20 December 2018

What have we learnt from 2018? Year in review

(Nick Griffiths, Pengana Capital Group's CIO)

Something unusual may have happened in 2018, and it’s not a double-digit correction in equity markets. The rare event is that for the first time in at least 25 years, real returns from 10 major asset classes are likely to be negative this year. With major economies slowing, concerns regarding political events and valuations, and regulatory issues facing a number of industries, it is likely that investors will face another turbulent year in 2019.  Smart investors will prepare for this, foolish investors will make predictions - stock markets, bond yields etc, and probably divest as a result.

At the time of writing, the ASX All Ords had fallen -4.8% for the calendar year, the Small Ords -8.2%, and the MSCI All Country World Index was hovering around zero. These numbers mask the volatility at the start of the year, the change in the market sentiment and direction mid-year, and the variations in terms of styles and sectors that have occurred. For example, August saw a marked change in style factors in Australia, with Growth and Momentum falling out of favour, and Value becoming the dominant style factor. Many investors and managers previously enjoying the mid cap growth story were caught unawares and have suffered significant losses since.

It is well known which sectors typically perform well in the latter stages of a bull market and into a bear market. On the plus side Consumer Staples, Healthcare and Utilities typically do well, on the negative Information Technology, Consumer Discretionary and some Industrials tend to suffer. Of course, it’s more about the stocks themselves, but it is still surprising to us how many investors were prepared to ignore such simple pieces of information, perhaps because they’re inexperienced, perhaps because “this time it’s different” or perhaps they just didn’t want to think about it.

Falls in equity markets are however the norm, and the recent correction should have come as a surprise to few. For example, the S&P500 has experienced a double-digit intra year drawdown in 57 of the 91 calendar years since 1928.  In 23 of these years the maximum drawdown exceeded 20% - when markets fall they fall a lot. Maximum intra year drawdowns of less than 5% are far more unusual.  At the time of writing, the S&P500 had fallen 15.4% in 2018 and will almost certainly finish the year in negative territory.

It should also not have been a surprise that the correction had an arbitrary nature. During a correction or crisis, stock markets become less efficient in incorporating firm-specific information into stock prices. This creates an element of unpredictability, for example it is not necessarily the case that the most expensive stocks fall the most. In some cases, it is the most liquid stocks that fall the most, because these are the stocks that investors can sell. The reaction to the changing tide may be determined by sentiment, mandate and circumstance, rather than logic. 

Pengana’s funds tend to perform relatively well once the dust has settled after weak and volatile markets. While they can’t combat the unpredictability, they do have a few inbuilt advantages, as well as the experience of their managers. 

All of our funds are benchmark unaware. They are not constrained by the construction of a benchmark, indeed they’re not even interested in the benchmark.  The importance becomes clear when, as discussed above, the relative performance of certain styles and sectors is considered at different points of the cycle.  As mentioned certain sectors are cyclical and their performance is economically dependent.  As at 30 November this year, the weightings of the IT and Consumer Staples sectors in the S&P500 were 20% and 7% respectively, and that was after an already large correction in the IT sector. Having the flexibility to vary sector weights throughout the cycle is a clear benefit in managing an equity fund through the cycle.  But sectors are just one example.  The same observation could be made regarding companies of different sizes, different valuation and growth characteristics, different leverage, and so on.

Many of our funds are also able to vary their cash weighting, they do not need to be fully invested. This has many advantages. Firstly, as value becomes harder to find, they are not forced to invest but can accumulate cash rather than being forced to buy expensive stocks. Secondly, when the market corrects their performance is relatively good, it may still be negative but they are not suffering the pain and distress of fully invested funds.  They remain “emotionally whole”, to coin a phrase of one of our managers.  Lastly, when the market has fallen to the point where there is identifiable value, they have cash at hand to invest and can make the most of the recovery.

Looking forwards, we can predict the future no better than anyone else, and so we don’t try.  As Jack Bogle, Vanguard’s founder once said, "It would be great to get out of the market at the high and back in at the low. But in 55 years in the business, I not only have never met anybody that knew how to do it, I've never met anybody who met anybody that knew how to do it." He may have been talking his own book, and we certainly don’t recommend index products, but we agree with his observation.

Many investors however do not, and are convinced they can time their exit from markets, and presumably their re-entry as well.  There is a vast amount of evidence that this is not the case, we’ll quote just one of the many sources here. The Boston based institution DALBAR has been studying retail investor behaviour in the US since 1994.  To quote directly from its findings: “No matter what the state of the mutual fund industry, boom or bust: Investment results are more dependent on investor behaviour than on fund performance.  Mutual fund investors who hold on to their investments have been more successful than those who try and time the market.” As a reminder, in the 6 months to February 2009 the Australian market (ASX All Ords) fell by 35%, in the following 6 months the market rose by 39%.  How many investors got that right?  We don’t know any.

Like many investors, we expect global equity markets to struggle again next year, with some stock markets likely to experience further declines. It is generally agreed that the global economy is in the late stage of the business cycle; Chinese and Emerging Market economies are showing signs of slowing, the US economy is expected to slow further once the effects of the fiscal stimulus wear off, interest rates are no longer falling but are flat or rising in most economies, equity markets are overvalued and a correction is underway.

Divesting however is not the answer. As discussed, no one can predict the timing and magnitude of market behaviour, nor the underlying economic fundamentals such as yields, and certainly not the drivers of investor sentiment, which in the short term at least are the main determinant of equity market behaviour.  What is required is experience, a flexible mandate and a strong investment process.  And let’s face it, a bit of luck.

Wishing you good fortune in 2019 and an enjoyable and well-earned break, from the team at Pengana.


This report has been prepared by Pengana Capital Ltd (ABN 30 103 800 568, Australian Financial Services Licence No. 226566) (“Pengana”).  This report does not contain any investment recommendation or investment advice and has been prepared without taking account of any person’s objectives, financial situation or needs.  Therefore, before acting on the information in this report a person should consider the appropriateness of the information, having regard to their objectives, financial situation and needs.

The value of investments can go up and down.  Past performance is not a reliable indicator of past performance.
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