Time to look to Europe

Overall, I'm not about to set the world of investment alight with these returns but I have consciously attempted to diversify my exposure between adventurous stuff as well as much more cautious investments including hedge funds, structured products and infrastructure assets. I'm happy with my two- and three-year returns - and that 2.4 per cent gain over the past three months - but I've underperformed over the past 12 months.

I reckon that my poor numbers for the past year can be accounted for by two main factors: a few disastrous small-cap investments and my bias towards equities with a strong resources flavour. Both of those factors find an echo in returns (both positive and negative) for the last quarter - my investment in African agriculture business Agriterra (AGTA) continues to sink at an alarming rate (what on earth is going on?) as does small-cap resource investor Praetorian, which has been an utter stinker. Oil services giant Petrofac (PFC) has also been a veritable dog over the last quarter after a poorly received profits warning - it's down 10 per cent over the last three months although I am thinking of topping up my holding in this business.

Yet I'd also argue that my over-exposure to deeply unloved contrarian ideas such as resources businesses can sometimes pay off. Over the last three months, for example, BG's shares shot up 19 per cent after investors reacted to boardroom turmoil by marking up the shares sharply in value. I think BG, despite its managerial travails, has great set of strategic assets which will almost inevitably be a takeover target at some point. The 17 per cent uptick in Ecofin's shares is also a result of increased activity in the energy sector, this time based on shale gas and oil - this London-listed investment trust holds big stake in an Australian-quoted, US-based shale oil and gas business called Lonestar which is ludicrously cheap and has just raised a large amount of money to invest in new drill sites. In passing I'd also note that my various energy sector trackers from iShares have increased by 10 per cent in value - increasing oil prices have helped boost sentiment towards some energy equities, a trend I sadly see reversing in the next six months as oil prices slip back again.

So, taking a step back, what should I do to improve my performance? Over the next few weeks I'm going to take a long, hard look at my portfolio and make some big changes. One catalyst for this review is that a big chunk of money invested in a structured product called the Incapital AAA Plan will mature in July - this influx of cash will push my cash reserve back up to 25 per cent.

It's clear that some of my small-cap choices have been flaky to say the least (Agriterra and Praetorian spring to mind) and I need some new ideas - I'll report back on this in my next column. I'm also wary about some of my more contrarian themes - I'm a bull on Chinese equities but I have a horrible feeling that we've not yet seen the worst for local equities there, especially as Chinese credit tightens and the local property market goes pop. I'd quite like to start feeding money slowly into the growing list of long-term opportunities but I think I'll wait until after the summer before making my next move.

My other key worry is that I'm growing ever more cautious about the short-term prospects for equities in general, which is in turn prompting me to increase my cash levels for the next six months. I'd really quite like a brutal but short-lived stock market correction to take equities back another 10 or 15 per cent - at that point we might run into some bargains again.

What's behind my wariness for the next few months? Andy Lapthorne, chief quantitative equity strategist at Society Generale, sums up my concern succinctly when he observed that "a strange calm seems to be enveloping asset markets, a sense that with inflation under control and continuing central bank support there is little downside to owning any asset. The risk of not investing, rather than sitting on the sidelines and moaning about the lack of underlying value, appears to be the greatest concern. This investor complacency is apparent in a wide variety of charts we look at, from cross-sectional performance to valuation dispersion to overall levels of market volatility."

Three vastly contrasting measures sum up this growing complacency about risk in my humble opinion. US advisory company Acertus has recently launched a fascinating new indicator that combines a bunch of measures aimed at looking at everything from valuations through to investor behaviour. It's a really useful measure of the US equity scene and it's called the Market Sentiment Index (AMSI) - the company releases the main findings on a monthly basis and it currently suggests that investors are complacent although not dangerously so.

Another risk indicator worth keeping on your radar focuses on the cost of options to insure bank bonds via the credit default swap (CDS) market. Each individual bank has a basis point charge for insuring those one-year or five-year bonds - and rates have pretty much collapsed over the last 12 months as investors have decided that there's no real meaningful risk of default.

Banco Santander and RBS, for example, have changed quite remarkably in the past six months - both were once viewed as much riskier by investors, but looking at one-year rates Santander is now viewed as less risky than Morgan Stanley and Nomura, and only just a little bit riskier than rock-solid JPMorgan. At the five-year CDS level, the changes are even more remarkable - both RBS and SG have seen their rates move in sharply (lower CDS prices) to the point where they are both roughly at the same level as Commerzbank, Goldman Sachs and Nomura.

This all smells a bit fishy to me and suggests we are underestimating systemic risk, especially in the financial services sector.

I've also reached the same conclusion from news emerging out of the government bond markets, where a crucial 3 per cent yield barrier has finally been breached - Spanish and Italian 10-year bond yields have fallen below 3 per cent and the spread between against super safe German bunds has broken the psychologically important 150 basis point mark. In fact, both of these countries' bonds are yielding only a fraction above UK gilt rates - a remarkable number for countries that don't have their own currency.

If I were a bond investor (which I'm not), I'd hazard that these numbers suggest we are underpricing risk levels. But it's also true that those eurobond numbers do have one positive upside - investors have finally stopped worrying about a systemic eurozone crisis. Declining yields on those European government securities make local bonds increasingly unattractive, which in turn should help push more money towards European equities, making them much the most attractive asset class on the block.

Morgan Stanley's highly-rated equity analysis team led by Graham Secker recently put out a note that suggested that Europe's large caps are trading at record low valuations in relative terms - "after years of underperformance, we believe now is the time to raise exposure to large-cap stocks as they offer the best risk-reward across the market, in our opinion - and that these bigger companies are now trading at 30-year relative valuation lows to the rest of the market on P/BV and are close to 30-year highs on relative dividend yield. Their relative normalised PE ratio is also at record lows and the current 30 per cent discount is comparable to the premium we saw in 2000 at the structural peak for large caps." The good news for contrarians is that these large caps are a "significant consensus underweight across both long-only investors and hedge funds. Recent ETF flows have strongly favoured mid and small caps and the average sell-side analyst rating is considerably more bullish on this area of the market than it is for large caps." That could change as M&A activity picks up (AstraZeneca).

The other positive driver could be the surging dividend payout across Europe - as of the end February 2014, despite the good equity performance in the last year, the dividend yield of some 60 companies in the MSCI Europe Index (of a total of 461) exceeded 4 per cent. According to a report by analysts at Allianz, these dividend payments will "continue to grow moderately in 2014. Overall the framework of monetary policy should continue to support global growth – monetary policy therefore represents the safety net for the global economy. The inventory build-up should benefit the developed economies additionally. Accelerating investment activity boosts economic growth further... In Europe, the ratio of paid dividends to earnings per share is currently around 55 per cent, which is moderate by historical comparison. In the US, it is close to its lowest levels ever, at about 35 per cent. There is thus scope for dividend hikes."

I reckon that it's time to start building up my eurozone exposure.