The violent swings that have characterised equity markets in recent years – the increase in the volatility of volatility – have helped to persuade many investors of the advantages of ‘market neutral’. It is a simple principle. We maintain a portfolio balanced between long and short positions. This allows us effectively to remove the impact of the market and focus on the value in individual stocks.
The principle is simple, but the practice is slightly more complicated. When we make decisions on stocks, we look at an array of fundamental data – key valuations, growth prospects, analyst views and so on. But as we have seen, it is not always the fundamentals that move equity markets. Over the past year especially, macro factors have tended to be primary, displacing all other considerations.
It is tempting to dismiss the macro-driven market panics as a distraction from the ‘real economy’ in which companies operate, particularly when we know that many companies doing business at a global level are in robust financial health. If there is money anywhere in the world economy at the present time, it is in the revenues and balance sheets of the companies represented in the MSCI World Index.
We can dismiss it all as a distraction, but it is happening and as investors we need to function in the world as it is rather than as it should be or might be. While we need to keep vigilant on the fundamentals, obviously, but we also need to take account of what we might call investor sentiment, or even investor perception. If investors think there is about to be a massive credit event in the eurozone, they are likely – wisely enough – to want to retreat to quality stocks as quickly as possible. In this environment, valuations, management quality, analyst expectations and other fundamentals give way to considerations such as balance sheet strength and resilience of earnings.
Last summer was all about quality, while the autumn and winter months, seeing strong risk on rallies, witnessed a swing into value and even deep value. More recently, the emphasis has been risk off, with investors moving back to quality. What next? There is significant instability within equity markets right now, and the instability is being driven by the unknown. The macro views driving equity markets are difficult to forecast – what will happen with Europe, in the US, whether or not their budget deficit will be cut, whether the UK will, given the coalition government, make the right decisions or not.
These macro-political issues are difficult to forecast and that is being played out in equity markets, so that the types of stocks that outperform or underperform change quickly and in a volatile manner. But the one thing that does not change is mispricing, and if you get the mispricing correct you can to a large degree avoid the instability that you see in markets. You can be market neutral.
Valuation strategies – decisions on whether ‘quality’ or ‘value’ are likely to outperform – have tended to dominate over the past year or so. Insofar as high levels of volatility continue, that may remain the case. However, in less violent periods we expect to market dynamic strategies, the framework through which we study price signals, is more likely to come to the fore. In periods of re-adjustment, analyst sentiment can become important as market participants revise estimates and forecasts. Equally, monitoring management decisions can be vital at certain phases of the cycle.
In this environment, with markets swinging between unpredictable, high impact macro events on one side, and fundamental corporate data on the other, the key is not to try to second-guess every chop and change in every mini-cycle. What is critical is to identify the signals foreshadowing larger movements and being ready to act positively and effectively on the appropriate information.
Ian Heslop is manager of the Old Mutual global equity absolute return