How to ensure rotation can keep portfolios fertile rather than fallow

He may have been in charge of foreign policy under George I, but eighteenth-century politician Charles Townshend is best known as ‘Turnip’ Townshend for his work in the field of agriculture. He introduced the four-crop field rotation system, as wheat, barley, clover and turnips were grown annually in order in enclosure. The system helped keep the land fertile and boosted yields and returns for farmers.

But it is not just producers and consumers of knobbly winter vegetables for whom the concept of rotation is important. It is a key issue for investors too.

Even if we must all accept that timing the cycle perfectly is fraught with danger, investors can identify the shifts between asset classes, or within them, that may herald a broader change in risk appetite and potentially portfolio performance. Adopting more or less aggressive strategies at certain key periods, even on a tactical basis, could in these circumstances help to augment returns or protect portfolios.

In the context of the stock market, this column is always on the look-out for

• An increase or decrease in overall market volatility
• An increase or decrease in individual stock price volatility
• Changes in market leadership between certain sectors, styles or groups of stocks
• A reversal in market momentum at an individual stock level

Changes here can signal a shift from a bear market to a bull market or vice-versa and for the moment the signs are that investors may need to tread carefully. This is not to say that the long-feared, long-awaited correction is upon us by any means (this column’s crystal ball is not that powerful, alas).

But certain trends do suggest that the ingredients might be there for a wobble of some kind. Investors need to ensure that their portfolios are suitably calibrated to ensure they are prepared for any unforeseen event and that risk tolerance thresholds are not unwittingly tested.

Calm above the surface

At first sight, markets still appear serene, using the so-called VIX (or ‘fear’) indices for the UK and USA. These benchmarks are a guide to expected stock market volatility over the coming 30 days and both reside near record-lows, to suggest that an extended period of calm is still expected.

Volatility is very subdued by historic standards in the USA ...

Source: Thomson Reuters Datastream

In some ways this bodes well, as low volatility has historically coincided with good share price performance. Equally, the charts for the UK and US show that the previous extended periods of low volatility and rising stocks (such as 2005-07 for the UK and 1994-96, 1998-2000 and 2005-07 for the USA) were followed by the substantial bear markets of 2000-03 and 2007-09 and the wild wobble that was the Asian and Russian debt crisis of 1997-98.

... and also in the UK

Source: Thomson Reuters Datastream

Three more tests

This means that stock markets are still comfortably passing the first of our four tests, namely that the price action at headline index level remains calm.

That takes us on to the next three tests, where the news is potentially more thought-provoking.

• An increase or decrease in individual stock price volatility

For all that the headline indices seem as flat as a mill pond, they are churning below the surface and this can be seen in a number of ways.

First, six FTSE 100 firms – AstraZeneca, BT, Convatec, Merlin, Pearson and the now ex-constituent Provident Financial - have all fallen by more than 10% in one single trading session this year.

The dispersion between the best and worst performer even over the past month is wide, with theme park operator Merlin down 16% and Pearson up 12%, to suggest growing intolerance of even the slightest disappointment and a gathering desire to latch on to positive momentum (Pearson hasn’t issued a profit warning since January to end a dismal run of them).

Second, other names, such as Burberry, ITV and Marks & Spencer, have all suffered rough treatment this month alone as the market has rejected long-term investment plans and the short-term profit this may entail in favour of a more ‘jam today’ approach.

Finally, it is possible to see a shift in which stocks are doing best and which are not. While not all investors will have the time or inclination to do to much digging (as that is what fund managers are for) they may be intrigued to note the shift to a combination of relatively steady names (Shell, Croda, Vodafone) and growth (Scottish Mortgage and Micro Focus) and away from serial acquirers (drug stock Shire) and potential value plays (or value traps) like Next, Morrisons and ITV, all of whom rely heavily on the UK economy.

Stock leadership within the FTSE 100 has changed markedly in the fourth quarter

Source: Thomson Reuters Datastream

• Changes in market leadership between certain sectors, styles or groups of stocks

The change in stock leadership hints at a change in sector leadership, which takes us back to the concept of Turnip Townshend and crop (or sector) rotation. Before central banks started actively intervening in markets, it was pretty easy to argue the case for company profits reverting to the mean over time and the economic and stock market cycles following a clear pattern.

This is pretty much how it used to work:

How certain sectors have tended to perform over the economic cycle

Source: Shares Magazine. * Based on FTSE All-Share sector performance, 1 January to 14 November 2017

The numbers next to each sector show their performance ranking, from one (the best) to 39 (the worst) within the FTSE All-Share in the year to date. Note the preponderance of low scores (and thus good performance) among the late-cycle plays – so investors need to watch out for any improvement from the traditional sources of protection from recession, as that could signal trouble ahead.

Equally, many of those areas – telecoms, food retail, and general retail – are dogged by internet-driven or regulation-inspired price deflation, so perhaps this old model is now less reliable than previously.

• A reversal in market momentum at an individual stock level

Attention must be paid once markets start handing out harsh treatment to concept stocks that previously flew, so the hammering handed out to electric vehicle leader Tesla is interesting in this context, as earnings disappointments are now being held against the stock rather than treated as a blip.

Nor is narrowing leadership usually a good sign. This final table shows the number of FTSE 100 stocks that are up over six distinct time periods. The shorter the time horizon, the fewer risers there are, to hint at some huddling in names that are seen as safer, or better quality or more reliable. This is often a trend seen toward the fag end of an economic or stock market cycle as momentum ebbs and disappointments pile up. This column will keep watching this one with interest:

Breadth of leadership in the FTSE looks to be narrowing

Source: Thomson Reuters Datastream. *Flat defined as a price change of less than plus or minus 1%.

Pondering plateaus

It must be noted that rising volatility does not mean a bull market is destined for an immediate demise. The charts for the VIX in the US and UK showed that volatility increased steadily for some time before the wheels fell off and the final crescendo actually signalled a buying opportunity for those who were brave (and liquid) enough to get involved.

This can be seen in another way, by looking at the monthly number of daily movements in the FTSE 100 of more than 1% (up or down). We all know history is not guaranteed to repeat itself, but in the past genuine calm has coincided with gains which continued even as doubts and volatility grew before the final smash, so at least investors got some sort of warning which gave them a chance to take out some additional portfolio protection.

Rising volatility does not have to mean the immediate end of a bull market

Source: Thomson Reuters Datastream

Even if the four signals outlined above prove to be false (this time) it would certainly be unwise to assume that equity valuations and stock prices will merely go sideways once they give a stronger sign that volatility may finally be about to return with a vengeance.

After all, the highly respected economist Irving Fisher argued on 15 October 1929 that “Stock prices have reached what looks like a permanently high plateau,” only to walk straight into the Wall Street Crash just two weeks later.

Russ Mould, AJ Bell Investment Director