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One odd thing about this nasty market is how little it seems to bother most investors. Global equity markets are down 15 per cent so far this year — and many parts of the market are off very much more — yes, I am looking at you, US technology stocks.
But while data from the platforms shows investors looking at more conservative investments than in the past (a good thing), Scottish Mortgage is still the most popular investment trust on buy lists (an odd thing given that it is at the epicentre of the market meltdown).
However, the lack of obvious stress amid private investors makes a certain kind of sense. After all, most of us have still made a little money in nominal terms over the past two years and quite a lot over five.
The latest numbers from Interactive Investor show that while their average DIY investor is down 11 per cent this year, they are up 13.2 per cent over the past two years and 2.6 per cent over the past two and a half, that is since just before the lockdown-induced crash of March 2020.
The past two years have been so unreal in so many ways that having the same amount of money as you did then seems sort of all right. A lucky escape even.
The problem is that we cannot be sure we have yet escaped. Valuations are not as bad as they were — the cyclically adjusted price/earnings ratio of the US market is back down to 28 times from a high of 38, for example — that’s only about 15 per cent higher than the 15-year average.
The UK market is on a cyclically adjusted price-to-earnings ratio (CAPE) of 14.6 times on numbers from Cambria Investment Management — that’s only a few per cent off its long-term average.
This might all sound reassuring, comforting even. It probably shouldn’t. The truth is that in markets such as these merely reverting to long-term averages is not enough. It makes sense says Matt Kadnar, portfolio manager at GMO, an asset manager, that price/earnings ratios should be higher than their long-term averages when things look good. If profits are high, economic growth is good and inflation is low, investors feel comfortable and “they are more likely to pay a higher multiple on the market”.
It makes sense then that in the pre Covid years, when all this was true, valuations were “substantially higher” than their long-term averages. Things are clearly rather less comfortable now — very uncomfortable, in fact.
So valuations should now not be at their long-term averages, but rather below. How much below? GMO has a model for that — one that Kadnar says has historically shown “incredibly high” explanatory power. Unfortunately, this model — the Comfort Model — is not telling us anything reassuring: the CAPE should be knocking around 19 times, rather than 28 times as it is now. To get back to average would require a fall of 15 per cent — more if the earnings bit of the equation gets nasty. If investors eventually react to current circumstances as they have to similar events in the past that 15 per cent might be just the beginning. Feeling less comfortable? You should be.
You should also now turn your mind to getting a little insurance against valuations falling not to, but well below, their long-term averages.
One place is in the investment trust sector. Most analysts keep a close eye on the discount at which their shares trade to their net asset value (NAV) to get a sense of when it might be time to buy. In June, the average discount across the sector widened to 9.5 per cent, says Winterflood — that means you can buy the shares in the average trust for 9.5 per cent less than the actual value of the assets it holds. That number was 2.2 per cent at the start of the year — which should have been a danger signal by the way. That’s against an average of 4.4 per cent over the past year and 4.7 per cent over the past decade.
There’s a huge range here of course — huge discounts in sectors such as property, private equity and technology, something that reflects the expectation that the prices of the underlying assets they hold will soon fall further, and not so huge ones in the likes of UK equity income.
But the key is that the discount is wider than usual, which is good, but probably not quite wide enough to be a screaming buy signal. It’s clearly not if we think of it in terms of the Comfort Model — there have been times in the past when the average discount in the sector has been 20 per cent.
That said, any discount over a couple of per cent offers you some insurance, as the expectation of falling prices of the underlying holdings is already in the price. And there are some trusts that seem to offer very significant levels of long-term insurance.
Look to the private equity sector says Nick Greenwood, manager of the MIGO Opportunities Trust, a trust of investment trusts.
Many trusts in the sector deserve to be on whopping discounts, the average being currently well over 30 per cent. The value of a lot of the holdings will soon be written down in line with price falls in the listed markets.
But not all private equity trusts invest in the kind of early-stage growth businesses that are collapsing in value. Some have long focused on mature businesses and focused on profits and cash flows. They will not see the same writedowns — so might be genuinely cheap and provide you with built-in insurance. Look at Oakley Capital Investments — on a discount of 30 per cent — and NB Private Equity Partners on 36 per cent, says Greenwood.
The other place to look for insurance in the UK at least is in dividends. Those invested in the FTSE 100 this year will have lost about 3 per cent. But this will for now at least be compensated for by the dividends they will receive along the way — the yield on the UK market is forecast to be 4.2 per cent this year — a total payout of £85bn, up from £78.5bn in 2021.
This is not a one off: the payments are well covered by corporate profits, notes AJ Bell, and while there is some concentration risk here, as over half the total payout comes from only 10 stocks, more companies are paying dividends this year than last year.
These dividend payments matter. The FTSE 100 may fall 20 per cent from here — who knows? But if it goes down and stays down, dividend investors will at least know they have an excellent chance of being evens in nominal terms at least in five years, thanks to getting 4 per cent-plus in dividend payment every year.
You might even go for a double bite of cover — and buy one of the UK’s income trusts. They don’t come with much of a discount these days, but you can get 2 per cent off NAV at Murray International (yielding 4.5 per cent) and JPMorgan Claverhouse (4.7 per cent). And 10 per cent at the Lowland Investment Company (5.4 per cent). There’s got to be some comfort in that.
Merryn Somerset Webb is editor-in-chief of Money Week. She holds shares in investment trusts but none in the companies named. The views expressed are personal. merryn@ft.com
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