Post-pandemic asset allocation

After 66 days of break, the stock exchanges restarted the trading session from Sunday. The investors have been waiting for over two months to see the secondary market trading. However, many investors are edgy and worried about the uncertainty that the economy is currently facing.

Since early 2018, the market had been on downward pressure and the Covid-19 crisis increased uncertainty on the outlook of asset pricing. Many investors think that after the resumption of trading the implied risk premium will increase and investors will be much more cautious in allocating assets. Though the investors have seen past market cycles and are aware of the negative wealth effect of the market downturn, however, this crisis is much more different and it has transitioned into an economic and psychological crisis. Thus these issues will play a role in how the investors allocate their assets and focus on liquidity in a much distinct way than before.

The change in leadership at the Bangladesh Securities and Exchange Commission (BSEC) has made the investor much more helpful. We appreciate the government for putting the right team at the helm of BSEC and we hope that the team will play a pivotal role in reforming a stronger capital market. The newly appointed Chairman, Professor Shibli Rubayat Ul Islam already mentioned that our market is equity-based and he will focus on launching bond, debenture, Sukuk and alternative investment fund in the market. And, since the market has remained equity-based, it is difficult for the investors to focus on asset allocation- the key part of the investment process.

At Asian Tiger, we always focus on a top-down strategy. Though the uncertainty level has increased, the basics of investment have remained the same and investors should focus on their goals and timing to allocate assets accordingly.

At the very basic level, investors need to make three major decisions: Which assets to hold, in what proportions and when to change the proportions. While institutional investors have boards, trustees and/or investment committees who set broad strategies and goals, for individuals this is a subjective process and should be done by keeping their life goals in mind and taking advice from trusted advisors.

From an individual investor's perspective, each investor has unique needs and when it comes to portfolios, one size does not fit all. A good portfolio will have sufficient liquidity to take care of cash needs and the absorption of capital losses, and also will take into account the time horizon and risk tolerance of the investor. The portfolio should have sufficient liquid reserves and cash flow, if possible, to avoid the need for selling securities at an inopportune time. The less cash flow that investors have, the more liquidity they should hold. The portfolio must focus on protecting against inflation at a minimum. Also, the portfolio must be diversified across and within asset classes to reduce risk.

When it comes to asset allocation, there are three legs to a portfolio, stocks, bonds and short-term liquid assets. Owning a house can add another leg to the portfolio and make it more robust. However, with the increased uncertainty because of Covid-19, investors' risk tolerance have been affected and they are focusing more on liquidity. This situation has made adding the property to the portfolio a hard choice.

For most investors, stocks and bonds are the two core asset classes or an investable portfolio. Since we do not have a vibrant secondary market for bonds and there are no bond focused mutual funds, investors focus on governments savings certificates and fixed deposits for allocating their fixed income portion of the portfolio.

When it comes to allocating money to the equity asset class, investors find it extremely difficult to decide when to change the allocation to their equity portfolio.

Since we follow a top-down strategy, we spend a significant amount of time to focus on macro variables and make a sense on money, credit and liquidity conditions of the market. Money, credit and liquidity are the lifeblood of the economy and drives equity prices through the economic cycle.

The purpose of our analysis is to generate reliable signals as to when liquidity is getting sufficiently tight to increase our risk premium and to generate signals as to when liquidity flows are about to shift to the expansionary stage that leads to stock market recoveries. We especially focus on the outlook for economic growth, the monetary indicators like expected changes in interest rate, money and credit situation. Most financial indicators of liquidity have leading characteristics and provide a signal to expected changes in the capital market. For example, the US equity market as represented by the S&P 500 benchmark fell by more than 30percent in March 2020 as the coronavirus pandemic spread throughout the world. However, massive stimulus measures by the US government and Federal Reserve has led to a remarkable recovery in the US equity markets, with the S&P 500 has increased 36% from its March low even though the real economy is yet to recover.

Most other indicators like industry profits, inflation rate, employment situation, changes in retail business and consumer confidence level have coincided to lagging in nature. In developed markets, investors get timely data on such indicators. Since we do not publish data on a timely basis for a few indicators, investors need to rely on anecdotes and survey data.

Another important indicator that is used widely in developed markets is a yield curve and changes in the shape of the yield curve. Since we do not have a highly liquid secondary bond market and published yields on secondary transactions, It is difficult for Bangladeshi investors to formulate decisions based on the available primary market yield curve data. Still, the available data and changes in the shape of the available yield curve and secondary market volume give some sense in forming views on the liquidity condition of the market.

