Investment success isn’t as clear-cut as just following the Fed

Source: Reuters.

While South Africa has faced economic challenges, the idea that local equity investments should be avoided in favour of rand-hedge or offshore stocks is flawed. However, the reality tells a different story.

Since October 2020, the FINI 15 index, which includes major South African financial firms and Real Estate Investment Trusts (REITs) like Redefine and Growthpoint, has surged by 122%, outpacing the S&P 500’s 75% gain in rand terms.

This strong performance, against expectations, highlights the resilience of South African financial and property sectors despite local economic headwinds. Notably, the growth in FINI 15 valuations hasn’t outpaced earnings, underscoring the strength of these firms’ fundamentals. Much of the negative sentiment had already been priced in, allowing for the potential for better-than-expected performance.

What's particularly noteworthy is that if we compare two hypothetical portfolios—one invested in the FINI 15 and the other in the S&P 500, starting with the same amount in October 2020—the FINI 15 portfolio has outperformed the S&P 500 on 95% of all trading days since then. This consistency in performance is truly remarkable.

Sell high, buy low

Now let’s consider the notion that US markets always rise when interest rates decline. This topic is particularly relevant now, following the Federal Reserve’s (Fed) recent 50-basis-point rate cut.

While US valuations, particularly in tech-heavy segments, appear stretched, investors are often hesitant to sell their successful investments. However, this approach can be counterproductive over time and a more effective strategy is to sell high and buy low.

Currently, many investors anticipate that lower rates will boost consumer spending and benefit the market. Yet, this outlook hinges on more than just Fed policy, and the valuation aspect of this strategy is critically important at this stage.

We’ve seen similar scenarios in the past, where high market valuations coincided with Fed rate cuts, yet the market still sold off due to overstretched valuations. This was evident during the Dotcom bubble in 2000 and again during the 2007-2008 Global Financial Crisis. We believe a similar situation could unfold in the coming months.

Rate cuts, recessions, risks

Another noteworthy point is that rate cuts often precede the onset of a recession. For instance, in late 2000, the Fed reduced rates from 6.5% to 1.5%, but a recession still emerged six months later, leading to a steep market drop—from around 1,500 on the S&P 500 to approximately 1,000. Similarly, in 2007, despite the Fed’s rate cuts late in the year, a recession followed in 2008.

Investors should keep in mind that the path to successful investing isn’t as simple as just following the Fed's moves. While Fed policy is a key consideration, other factors must also be weighed, especially at this stage in the economic cycle. This broader awareness is essential.

Additionally, there’s a prevailing view that when the market sells off, the dollar tends to strengthen. This is because the dollar is widely regarded as a safe-haven currency, attracting investors seeking stability until market conditions improve.

Extending that argument, investors tend to shy away from riskier assets like emerging markets during market downturns, which can put pressure on emerging market currencies while safe-haven currencies in developed markets tend to perform well. Although this pattern holds true, particularly in times of panic, there are occasions when emerging market assets show surprising resilience.

It’s worth noting that dollar strength follows a cyclical pattern, much like other trends in investment markets. Contrary to popular belief, the correlation between the S&P 500 performance and the US dollar's strength isn’t always negative.

In fact, about 40% of the time, we observe a positive correlation—where markets and the dollar either decline together or rise together. This means that the commonly accepted narrative doesn’t hold nearly half the time, prompting us to consider why this occurs and whether a similar scenario could play out now.

The valuation factor is also relevant here, as we believe the dollar is currently overvalued. This overvaluation limits its capacity as a protective asset, as it cannot continue strengthening indefinitely without eventually reversing.

Hedge, diversify, assess

For investors aiming to hedge against a market sell-off, precise timing is crucial. However, this is often challenging, as investors might get one aspect of the timing right but miss the other.

Maintaining a diversified portfolio has substantial benefits, as today’s apparent winners can easily become tomorrow’s laggards, while assets that seemed unlikely to perform can sometimes surprise on the upside. Diversification remains essential, but it’s equally important to assess what is currently overvalued and what offers value in this phase of the cycle.

At present, both the US dollar and US markets appear overvalued, which should be a consideration for investors looking to use them as diversifiers. We are approaching an extreme point where valuations are no longer attractive, and the dollar is also expensive.

This suggests that the upside potential is more limited than it was a decade ago, and the diversification benefits from the dollar may now be compromised.

Against this backdrop, it is crucial that investors seek professional financial advice to make well-informed decisions and avoid over-reliance on these outdated assumptions.