sentiment has certainly improved over the past few months. There is now a consensus that the rate of deterioration in the global economy has decelerated, giving investors renewed hope that the worst is behind us.
It is also worth noting that the response to the global economic crisis at the company level has been equally wide ranging; a huge cost-cutting exercise has been underway across the globe since 2008 to reflect the lower the companies' future earnings. Furthermore, the top management is trying to keep companies well-capitalised and flush with cash.
All this has had a positive impact and recent data suggests that the global economy may indeed be turning the corner; for instance, the latest US jobless claims have risen but at a slower pace; similarly, the latest Eurozone PMI figures still pointed to a contraction but embodied a continuing improvement. A vast majority of the first quarter earnings of the S&P 500 companies beat analysts' expectations, which were more pessimistic.
But are we really out of the woods? That is the million dollar question and obviously no one knows with certainty if we are. Those who believe that the current upsurge is not a cyclical but a bear-market rally point out the following: the recent huge buying in the US is mainly down to institutions such as pension funds whose equity exposure has fallen below the required limits; these institutions are pumping in money, which in turn is pushing up prices; the recent improvement in the Eurozone PMI includes the impact of companies replenishing their stocks; corporate issuance is at record highs and empirical evidence warns retail investors should not be buying when companies are selling; the first quarter GDP declines in Germany and Japan are staggering and reflect the weak global demand; and, last but not the least, insider selling in the US is nearly 10 times higher than insider buying, which is another sign investors ought to be sceptical of any talk of a sustainable recovery.
Much like the fund managers, investors in the UK All Companies sector also find themselves standing at a crossroads. Those who are invested in funds which have lagged recently are likely to be with managers who think it is too early to shed the defensive stance. Others who have benefited from the recent upsurge in markets are likely to be with managers who are more in the 'green shoots' camp; but if markets deteriorate rather than improve and trample on the fragile 'green shoots' then they would probably give up more than they have gained recently.
There are others who are invested in funds whose managers have enjoyed great market timing, both going into the downturn and during the recent rally. Needless to say, it is unlikely the managers will be successful in timing the markets consistently. So how should investors temper their expectations?
From where we stand now, there is simply no clarity as to what the next 12 months will be like. One can only hope it will be better than the previous 12 months. For every voice of optimism, there is a counter-balancing note of pessimism. For every strong reason to buy there is an equally compelling argument to hold back. Whitmore says: "Certain factors remain crucial such as the oil price and emerging market demand.
As regards the wider global economy, managers will be watching for stabilisation in the US housing market, a return to bank lending and renewed demand from the American consumer. The US economy still accounts for 25% of the global economy.
Robert Harris, fund manager at Majedie Investments, says: "It is important for investors to remain sensibly diversified and invest in line with their risk profile. At the end of the day, investments are for the long term."