Keeping your head. - DMG Diversified Portfolio

These are certainly trying times for market participants. We have now entered into true ‘market correction’ territory – that is, a fall in excess of 10% peak to trough in terms of market performance. What started all this off? Well, last week the US Federal Reserve surprised most when minutes of its meeting did not provide a clear signal that they would raise rates at their September meeting. This rattled market participants as it set in place rumours that the correction in China’s equity market could be having considerable economic consequences (hence the Fed’s reluctance to raise rates). As China remains an enigma and there is very little clarity as to whether the information emanating out of China is truly accurate, then we are in effect dealing with pure uncertainty – and markets hate uncertainty. Subsequently, there is no way to refute the rumour that there is something considerably wrong in China. Indeed, to make matters worse, on Friday China’s unofficial manufacturing PMI series came in below expectations and this (combined with the fact that the US market has been overstretched from a valuation standpoint for quite a while) was sufficient to generate the types of moves we witnessed in the US on Friday night and we have witnessed today in Asian markets.

Let me state at the outset that I think this is a correction not a crash. We went through a similar shock last year. This time the move is larger but I believe we should expect this given that the investment cycle is at a more mature stage. Indeed, it has been the Investment Committee’s standpoint that we are likely to experience an increasing frequency of market shocks (corrections) going forward and they are likely to grow in scale. This is a normal pattern of market behaviour for the mature stage of the investment cycle – and in fact one of the mechanisms we use to identify as to what stage of the investment cycle we are actually at. As for the economic consequences of all this, if China is truly in trouble (which I think it could be) then we are likely to see a considerable monetary stimulus response from China’s ruling elite. This could cause a sharp reversal in markets if and when it does happen. In terms of the rest of the global economy, the US is just fine (its slow economic recovery remains firmly on track) and for Australia’s economy, the slowdown in China is one of the reasons why we think the RBA will cut again. Up until a couple of days ago this was a very little held view but now many now are coming around toward our way of thinking.

For the DMG Diversified Portfolio (DDP) our responses have been two-fold – defensive and opportunistic. From a defensive standpoint, given that we believed we had already entered into the mature stage of the investment cycle, we have already increased our defensive exposures in anticipation of greater volatility shocks. So far, this strategy appears to be paying off with reports from defensive managers such as Triple 333 that they stand to make considerable profits should the present heightened volatility environment persist. Still, it would be hard for these managers to totally offset the losses in the DDP elsewhere and I expect if the market rout continues the DDP will still record a considerable monthly loss – but nowhere near as large as that experienced in equity markets. From an opportunistic standpoint, we have been topping up positions where we feel value predominates and where the market appears oversold.

I do admit these are trying times and it is difficult to keep one’s head when everyone else seems to be losing theirs. The trick to staying calm is to have a definitive plan. Indeed, we should expect market corrections such as the one we are presently experiencing to be an endemic feature of our investment landscape just as much as drought and flood is an endemic feature of the farming landscape. Having in place a plan to mitigate against the downside when it inevitably comes (which we already have) and then opportunistically seizing upon any irrationality by others when such shocks occur (which we are presently doing) is the key to long term investment success.

By Bart Dowling, Portfolio Manager, DMG Diversified Portfolio. This is a portfolio for clients of DMG Financial Planning.