Going on Forever?

By Dr Stephen Barber 15:45 31- Jan -2008

Stephen Barber considers investment strategies during the current stage of the market cycle.

If Herb Stein, chairman of the Council of Economic Advisers under Nixon and Ford, had achieved nothing else, his legacy would be an eponymous economic law. Back in the 1970s he contributed a phrase to public life that investors should periodically remember. "Things that can't go on forever won't," he said and of course he was talking about the economic cycle. We are all getting rather used to sustained economic growth, a strong housing market, low inflation and good stock market returns. But we should not expect them to continue indefinitely and were Herb still with us it is what he might warn us today.

The United States appears on the brink of a downturn with the sub-prime crisis stubbornly unabated and monetary policy loosened specifically to inject some vim into flagging equity markets. Policy makers in Britain and the rest of Europe are performing a delicate balancing act between warding off America’s cold to the West, enjoying the continued fruits of Chinese and emerging market growth in the East and ensuring inflation is controlled at home. Such a balancing act puts constraints on the economy and on equity markets but should also support it through the sort of turbulence most commentators now expect in 2008.

Such an environment is not bad news for investors. It simply means that strategies need to be adjusted, structuring portfolios to best profit from market conditions. Assessing risk is key to portfolio management and this is all the more important during times of volatility. For the longer-term investor, rapidly recumbent market conditions can present opportunities to buy quality. It might also be a juncture at which the quality of existing holdings can be assessed.

For active investors, the most unattractive conditions are the sort of sleepy markets we experienced a couple of years ago when volatility slowed to snail’s pace. 2008 promises to be the antithesis of this with a heady ride to what could still be overall progress, should share prices continue to rise commensurate with earnings. Stock pickers will be able to profit from market vicissitude, by selecting both individual equities and indeed outperforming sectors.

But it is not only a market for the trader. With small caps still underperforming their larger brethren, index trackers remain a sound method of gaining equity exposure, especially when funds are drip-fed, regularly into the market. Here that old chestnut ‘pound-cost averaging’ can be achieved. This means that investors buy as the market peaks and as it troughs but buy disproportionately more as it falls, thereby helping to neutralise risk.

Instruments such as covered warrants and CFDs can appeal to both branches of the private investor tree. They offer the ability to leverage and profit from market falls as well as hedge an existing portfolio against such setbacks. The ability to effectively short sell the market can prove profitable for those able to call those peaks and troughs but naturally is accompanied with an increase in risk. Insuring against market falls by using these products as a hedge will reduce risk but also potential returns. It is a balance that all investors need to weigh.

When market conditions appear bearish it is time to reassess investment strategies to take advantage of the new environment. These conditions will be with us for a while but will work themselves through the cycle. After all, if Herb Stein is right, things that can’t go on forever won’t and that is as true of bear as it is of bull markets.

Stephen Barber is Head of Research for Selftrade.