The Bluebird portfolios are already defensive in nature due to our quality and value investment philosophy. Stocks with defensive qualities make-up around 50-60% of each portfolio. However, we have noted that financial market conditions have turned decidedly bearish in the past four months. Equity markets in the US and Australia have fallen (15-20%), the VIX has touched 36, bond yields have retreated, credit spreads have expanded and commodity prices have generally fallen sharply.
The increase in market volatility seems to have been sparked by increasing tensions between China and the US on a number of fronts (trade tariffs, technology theft, border disputes), a softening in the outlook for technology stocks, the Federal Reserve continuing to increase the cash rate and an increasingly defiant US President, in the face of mounting political and public pressure.
While the bottom-up outlook for company earnings may not have changed that rapidly, market valuations are a combination of bottom-up earnings and market sentiment. Market sentiment is affected by many different macro-economic and company factors and is forward-looking. It is the major reason why company valuations can vary to quite a degree and it is the most uncertain aspect of the share-market.
While it is impossible to predict market sentiment accurately, we believe it is prudent to take a bearish stance from time-to-time. The normal pattern of the share-market is a run of 8 bull years, followed by 2 bear years. Bear years are usually short because markets fall quicker than they rise and they encourage stimulus from governments and central banks, and prudent measures from companies, which sows the seeds for the next bull run.
The last bull run in the US lasted from March 2009 to October 2018, over 9 years, and took the S&P 500 from ~700 to 2,900, a gain of 414% or a CAGR of 17.1%. These are large numbers in absolute terms and relative to history. Since October 2018, the S&P 500 has retreated to a low of 2,351, a retreat of 20% from its highs. Given the long run in the US market and the large gains, followed by a material correction, verging on a crash, we believe it is prudent to expect a bear market for 1-2 years, given the normal pattern of bull and bear markets, described above.
S&P 500 2009-2018 Bull run | Source: Thomson Reuters
We have also noted that Gold does well in periods following major market volatility. This is because it is widely recognised as the original store of wealth, outside of government currency manipulation (ironically the major feature of bitcoin but gold has been around since the dawn of civilisation!) and it benefits when the US central bank moves to lower US interest rates. In the period, post the GFC, Gold rose from US$700/ounce in 2008 to US$1,850/ounce by 2011.
Gold price US$/ounce | Source: Thomson Reuters
This was the period where the Fed was implementing stimulatory monetary policy. While we don’t expect such drastic monetary policy as quantitative easing, we do expect the Fed to change course in 2019 and begin to lower rates as the global and US outlook softens. This should be a good period for Gold and it may well be the best performing sector in the short-term. That said, exposure to Gold is only appropriate for growth portfolios and not income portfolios. We prefer gold exposure via gold producing companies rather than physical gold, as we get much more leverage. We have recently increased our exposure to a mid-tier gold miner that meets our quality, value and momentum investment philosophy.