One day the outlook may be less bleak, the haven may lose its appeal and money could swiftly flow away from the dollar and US equities. The index tracker funds will not anticipate this.
One signal that Japanese equities had become inflated in the late 1980s came from comparing the Japanese market’s share of the investment index to the economy’s share of global GDP. There are many hazards in this measure.
Equity values reflect discounted future cash flows, while GDP reflects current income of a whole economy – not profits in the quoted part of that economy. All the same, Japan’s share of the core global indices was around three times what its share of global GDP might have suggested. Today the US’s share is around four times what its GDP would imply.
Then we must consider currency. The dollar’s strength is a concern, especially versus the yen, which has not been valued this low against the dollar since 1998. This is a boost to Japan’s exporting manufacturers.
We now have nearly 10 per cent of our portfolios in Japan. We have brought our exposure to US assets down to 58 per cent. This is a modest 4 per cent under the index weighting, but we can reduce it further if risks mount. There are other steps we and other global equity managers can take to mitigate risk and help deliver alpha.
Defence against bubbles
We believe inflation is likely to be persistent, and in such an environment highly valued shares tend to underperform. Within our portfolios we have addressed this risk by shifting to a mix of growth and defensive stocks, bringing our average P/E down from 22.3x to 14.7x in a year, while increasing dividend yields by 72 per cent.
When bubbles inflate they tend to pull more and more passive funds in behind them. Nobody can tell exactly when bubbles will burst. When they do it is too late to have moved your savings to a more prudent home.
Markets have fallen a fair bit over the past year, but it is not obvious that the bubbles have entirely been burst.
Investing to protect and grow wealth
There is another problem with benchmarks. Their construction reflects recent past performance but, as the regulator requires us to hammer home to clients constantly, past performance is no guide to future performance.
