According to a new study by US bank Goldman Sachs, hedge funds currently have the lowest weighting to the US stock market in a decade and the highest weighting to European stocks instead.

Considering hedge funds are supposed be a lot smarter than the average investor – which is why they typically charge their clients a 2% management fee and a 20% performance fee – that trade hasn’t worked very well for them so far this year.

The S&P 500 index is up over 17% and the tech-heavy Nasdaq Composite is up more than 35%, its best first-half return in four decades, while the broad Stoxx 600 European index is up just 7% and the FTSE 100 has fallen by 1%.

Indeed, the rally in US stocks has been called ‘the loneliest bull market in living memory’ because nobody expected it at the start of the year and investors with mostly UK exposure in their portfolio are wondering why everyone is talking about stocks racing higher when their investments have been stuck in the mud.

NOT A STOCK PICKER’S MARKET

As Liberum strategists Joachim Klement and Susana Cruz point out, large-cap indices on both sides of the Atlantic have become increasingly skewed which has made it almost impossible for stock pickers to beat the market.

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In the US, performance has been led by the so-called ‘Magnificent Seven’ – Alphabet (GOOG:NASDAQ); Amazon (AMZN:NASDAQ), Apple (AAPL:NASDAQ), Meta Platforms (META:NASDAQ), Microsoft (MSFT:NASDAQ), Nvidia (NVDA:NASDAQ) and Tesla (TSLA:NASDAQ) – with Nvidia alone accounting for 30% of the market’s gains in dollar terms.

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These are the same stocks which underperformed the indices in the second half of last year, and as the analysts say, ‘being overweight the mega caps when they do well and avoiding them when they do poorly is not stock picking, that is market timing, and as we know market timing is extremely difficult to get right.’

The divergence between this handful of stocks and the rest of the market has been so stark that by the start of July six of the ‘Magnificent Seven’ accounted for more than 50% of the Nasdaq 100, according to data compiled by Bloomberg, forcing the index provider to reduce their weighting from the end of this month to ‘address overconcentration by redistributing the weights’.

The concentration, or ‘skew’, has been less pronounced in the UK, but even so not having a handful of key stocks in your portfolio means you will – along with the vast majority of UK institutional active managers – have underperformed the index so far this year.

WHAT HAS WORKED GLOBALLY?

According to Mike Bell, global strategist at JPMorgan Asset Management, after a tough 2022, the first half of 2023 has been ‘kinder’ to balanced portfolios.

Developed market equities on aggregate have delivered 15% gains in the first six months and 7% over the second quarter, with big growth stocks bouncing back strongly, returning 27% year-to-date and 11% over the quarter.

Value stocks have lagged, up just 5% in the first half, and bonds – which were also hit hard last year – have yet to recover meaningfully, with global government bonds only up 1% and UK government bonds down 4% as of the end of June.

Commodities, which were last year’s star performer, gave up some of those gains this year, down 3% for the quarter and 8% for the half.

‘This means last year’s worst-performing asset, growth stocks, has been this year’s best-performing asset, and last year’s best performing asset, commodities, has been this year’s worst performing asset, demonstrating the importance of diversification within portfolios,’ says Bell.

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STRONG SENSE OF DÉJÀ VU

While the risk in large-cap US tech is reminiscent of a previous bubble, the performance of the various global asset classes so far this year has clear similarities with the more recent past – 2019 to be precise.

The same sectors and regions which led the rally in the run-up to the pandemic are at the top of the table again, with the added twist of emerging markets which have not only beaten value stocks but have narrowly outpaced European equities too.

The obvious differences with four years ago are price weakness in global bonds, real estate investment trusts and commodities, which stands to reason given the unprecedented rise in global interest rates accompanied by a slowdown in growth.

One unexpected trend, which is more reminiscent of the pandemic, is the resurgence of ‘meme stocks’ in the US market as investors try to chase lower-quality names which have been left behind by the rally. Meme stocks are typically names actively traded by a group of investors who communicate on social media networks. They tend to be damaged companies rather than ones with positive attributes.

The Solactive Roundhill Meme Stock index, which tracks the performance of 25 US stocks with a high ‘meme’ score and a high level of short interest, has been rallying hard recently and is almost at a new 12-month high.

In a letter to clients seen by Bloomberg, BTIG chief market technician Jonathan Krinsky wrote: ‘It’s a double-edged sword when we start seeing some of the lower quality names rally. When we see a surge of this magnitude, especially relative to a defensive group like consumer staples, it often indicates a chase for what hasn’t moved and can move the most, and this often is the tail end of the move.’