Another important variable we look at is the liquidity in the banking sector. By looking at banks' holdings on government securities and other securities, one can make a sense on the direction of liquidity. During periods of the downward business cycle, the demand for bank loans tends to fall sharply and the central bank usually injects liquidity into the system to keep the interest rates low.

To navigate the Covid-19 crisis, we have also seen that our central bank has taken many measures to inject liquidity in the economy. The government has also undertaken fiscal measures such as direct cash payments to the mobile wallets of poor households. Investors can watch the rate of change in banks' business loans and the rate of change in securities' holdings to make some sense about the liquidity condition of the market. The bottom line is investors should be bullish on stocks when liquidity is improving on a rate-of-change basis.

The second metric we look at is valuation. Periods of over and undervaluation are an integral part of the stock market cycle and it is extremely important to monitor the valuation levels to gauge when risk is increasing unacceptably so that action can be taken accordingly.

Sector-specific valuations are also subject to constant change according to the business cycle. For example, defensive sectors like consumer staples, utilities and pharmaceuticals are relatively better placed during economic downturns while pro-cyclical sectors such as the financial sector, consumer durables and construction materials are relatively better placed during economic expansions. By shifting investment focus according to the stage of the economic and business cycle, we always position ourselves to take advantage of the prevailing trends in the economy. When valuation improves sharply in a bear market, the risk is much lower, potential returns are higher, and investors should increase exposure in that scenario, even though it may be psychologically difficult for an investor to invest when the market has been declining for a while.

As investors, we must not forget that the higher the price paid for security relative to future earnings, the greater the hope of investors, but the lower the realised return in the future. Valuation of individual companies and markets as a whole is extremely important because the bigger the overvaluation of security, the more vulnerable the security is to a liquidity squeeze and the bigger the fall when it comes. The opposite can also be true but investors have to understand that there might be a lack of symmetry. Expansionary liquidity will not necessarily lead to a cheap market upward very quickly.

The third metric we look at is the psychological traits of investors. The reason is as human beings we often cannot control our emotions and our moods which can levitate from excessive greed to extreme fear. Investors as a group, often fail to apply discipline, patience, and common sense. We try to gauge the psychology by analysing and surveying from anecdotal evidence and try to formulate our views. Our knowledge and analysis of human cognitive limitations enable us to guard ourselves against making irrational investment decisions while being able to profit from the emotionally-driven decisions of other investors in the capital market.

Many investors focus on having a contrary opinion but one must remember that only having a contrary opinion is not enough. We may have contrary opinions to the market and our forecast can also be wrong. There are many indicators for a view about the overall psychology of the market. One indicator is the level of margin debt used by investors. This can indicate the amount of money individuals have borrowed to buy stocks. Since we do not have any published data on the level of margin debt used and the rate of change of margin loans, one can form a view by surveying a greater group of professionals and investors to achieve a view on the overall psychology of the market. Another measure of psychology is the amount of cash people hold.

During the bearish market, investors tend to be mostly in cash. However, there is a wide variety of views on cash as an asset class among veteran investors. The legendary investor Ray Dalio recently said that investors should not stay on the sideline because "Cash is Trash".  On the other hand, Allianz's chief economic adviser and former CEO of Pimco said that Most people think that cash is not part of strategic asset allocation because cash acts as an option.

Another measure of psychology prevailing in the market is media coverage. When the market reaches bottom cycle and usually stays there for longer periods, positive media coverage of the market ceases.

The fourth analysis we do is statistical analysis. Our analysts use a variety of tools for data collection and analysis to analyze the quantitative parameters of the stock market and its constituents. The statistical analysis and charts often help to see when asset prices started deviating from its fundamental values and historical valuation ranges. We are then able to position ourselves to profit from historically low valuations only if the valuation converges to their expected values.

Since the market uncertainty has increased due to Covid-19, we as investors need to be even more methodical than before and have the discipline to focus on asset allocation and security selection in response to our goals and risk tolerances. Though the wealth management industry is still not developed to provide such services to investors, investors can do their due diligence and make an appropriate decision based on their circumstance. Individual investors often find the process extremely complex and time-consuming. They can rely on trusted fund managers to execute their asset allocation.

The author is the Managing Director & CEO of Asian Tiger Capital Partners Asset Management