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3rd October 2014

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Darius McDermott, Managing Director

In the fund management industry it often pays to follow the herd. If a manager positions his fund defensively and, in doing so, goes against the consensus, he exposes himself to asymmetric risk.

If he is wrong, his relative performance numbers tumble, and his fund may languish near the bottom of the sector. However, if markets continue to retrench, the majority of managers caught out can then trot out the usual “no one could have seen this coming” line, and their jobs are safe for another year.

I’m telling you this is because, in recent meetings, an increasing number of fund managers, while not explicitly predicting a sustained correction, are positioning their portfolios in such a manner which would make you think that this period of market volatility may be overdue. In short, the number of managers who are prepared to go against the herd, anecdotally at least appears to be increasing.

It therefore makes me wonder if markets have become complacent in recent months – the recent sell-off has shown investors that equity markets are not a one-way street, so I thought I would try and see if I could identify any “canaries in the coal mine”, which might give us a clue as to what we can expect from equity markets over the short to medium term.

Junk bonds (or the asset class formerly know as high yield!) are offering extraordinarily low yields. If default rates, currently near all-time lows at around 2%, rise to the long-term average of 4.5%, it would send ripples not just through bond markets, but also through equities. The Phones 4 U default is a timely reminder that seemingly healthy companies can, and do, go bust and with bonds trading at their current elevated levels, there is an argument that investors aren’t being adequately compensated for this risk. In the current environment, stock selection in the high yield part of the market is more important than ever.

The recent boom in IPOs is also a good indicator that markets are getting frothy. Companies usually choose to sell themselves when it is a good time to sell, rather than when it is a good time to buy. This trend could continue for some time, but the longer it goes on, the more nervous equity investors ought to be.

In addition analyst earnings downgrades have outpaced upgrades over the previous two years, yet shares have trended higher. This has been driven by multiple expansion, cost cutting and, dangerously, companies issuing debt to buy back their own shares, which artificially increases their earnings per share numbers. If real earnings growth fails to materialise the markets could lose patience very quickly.

Of course, the US Federal Reserve and Bank of England have indicated that rates are likely to rise in the near term. In previous cycles, rate rises have often signalled the top of the business cycle and that corporate profitability may be on the wane.

The sell off in small and mid-cap stocks (especially in the UK) perhaps indicates that some investors are de-risking. In previous downturns, liquidity often leaves smaller companies first, before moving up the food chain.

So what does this mean for UK retail investors? Well, the consensus view at the moment appears to be a long developed-market equity position. I would go along with this, for the time being at least, as equities are slightly expensive by historical standards, but by no means exorbitant, and our economies appear to be moving in the right direction. However, while I cannot predict the length and breadth of a sustained correction, we can expect periods of volatility. So, if you are worried, you have a range of options available to you.

Firstly, you could try to identify a defensively-minded equity manager who may be able to preserve capital better than the market, but still capture some upside if markets go higher. Secondly, targeted absolute return funds limit their overall market exposure, and may even be able to profit from falling equity prices. If they do their job properly they should offer a smoother ride. Lastly, you could diversify your asset mix, perhaps with property, commodities or cash. Since the global financial crisis, multi-asset funds such as Artemis Strategic Assets, have become increasingly popular with investors.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius' views are his own and do not constitute financial advice.