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Quotidian Investments Monthly Commentary – January 2018

February 2, 2018

We noted in our December report thatit would not be a complete surprise if the artifice and froth of the ‘Santa rally’ were to disappear again in the early part of the New Year.

In fact, the London market’s exuberance continued through the first two weeks of January but eventually economic and political reality reasserted itself and equity valuations in the UK fell back again into negative territory by the month end.

Conversely, stock-markets in the USA continued relentlessly to make record highs and trading activity in US equities in the last full week ending 26thJanuary saw an inflow of US$7 billion.  US markets have now surpassed their previous longest-ever period without having at least a 5% correction.  However, as the US dollar continues to weaken against the pound, their equity returns to a sterling investor have been subdued.

There continues to be a great deal of speculation in the media about an impending stock-market crash and, in broad terms, we agree with the premise that a correction (not a crash) is overdue.  That, of course, is why we substantially reduced the Fund’s exposure to equity markets last July by going largely into cash and, to date, this decision has served us well. 

In the medium to long term, though, cash is an unimaginative, unproductive and risky place to hold one’s money.  As evidenced above, flight capital continues to flood into the USA and the paltry yield available in Treasury Bonds (T-Bonds) simply drives that money towards equities.  Whilst this weight of incoming money continues, historical market certainties seem to be temporarily in suspense.

On 31st January 2018 the FTSE100 closed at 7533.55, a fall of -2.01% for the first month of the New Year, and it therefore stands at -2.01% for the 2018 calendar year too. By comparison the Quotidian Fund’s valuation at 31stJanuary shows a rise of +0.81% for the month and it follows that the Fund is also up +0.81% for the 2018 year to date. 

The financial media is fond of making reference to CAPE (Cyclically Adjusted Price Earnings ratio) and PE ratios as measures of equity market attractiveness.  We look most closely at the current Price/Earnings (PE) ratio.  Over the years a PE ratio of 16 has been seen as a reasonable average and a good touchstone for making value judgements on equity investment.  In terms of evaluating the market as a whole, anything higher than that is an indication that the market is over-valued; conversely, anything lower is obviously seen as the market being undervalued.

The current PE ratio of the S&P500 (as a proxy for global markets) today is 26.4, indicating that the market generally is indeed overvalued.  But the PE ratio just before the dot-com bubble burst stood at 40 and that suggests that we appear to be a long way away from ‘crash’ territory.

Another issue which, perhaps temporarily, supports current valuations is that the figure quoted above in relation to trading volumes in the US validates the assertion that there is still a huge wave of flight capital flowing into the USA from troubled parts of the world.  In years gone by a large percentage of that incoming capital would find its way into Treasury Bonds (the US version of gilts) which were then seen as the safest of safe havens.

To develop that theme; the best measure of Treasuries as an investment alternative to equities is the 10 year T-bond which, at the moment, is yielding just 2.60%.  Prospective T-Bond buyers are therefore faced with the deeply unattractive prospect of exchanging their capital in return for a 2.60% annual income and the return of just their original capital in ten years’ time (with no prospect of growth in either the coupon payment or the capital).  Alternatively the yield alone on the S&P market for example is 3% and there is the strong prospect of capital growth over a 10 year period too.  It is unsurprising therefore that the majority of this flight capital is flowing into the stock-market (instead of into Treasuries) and so supporting current equity valuation levels.

Exactly the same rationale applies to the UK market where the return on 10 gilts is presently running at 1.4%.

A further consideration is that the latest quarterly earnings reporting season is now underway and, perhaps surprisingly, has largely been supportive of current equity valuations.  In the USA by the end of January, 204 of the companies in the S&P500 had reported their results and, of these, 167 (that is, 82% of them) had declared positive earnings surprises.  The majority had also announced better than expected sales figures too.

Of course, these situations will evolve and when annual yields on 10 year T-bonds eventually come back up to exceed 3%+ and, in the UK, rise to at least exceed inflation then monies will again gravitate towards bonds at the expense of equities.  We still appear to be a distance away from that situation right now.  As and when circumstances change we will reconsider our investment strategy accordingly.  In the meantime, equities hold sway in our strategic planning.

However, we have now to solve the conundrum of when and how to take up equity positions again and we have been weighing up the evidence, much of it outlined above.

We have already selected our portfolio; we know exactly what we want to buy and have simply been patiently waiting for an appropriate time to get back in to stock-markets.  In particular we wanted to see a correction, ot at least a little downturn, before re-taking equity positions.

The fall back in latter part of January in the UK markets and three negative days in succession in US stock-markets gave us an ideal buying opportunity and so we have now begun to rebuild our equity holdings on a piece-meal (little by little) basis and we will continue to buy on market dips until our current portfolio requirements are filled.

Given the inherent nature of stock-markets there is always the risk of further downturns in equity valuations but if one has a well-chosen portfolio and is prepared to hold on through occasional periods of stockmarket volatility then capital values will inevitably recover. Perseverance, confidence, timing and patience are some of the necessary attributes in achieving the right long-term result.

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