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Fuzzy logic

Reflecting on the past couple of weeks, I am reminded of the old gag that markets have correctly predicted nine of the last five recessions. It is a fundamental principle of investing that markets do not always act rationally. Sometimes they get things wrong and usually they overreact in the short term.

This is often a good thing for a fund manager. Markets are self-correcting in the longer-term. As a result, windows of opportunity open for the astute manager to sell when assets look overpriced and buy when they appear underpriced.

One of the advantages of managing a multi-asset portfolio is that it gives you a chance to switch between asset classes to maximise these opportunities.
Heading into the recent bout of turbulence, we held more than 17 per cent cash in the T Bailey defensive cautious managed fund, largely through our reluctance to allocate to the traditionally perceived safe havens of sovereign debt.

With the FTSE 100 below 5,000, an opportunity opened up to bring that cash down and selectively buy good equity funds, increasing US and emerging market exposure and buying the BlackRock gold and general fund. Gold equities have lagged the price of gold itself and appear to represent attractive value relative to bullion.

But markets can also be infuriating. The arguments for avoiding an asset are sometimes screamingly obvious and yet markets persist in rewarding what can seem totally irrational.

Aversion to sovereign debt is nothing new. The risks have appeared too great for many months, the rewards too little. And yet US treasuries, recently downgraded by S&P, rode through the recent turbulence on a wave of deflationary fear, with yields falling on 10-year treasuries to below 2 per cent as their prices rose.

Similarly for UK gilts, to invest in a low nominal yield on a 10-year term requires confidence inflation will be muted for the next decade, especially given current CPI of 4.4 per cent. At the same time, UK equities are offering a historic yield on real assets of more than 3.5 per cent.

Short-term investors are concerned the markets could tumble further and memories of 2008 have been stirred. But this is not 2008. Credit markets appear to be functioning with greater liquidity, companies are not so heavily leveraged and neither are their inventories as high. Businesses that survived 2008 are leaner and fitter.

The 2008 crisis was a liquidity crisis. Banks were unwilling to lend to each other and investors were wary of leaving money with them. Now, outside the euro-zone at least, we have the bizarre situation in which the Bank of New York has told clients with more than $50m cash to deposit that it will charge them for holding it.

Sometimes we can listen too hard trying to catch history rhyming with itself. Longer-term investors moving into equities could look back on this as a good buying opportunity. And those buying sovereign debt now may live to regret it.

But it could be some time before such logic is reflected in valuations – and we could be in for more ups and downs in the meantime. That is the enticing and infuriating way markets behave.

Elliot Farley is manager of the T Bailey defensive cautious managed and dynamic cautious managed funds


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