DON’T GO CHASING RETURNS

The best advice at this stage is not to dive headfirst into US tech stocks just because they are performing well, especially as the imminent round of quarterly earnings reports will likely separate the wheat from the chaff.

In fact, the exponential price rise in these stocks has all of the trademark features of a bubble according to Saxo Bank chief investment officer Steen Jakobsen.

‘The hype surrounding AI (artificial intelligence) is the chief driver of the latest stock market surge, with talk of this being a new iPhone moment or even akin to the introduction of the internet.

‘This is not knocking AI, as we are keenly aware of the potential for generative AI to increase productivity over time, but the market is getting ahead of itself in selecting winners, and current valuations are already discounting too much of the longer-term future gains to be had.

‘We don’t have the ability to time and project where the markets are going, but we do have the ability to recognise when a bubble is forming and where data doesn’t support the narrative.’

Moreover, the concentration risk in US stocks as measured by the Herfindahl-Hirschman index is more extreme than it was even at the peak of the dot-com bubble in 2000, meaning the market is more fragile.

DON’T EXPECT A REPEAT OF THE FIRST HALF

At the risk of tempting fate, it seems unlikely that what has worked so well in the first half of this year is going to continue working through the second half.

In fact, the phrase we’re starting to hear more and more regarding the second half is ‘difficult’.

‘The surface of this economic sea may be calm, with volatility at extremely low levels, but beneath the waterline there are strong currents and counter-currents, which, to our minds, set up a difficult second half of 2023,’ says Saxo’s Jakobsen.

‘The good news is a deep recession is unlikely to happen. The bad news is interest rates will need to stay high for longer. We simply don’t think the audio matches the video, looking at complacent market expectations versus the likely path from here.’

Terry Smith, manager of Fundsmith Equity Fund (B41YBW7), summed up the first half of 2023 – during which the fund gained 8.5%, just behind the MSCI World index with 8.9% – by saying conditions had got ‘tougher’ for his companies, which are mostly having to cope with slower revenue growth and/or higher input costs.

‘However, that’s what happens from time to time so we are mostly sanguine about it. We have a few more worries as a result but not a wholesale concern about what is happening,’ he added.

In classic Smith style, he signed off by saying there might be a recession, but he had no idea how to time it, nor did he have a view on how high interest rates would have to go to quell inflation, as Fundsmith’s approach is not to try to predict macroeconomics or geopolitical events but to buy quality companies and hold onto them.

‘TOO GOOD TO BE TRUE’

Mike Bell and his colleagues at JPMorgan Asset Management worry that markets are pricing in a ‘Goldilocks’ scenario where inflation subsides and the global economy avoids a recession.

‘Inflation is priced to fade quickly, allowing central banks to shift their attention to supporting growth. Instead of driving a recession, they will be aiming to prevent one, which would be music to both stock and bond investors’ ears. To us, however, this feels a little too good to be true.’

If interest rates are cut quickly, it’s probably because a recession has occurred, which would be bad news for risk assets such as stocks and shares.

The advice from all corners is to invest defensively, that is without taking excessive risk either in terms of visibility of earnings or valuation.

‘We believe an uncertain economic environment requires even greater focus on company fundamentals and provides an opportunity for stock picking to make a difference in investor outcomes,’ says Helen Jewell, deputy chief investment officer for EMEA fundamental equities at US group BlackRock.

Jewell suggests investors should look for a mix of quality defensive stocks on the one hand and under-priced cyclical stocks on the other.

In terms of defensive stocks, a company which can pass price increases on to its customers – be they consumers or other companies – while at the same time benefiting from falling input costs is the dream ticket.

In consumer cyclicals, premium brands seem to be able to maintain pricing and margins although this is broadly reflected in them trading on higher valuations – especially in the luxury sector. In industrial cyclicals, Jewell prefers companies with a dominant market position ‘which are priced for recession and which we believe will trade strongly on any positive economic news’.

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FOCUS ON QUALITY

While views on growth and inflation differ according to which expert you listen to, one thing they all seem to agree on is the key to returns for the rest of the year is to concentrate on ‘quality’. That means focusing on businesses with solid earnings, low leverage and protected dividends, rather than more speculative companies which might see wild fluctuations in earnings (or not make any money at all) and high leverage.

Amundi Asset Management sees a ‘narrow and uncertain path to growth’, with a further slowdown this year alongside a gradual easing in inflation although the latter is still expected to be above central banks’ targets for at least the next 12 months, meaning monetary policy will remain restrictive.

‘Amid low visibility on the economic outlook, quality – both for equity and bonds – is the compass with which to navigate this uncertain phase,’ says Amundi group chief investment officer Vincent Mortier.

