A correction at the end of January has ushered in a period of relatively heightened volatility through 2018, as markets have come to focus more on potential headwinds and attention has started to swing away from growth-orientated stocks, to ones with more defensive qualities, better able to operate through more challenging market-cycle conditions. In our view, while markets have regained some poise over recent weeks, further market falls are possible against the volatile backdrop. Is it best to keep chasing momentum and growth or to hunker down and invest in companies with more defensive qualities?
In attempting to answer this question, it is informative to look at 40 years of data from the S&P 500 index of US equities and the asymmetry between the effect of falling markets and rising markets on investors’ overall returns. Put simply, it has been far better for investors to miss out on the 10 worst market days over the past four decades, than to have missed out on the 10 best days.
To draw on a mountaineering analogy, many more climbers die on the way down from the summit than on the way up. Much of this could be down to the fact that a climber will use up the majority of their resources on the way up, and will be more tired physically and mentally on the descent when many of their supplies have been exhausted.
Similarly, the asset inflation driven by loose central-bank monetary policy and the abundance of cheap debt has helped propel markets to historic highs, but as resources are increasingly withdrawn, there is far less left in the tank to sustain the markets’ upward trajectory.
To us, using the mountaineering analogy again, the message seems clear: it is more important to acclimatise, prepare properly and manage resources prudently to boost your chances of surviving the descent. In the case of equity markets, we think one way to achieve this could be to invest in companies with strong balance sheets and visible, recurring cash flows that can be captured in the form of dividend income, to help augment returns when markets are volatile or on their way down.
Nick Clay – portfolio manager, Newton Investment Management.