In the main asset classes – equities and bonds – a passive buy-and-hold strategy is likely to produce disappointing returns in the years to come.
 
In bonds, the great bull market that started in 1982 seems to be over. The inflationary environment of the 1970s saw bond yields soar and by 1982, they had risen to record levels. The subsequent decline in inflation has resulted in long-term interest rates falling and bond prices rising.

Despite the current low level of bond yields, bonds should not be overlooked as an asset class, however. An increase in deflationary pressure could push bond yields down even further, which would be good for government bonds. Nevertheless, low interest rates by definition restrict the return potential of investments, and at the same time make them more volatile (a 1% rise in interest rates obviously has a greater impact on bond prices when yields are at 3% than when they are at 10%). In this context, an opportunistic strategy is necessary.

In terms of equities, a passive investment strategy is only justified in structural bull markets. In these kinds of markets, corrections are usually limited in both scale and duration and indices quickly rise again above the level observed before the correction.

Stock market history in the United States is made up of a series of bull and bear markets. Each bull market starts with very low valuations (as investors are deeply pessimistic) and ends with high valuations (as investors become very optimistic).



We are not at the dawn of a new bull market. The share price of a company (P) is equal to its earnings per share (E) multiplied by the number of times investors are willing to pay for these earnings (P/E): P = E x P/E. What is true for the company is true for the market on the whole: for an index to rise, either company earnings or valuation multiples have to increase. In major bull markets, both factors increase and investment returns are high.

So what is the situation today?  

Let’s take earnings first. In the long term, corporate profits grow in line with the economy (between 1947 and 2008, nominal GDP in the United States rose on average by 7.01% per year, while corporate profits rose 7.13%). There have been periods during which corporate profits have risen faster than GDP. During these periods, the share of profits in GDP rises to the detriment of salaries and wages. History shows that in a democracy, this kind of situation cannot go on indefinitely and sooner or later, the struggle between profits and wages (capital and labour, in Marx terms) is reversed. This seems to be the situation today. In the past few years, the share of profits in GDP has risen from 7% to 13% in the United States. However, as the impact of the economic crisis (increased regulations, greater role of the state in the economy, shift away from a free-market economy) takes hold, we are likely to see that share decline again. In sum, we could have an environment in which profit growth will be lower than GDP growth, the latter being already lower than in the last two decades (see my article 8 May).

I believe there is another point worth raising with regard to earnings. In previous years, many companies have embarked on aggressive share buy-backs that have resulted in earnings PER SHARE rising faster than earnings. In many cases, these buy-backs were paid for by recourse to debt. Here too, the next few years could see a turnaround in the trend with many companies raising capital to reduce debt.

Now let’s turn to valuations. Multiples are currently well above levels seen at the start of the great bull markets of the past (see article 7 April).

Once again, this does not mean that equities should be overlooked. There will always be companies for whom the conditions for long-term price appreciation – earnings growth potential and attractive valuation – will be met. But a strategy that focuses on simply tracking indices is not to be recommended – at least not for the US or Europe.

BL-Global Flexible

-    Investment strategy

BL-Global Flexible is a balanced fund investing in equities, bonds and cash. The percentage of the fund invested in each of these asset classes is variable and determined by valuations and market circumstances. The reference currency is the euro.

- 3 general principles  :
1. The fund has an equity bias. Over the medium to long term, quality companies bought at reasonable prices will produce a higher total return (i.e. increase in share price + dividend) than cash and bonds. While in theory the equity allocation of BL-Global Flexible may vary between 0% and 100%, in practice it will more likely be between 20% and 90%.

2. The bond portion is essentially (but not exclusively) invested in government bonds. The idea behind this is that the corporate risk is taken through the equity portion, while the bond portion acts as a buffer producing regular income and playing a stabilising role if the markets go down.

3. The equity portion is not tied to a benchmark index and the number of individual holdings rarely exceeds thirty. The fund does not (or hardly) invest in sectors such as financials, utilities or commodities, which represent a high share in some indices.