An end to Fed tightening and a possible US dollar depreciation could bode well for emerging markets, where growth could prove more resilient relative to developed economies.

Fidelity warns against complacency towards lagged policy effects and tightening lending standards which it argues could cause a hard landing for developed economies.

‘Excess savings accrued during the pandemic, as well as continued tightness in labour markets, mean that financial conditions are taking longer than expected to bite. But that recession will come when the lagged effects of policies eventually take hold. Resilience now is sowing the seeds for fragility down the line,’ says Fidelity’s global chief investment officer Andrew McCaffery.

‘On the positive side, non-labour costs continue to trend downwards, and are likely to turn deflationary this quarter. But persistently high wage cost pressures throughout developed markets suggest that central banks are far from done, while the majority of our analysts still anticipate recession over the next 12 months.’

McCaffery says the firm is moving up in quality across asset classes, which in equities means allocating to minimum volatility equities and defensive sectors over cyclical sectors, and in fixed income means buying government bonds and investment grade over riskier high-yield bonds, where it thinks the implied default rate is much
too low.

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THREE FUNDS TO BUY NOW

Fundsmith Equity (B41YBW7) 

Fundsmith Equity is a good way to access quality companies in developed markets.

Fund manager Terry Smith describes his investment philosophy as ‘buy good companies, don’t overpay, do nothing’. By and large that is exactly what he has done, with great success.

Smith doesn’t get emotional about stocks, as shown by his willingness to keep hold of Meta Platforms (META:NASDAQ) for the past year even when market sentiment was heavily negative, but when the investment case changes as it did with Adobe (ADBE:NASDAQ) and Amazon (AMZN:NASDAQ), he doesn’t hesitate to sell.

The fund currently has 26 positions, and although its largest holdings include Meta and Microsoft (MSFT:NASDAQ) the weighting in technology and communications stocks is under 20% compared with a more than 50% weighting in consumer staples and healthcare.

The fund’s focus on quality, high margins, resilience and above all capital allocation by the businesses it invests in is exactly the kind of approach which should pay off in an environment of slowing economic growth. It has a 0.94% ongoing charge.

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JPMorgan Emerging Markets (JMG) 

This investment trust has a clear process and sticks to it. It looks for quality companies with solid earnings growth and good governance across emerging markets.

Rather than trade in and out of stocks, trying to anticipate where the market goes next, the team at JPMorgan work hard to identify the best companies and they stick with them.

‘The basic strategy of the management team behind JPMorgan Emerging Markets is to blot out the noise and focus on identifying those businesses which have best earnings growth potential and hold onto them for the long term, refraining from overreacting to cyclical ups and downs and thereby incurring transaction costs,’ says research group Kepler.

Putting money into emerging markets requires patience and an understanding that share prices can be volatile. While the JPMorgan trust’s performance has been relatively flat over the past year, it has generated 7.7% compound annual returns over the past 10 years.

A 0.84% ongoing charge is not high for emerging markets and investors are currently being offered the chance to buy shares in the trust for a 9.3% discount to the value of its underlying assets.

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Janus Henderson Strategic Bond Fund (0753382) 

The fund is managed by industry veterans Jenna Barnard and John Pattullo, co-heads of global bonds at Janus Henderson Investors.

The managers have a differentiated investment approach with a focus on buying bonds issued by quality companies and mainly ignoring the rest of the corporate bond market.

In other words, the managers favour sensible income from large, non-cyclical businesses that are more likely to continue paying their coupons (interest payments) for many years to come.

The fund has performed ahead of the Investment Association’s Global Flexible Bond category over the last decade, delivering compound annual returns of 2.2% compared with 1.8% from the benchmark. It has an ongoing annual charge of 0.7% and a 2.2% underlying yield.

The chart shows how bonds suddenly went out of favour at start of 2022. That’s a reflection of interest rates shooting up during the year, pushing up bond yields but pulling down bond prices. If interest rates stop going up – or even start coming down – there might be more investor interest in bonds, particularly to make capital gains if bond prices start to recover.

Around 92% of the Janus Henderson bond fund portfolio is invested in investment grade bonds (the highest quality) compared with 50% for its fund category.

Writing in the fund’s report on second quarter performance, the managers said: ‘We think a recession seems inevitable and that Europe may be more vulnerable than the US. The next six months will be crucial in determining how this plays out, and either the employment markets have to give or something else in the economy has to. Then we would expect the best quality bonds to start performing well.’

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Disclaimer: The author (Ian Conway) and article editor (Daniel Coatsworth) own units in Fundsmith Equity Fund

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