Join our community of smart investors

Profit from unwinding of recessionary risk

Simon Thompson highlights pointers for the current market rally to continue, and suggests a way of playing it
January 21, 2019

At the start of the year I wrote that the strong likelihood of the US central bank easing off its monetary tightening this year could be a real game changer with positive implications for the commodity, energy and equity markets (‘A game changer’, 7 January 2019).

I am clearly not the only one thinking this way: the FTSE All-Share and FTSE Aim All-Share indices have rallied by 4.1 per cent and 6.4 per cent, respectively, in the first 13 trading days of 2019. The improvement in investor sentiment is being seen across international markets too: the S&P 500, Dax 30 and MSCI Emerging Market indices have all posted year-to-date gains of 6 per cent plus.

Importantly, I feel this is not a sucker's rally. That’s because the equity risk premium embedded in equity markets at the end of last year was at extreme levels and was largely predicated on heightened US recessionary risk as highlighted by the inversion of the US 10-year yield curve at low maturities.

Such was the negative sentiment that over 97 per cent of the constituents of the S&P 500 were trading below their 50-day moving average at the index low on Christmas Eve. This has only happened 24 times in the past 18 years as Charlie Bilello, director of research at Pension Partners LLC, points out. He also notes that on every one of those occasions the US stock market’s leading index has been markedly higher 12 months later, rising in a range from 9.9 per cent to 50.8 per cent with the average gain 23.4 per cent.

Importantly, the S&P 500 is rated on a price/earnings (PE) ratio of 16.5 for 2018, falling to 15.5 in 2019 using the latest earnings estimates, so the rating is not extreme. It's certainly not extreme in the UK as the FTSE All-Share index is priced on a PE ratio of 12 for 2018 and offers a dividend yield of 4.5 per cent, a rating that discounts any earnings growth emerging this year. Moreover, given the high correlation between returns in the UK and US, a recovery in US markets is clearly positive for UK investors.

I would point out that the 20 per cent fall in the S&P 500 between early October and Christmas Eve does not necessarily mark the end of the bull market that started in March 2009 as some market commentators are suggesting, nor a recession either. Cast your minds back to the extreme volatility in financial markets in 2011 during the eurozone debt crisis when the index plunged by 22 per cent between May and October that year, before recovering all the lost ground to make new highs the following February. Similar losses were suffered in European bourses, and markets there recovered too.

I also remember vividly the events of 1998 when the default of Russia on its sovereign debt almost led to the collapse of Long-Term Capital Management (LTCM), a hedge fund with $126bn (£100bn) in assets. LTCM’s highly leveraged investments crashed in value and by the summer of 1998 it had lost 50 per cent of the value of its capital investments. Many major banks and pension funds had invested in LTCM, so to avoid contagion risk to the global financial system the US Federal Reserve persuaded 15 Wall Street banks to bail out the hedge fund. It proved to be a game changer for battered equity markets and the S&P 500 subsequently recovered all of the 22 per cent three-month drawdown it had suffered between July and October 1998 to post record highs the following month.

The other important point to consider about events in 1998 is that the US yield curve had also inverted, but it was not a precursor to recession, nor a fully fledged bear market as the S&P 500 gained a further 68 per cent by the time it hit its dotcom high in March 2000. Moreover, the recession that coincided with the 2000 to 2003 equity bear market didn’t actually start until March 2001.

The point I am trying to make is that it pays to take a contrarian view when risk aversion is at extreme levels and is predicated on Armageddon economic scenarios that are highly unlikely to pan out. Indeed, since the 1930s, there have been nine occasions when the US equity market has fallen by 20 per cent or more (mean drawdown of 29 per cent, according to Pension Partners LLC) and didn’t enter recession. The 2011 and 1998 cases aside, the market sell-off between August to October 1987 proved to be a great buying opportunity too.

Interestingly, all three of these most recent 20 per cent-plus stock market sell-offs (that have occurred outside recessions) only lasted a matter of months, another similarity with the 12-week US equity market drawdown in the final quarter of 2018. That’s worth considering as an end to the US government shutdown, an easing of tensions in US-China trade relations, and de-risking the impact of the EU crashing out of the UK goods market in a no-deal Brexit, all have potential to improve investor risk appetite no end. It is certainly not a forlorn hope to think this way. In fact, selective buying of oversold shares is the sensible approach in the circumstances.

 

Lowly rated Miton presents a buying opportunity

And with this thought in mind, I noted the fourth-quarter trading update from asset manager Miton (MGR:54p), a company I first highlighted when the share price was 23p ('Poised for a profitable recovery', 4 April 2015), since when the board has paid out dividends per share of 3.67p. The price had trebled to 71p when I covered the 2018 interim results (‘Miton primed for further upgrades’, 25 September 2018).

The share price performance was justified as by the end of the third quarter of 2018, Miton had assets under management (AUM) of £4.87bn, more than £1bn higher than at the start of last year. This reflected £927m of net fund inflows in the nine-month trading period, buoyed by a stellar investment performance. No fewer than 13 of the 16 funds Miton manages are ranked in their first or second quartile by their performance. And despite the volatile market conditions, Miton still pulled in £92m of net inflows in the final three months of last year.

However, the business has not been immune to weaker stock market conditions and, after factoring in the fall in markets, AUM closed the fourth quarter at £4.38bn. That’s still 14 per cent higher than 12 months earlier, but it prompted analyst Stuart Duncan to clip his 2018 pre-tax and earnings per share (EPS) estimates slightly to £8.5m and 4.2p, respectively, up from £6.8m and 3.4p in 2017.

Mr Duncan still expects a hefty hike in the dividend per share from 1.4p to 1.9p when Miton reports annual results on 19 March. The board of directors can afford to be generous as closing net cash of £25.5m, a sum worth 15p a share, was 25 per cent higher year on year. On this basis, net of cash on the balance sheet, the shares are rated on a PE ratio of 9. They also offer a 3.5 per cent prospective dividend yield.

True, Peel Hunt is expecting flat EPS in 2019, but this could be a conservative assumption if the ongoing bounce-back in equity markets has legs, as I am predicting. Most importantly, I am not finding it difficult to find value opportunities in UK equities, and nor are Miton’s asset managers as I have noted a decent cross-over of my recommendations with holdings in Miton’s funds.

I would flag up too that Miton’s US Smaller Companies Fund was the second-best-performing fund in its space last year, and its European Opportunities Fund is the top-performing in its sector over the past three years and since launch, reasons to expect further positive net fund inflows on overseas funds. By my reckoning, Miton's European and US funds account for over £1bn of AUM, giving investors exposure to overseas markets too. Not that the UK funds are proving a drag in any way. For instance, Miton's UK Multi Cap Income Fund is the best-performing fund in the UK Equity Income sector since launch and continues to see strong demand from investors. That fund ended 2018 with AUM of £1.26bn, a 25 per cent year-on-year increase. Buy.

 

■ Simon Thompson's new book Successful Stock Picking Strategies and his second book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 to place an order. The books are being sold through no other source and are priced at £16.95 each plus postage and packaging of £2.95, or £3.75 if you purchase both books. Details of the content of the books can be viewed on www.ypdbooks.com.