Tuesday 17 June 2014 8:25 pm

Stock market correction: How to protect yourself from losses

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Income can help you weather any volatility, but be wary of bonds

AFTER a stellar few years for global stock markets, concerns are growing over a looming correction. The S&P 500, Dow Jones Industrial Average, FTSE 100 and MSCI All-World share index have all been at or near record highs in recent weeks, and valuations look stretched. On the Shiller price-earnings ratio, the S&P 500 is trading at 25.8, 56 per cent higher than the historical mean of 16.5. And the FTSE 100 has near-doubled in nominal terms since its post-crisis low, rising by 94 per cent since March 2009.

Analysts and commentators including Nobel Prize winning economist Robert Shiller, former US Treasury secretary Robert Rubin, and former Federal Reserve governor Jeremy Stein have all raised concerns over high stock prices, while last month’s Bank of America Merrill Lynch Fund Manager Survey found that average cash holdings have reached the highest level since June 2012. Just 37 per cent of the professional investors surveyed said they were overweight equities, down from 45 per cent in the previous month.

None of this is to say that a summer stock setback is a certainty, says Jason Hollands of Bestinvest. “But we do feel a more cautious stance is appropriate, as the easy money days of 2013 are well behind us.” Trying to time the market can be a fool’s game, but with both the Bank of England and Federal Reserve on track for eventual monetary tightening, worries increasing over a Chinese “hard landing”, and a spike in geopolitical risk due to the chaos Iraq and Ukraine, many investors are taking steps to mitigate against the impact of a stock market correction on their portfolios.

“For investors concerned about a stock market correction and protecting capital, one solution is cash,” says Richard Troue of Hargreaves Lansdown. But while you can protect capital by moving into cash just before a market storm, timing the switch perfectly is virtually impossible. And inflation, despite May’s fall to 1.5 per cent on the consumer price index, will erode spending power if you’re out of the market for too long. For these reasons, Troue says, many investors will consider re-jigging their portfolios instead, favouring more “defensive” investments.

One option is to take profits from any bets made on smaller and medium-sized UK companies. Some of these speculative “growth” investments have performed very well over the past 18 months, with the FSTE 250 easily outperforming the FTSE 100 (see chart). But according to Hollands, valuations now look especially stretched in some mid-cap sectors like housebuilding, while liquidity can dry up extremely fast outside the FTSE 100 in the event of a correction – leaving unprepared investors caught short.

It’s worth considering moving into more defensive funds and stocks, says Troue. Sectors with relatively constant demand (energy, pharmaceuticals) tend to do better during times of panic. And income-focused investors are likely to be burnt less by a sharp selloff, with guaranteed dividends partly compensating for any falls in share prices.

Troue tips the Trojan Income Fund and Neil Woodford’s new CF Woodford Equity Income Fund because of their focus on “large, defensive, undervalued companies.” Woodford’s successor at Invesco Perpetual Mark Barnett, meanwhile, who manages the Income, High Income and Strategic Income funds, has the strongest record in weak markets, with figures from Bestinvest showing that he has outperformed in 77 per cent of the months when markets fell. There are also a range of total and absolute return funds specifically designed to deliver a return regardless of what’s happening to markets. Troue likes the Artemis Strategic Assets Fund for its mixture of stocks, bonds and other assets.

Altering the weighting of different asset classes in your portfolio is another way to reduce exposure to a sharp stock correction, but this isn’t quite as straightforward as some make out. Gold, the apparent perennial safe haven, looks to be suffering a long-term decline, and its volatility could put some investors off.

Dramatically increasing exposure to bonds, meanwhile, may not be a good idea at a time when the winds of change at the Fed and the Bank are towards tighter money. Rate hikes aren’t at all likely this summer, but any changes in trajectory would likely be “telegraphed” some time in advance – and fixed income investors were dealt a heavy blow last year when the Fed first mooted the idea of tapering its asset purchases.

But it’s not all bad news for bonds, as the European Central Bank (ECB) and Bank of Japan are still some way behind the UK and US in the tightening cycle. If the ECB decides to go even further, with bond buying of its own, European asset-backed securities (ABS, a likely target if Mario Draghi and the ECB engage in quantitative easing) may be a pocket of value. Hollands likes the TwentyFour Dynamic Bond Fund, which he says has a decent exposure to continental ABS.

With the higher £15,000 Isa limit available from 1 July onwards, Isa investors looking to top-up from the current £11,880 ceiling may be faced with a dilemma. Conventional investing wisdom says to fill up your allowance as soon as possible, giving your money longer to compound. Tom Stevenson of Fidelity has calculated that an investor who put the full Isa allowance into the FTSE All-Share index at the beginning of the tax year every year over the last 14 years would be £3,487 better off than a latecomer who invested towards the end of the tax year, at the start of April.

But pouring cash into stocks and shares in July, when concerns are growing over a correction, may not be the most sensible step, warns Rebecca O’Keeffe of Interactive Investor.

Luckily, there are no rules on the amounts that can be held in stocks and shares versus cash with the Nisa, and most investment Isas feature a “cash park” facility to store money while you decide where to invest it.

Cautious investors can follow the strategy of “drip-feeding” money into the market, says O’Keeffe, lowering the risk of the whole lump sum falling in value at once. Buying in smaller units also means risk is automatically reduced – if prices fall, the investments will be bought at a cheaper rate the next time, naturally bringing down the overall cost. Such a strategy does mean that any large capital gains on the lump sum could be lower, but Hollands notes that those expecting a correction could use falling markets as a buying opportunity. “Remember, a correction is a time to buy, not to sell – fortune favours the bold.”