Staying awake at the helm

2017 ended up as another strong year in the decade long bull market. Almost all major asset classes produced excellent returns particularly the equity markets with the S&P 500 reaching a new all-time high. After so many years of strong performance and low volatility the challenge for many investors might be to stay awake at the helm as the natural tendency might be to expect a continuation of the current trends. It is essential to remember that major changes in market trends and crises often happen when they are least expected. In the financial landscape there is such a thing as a thunder from the blue sky.

We should however emphasize again that we do not have any crystal ball to predict the future and that we do not know what will happen in 2018. A continuation of the current trend is certainly possible and even likely considering the fact that a dramatic worsening of economic and financial conditions does not appear imminent. However the key issue is to manage the risk responsibly in order to be ready also for the less likely but potentially devastating consequences of adverse market developments.

While markets are impacted by macroeconomic factors such as recessions, economic growth and interest rates one of the key parameters is valuation levels. At some point in time assets reach excessive valuations. When this point is reached becomes clear only in retrospect as overvaluation and undervaluation is often in the beholder’s eye and there is no infallible indicator to objectively define them. The best one can do is to try to get a sense of whether assets are closer to being undervalued or overvalued. After ten years of increases in asset prices the answer to that is clear. Currently almost every asset class is trading at all-time highs by any metric (s. graph below).


The question is not whether markets have reached their top or not which no one knows. The right question is about the risks and the opportunities markets currently offer. As we mentioned in our September letter the elevated current valuations mean that equity markets will likely deliver considerably less than the long-term averages of 8-10% in the coming years - a 4-6% annual return for the next five years looks like a realistic possibility. On the risk side it is in or view illusory to try to put a number on the probability of major correction but historically equity markets have regularly experienced bear markers with drops of 30-60% (s. table below). A traditional portfolio with a 70% equity allocation can in such circumstances easily experience a 30% drop which is unacceptable to many investors.


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The current combination of limited upside and increasing downside risk calls for prudence and for overweighing lower risk-assets and those with limited correlation to equity markets. This is not an easy task considering that bonds offer little yield and considerable duration risk. The only solution in our view is to look for less conventional investments that still offer an attractive value proposition. Even dynamic investors willing and able to stomach mark-to-market losses based on the conviction that such losses would be “paper losses” that would be quickly recouped have to be cautious. If they are willing to take the risk of paper losses they should focus on those rare niche opportunities that currently entail high single digits or low double digits return potential –more than for equities and sometimes with less risk.

Finally, an important point to keep in mind is that while history is an important teacher it does not necessarily repeat itself. Assumptions based on past experience can be misleading. A widely held view is that “in the long term stocks always go up”. While this has generally proven true there were exceptions. For the fourteen years period between 1968 and 1982 the real return for the S&P 500 (including dividends) was slightly negative (the real return for bonds was even worse due to inflation). The Nikkei index of Japanese stocks is today still almost 50% down from its peak level three decades ago. This shows the need to avoid relying blindly on historic assumptions as well as the need for diversification across asset classes and geographies.

We thank you for your trust in 2017 and while positioning our portfolios cautiously for any circumstances we do hope that 2018 will be another smooth and profitable financial year.

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Getting paid for illiquidity

If you follow financial matters and sometimes talk about this subject with others, one sentence you might have heard in the last 5-10 years was: “How can you make money when the interest in the bank is zero?” This resigned, cynical statement has surprisingly been quite widespread both among financial laymen and investment professionals. The paradox is that this ended up being a period of a sustained bull market where most asset classes performed well – precisely because central banks and policy makers succeeded in their attempt to reflate financial markets by forcing investors to shift their assets into the financial markets through the minimal interest rate policy.

With markets at historic highs following years of bull market the pessimists will quickly conclude that all investors are doomed to choose between two evils: safe investments which are yielding little on one side or higher yielding investments which are bound to crash on the other side.

Is this point of view making any sense? The fact of the matter is that it does – for those whose financial perspectives and portfolios remain limited to the traditional asset classes of bonds and stocks. Traditional safe-haven investments such as western sovereign bonds, high-quality corporate bonds and bank deposits indeed provide low to even negative interest rates. The S&P 500 has a P/E of 23.51 which corresponds to an earnings yield of 4.2% and the dividend yield is 2%. These ratios as well as a range of others indicate elevated valuations by historic standards. However they also have to be put in the perspective of the low interest rates and the low inflation - the key point bears have been missing all along the rally in risky assets. Bull markets tend to end up in euphoria and with extreme valuations and both are missing right now.

We will not make any prediction about what will happen in the short-term because we do not claim the ability to forecast the future (and we do not know of anyone in history who has been able to reliably predict short-term market developments). What is clear however is that the risk-reward of the stock markets is not currently particularly appealing. There is a risk of significant downside in the short to middle terms and the current valuation levels imply that future returns should be below historic averages and that a 5% annual return in the next 5-10 years is probably rather optimistic. So at this stage those limited to bonds and equities are really between a rock and a hard place.

However, we have often made the point that there is a wide financial world out there that offers interesting niche investment opportunities with limited market correlation and attractive risk-reward. We have often talked about such opportunities and we will not detail them again here. Rather, at a higher level, we would like to focus on what we believe to be today’s elephant in the room: the illiquidity premium.

The illiquidity premium is the additional return investors sometimes require to hold onto illiquid investments which cannot easily be traded on a public market. It is not possible to size the illiquidity premium as it depends on the asset class and evolves over time.


At present time we believe that several areas do provide a significant illiquidity premium. This includes in our view a certain number of unlisted credit investments which can provide net returns to investors in the 8-12% range while offering an appreciable degree of downside protection.

Infrastructure investments is another area that can offer appreciable returns assuming that one focuses on the right managers in the right niches which is critical in that field. Provided that this is the case, annual returns north of 10% are not unrealistic. A key aspect of infrastructure investing is that if they are implemented effectively they can offer a considerable degree of predictability and security as a good infrastructure fund manager will focus on projects where a strong counterparty such as a country commits in advance to make certain payments if the provider of the infrastructure delivers on its commitments – for example delivering a new toll-road at a certain time and operating it according to predefined requirements.

While many real estate markets are fully valued and possibly overvalued and bound for corrections there remain pockets of opportunity throughout the world. Here too competent operators can still find attractive projects offering double-digits returns with a 2-5 years time horizon. If these projects are financed appropriately they can offer the downside protection typical of a well-located building.

Looking at the big picture there appears to be a staggering contrast today between these illiquid opportunities and the more liquid, “plain vanilla” stocks and bonds opportunities. While a careful and well-diversified selection of some of the illiquid investments mentioned above has the potential to provide a net return of 10% or more with a 5-10 years perspective, we believe that the traditional stock and equity portfolios will likely be limited to low-single digit returns over the same period (although not necessarily in a linear way – we could have for example initially a continuation of today’s bullish trend and eventually a correction).

What is clear is that in today’s world you get paid nicely for illiquidity. While in the old-world of higher interest rates and more promising equity returns many investors refrained from looking at illiquid investments this mindset is starting to change. In five or ten years the cynics might well be looking back and wondering how they missed this opportunity!

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