Looking through the storm

A £1,000 investment at the bottom of the market in March 2003 would have grown to £2,048 by the summer of 2007^†.

Since then it has been a different story. If anything, the swings have become even more pronounced in the first half of 2008.

The year started badly, as investors greeted the New Year with a renewed focus on the extent to which the credit squeeze would spill over into the wider economy and cause a slowdown in growth. The FTSE 100 fell from 6479 on 3 January to 5578 in less than three weeks.

By mid-March the FTSE 100 had tested a new low at 5414, down 17.4% in less than three months.

As often happens, markets continued falling until a particularly worrying piece of news (in this case the collapse of US investment bank Bear Stearns) convinced some market players that all the bad news was now out in the open. Markets hate uncertainty and clear events, even bad ones, can sometimes provide a measure of reassurance.

The decisive action of the US Federal Reserve in cutting interest rates and improving liquidity caused sentiment to improve and stock markets adopted a firmer tone until mid-May when investors turned their attention to a new concern: inflation.

It would be hard not to be aware that prices of a wide range of globally-traded commodities have risen sharply this year. It has not been possible to open a newspaper or switch on a news bulletin without exposing yourself to a barrage of news suggesting that the dragon of inflation, sleeping for so long, is stirring again.

Oil and food price rises

The most important commodity in the world is oil. We remain addicted to black gold, so its price doubling to a level that was scarcely imaginable only a few months ago is a serious concern. The cost of many basic foods has also risen rapidly. In both cases fast-growing demand and limited capacity to increase supply have combined with increased speculation in financial markets to push prices higher.

Rising input prices are never good news for companies but they represent a particularly acute problem in the relatively unusual event that they coincide with slowing demand. With clearer signs every day that the shortage of available credit is beginning to undermine activity and prices in the housing market, this is the situation we find ourselves in today.

This combination of rising prices and flagging growth – known as stagflation – creates an interest-rate setting dilemma for central banks such as the Bank of England. If they cut interest rates they risk stoking up inflation, but if they hold or raise rates the danger is that they exacerbate the economic slowdown.

Policy makers are even more torn when the general public’s inflation expectations start to rise because that can trigger a vicious spiral of rising prices leading to higher wage demands which in turn feeds back into higher prices again.

Rising inflation

According to a recent survey in the Financial Times, we are already there. More than two fifths of us believe that inflation is above 5%, the survey said, well above the official rate of only 3%.

The effect of all this in stock markets around the world has unsurprisingly been negative. Between May 19 and June 11, the FTSE 100 has fallen by 10.2% from 6376 to 5723 and there have been similar falls in other important global markets. Sectors that are most exposed to falling consumer demand, or vulnerable to higher interest rates, such as house-builders, banks and retailers have borne the brunt of the sell-off.

Taking the long view

At Fidelity, we have been through many similar market cycles over the near 40 years we have been investing our customers’ savings. In our experience, one of the most common mistakes investors make is to be sucked into markets when the outlook appears fair but markets are relatively expensive and to withdraw when the outlook is uncertain and markets are commensurately better value.

The psychology of investing, swinging as it does between optimism and pessimism, ensures that investors find it difficult to ride out the market’s inevitable fluctuations to benefit from the long-run outperformance of equities over other investment asset classes. They often try to time the market, selling their investments in the hope that they can buy back into the market at a more favourable moment.

Our experience of investing leads us to avoid market timing. Instead we have learned that it is best to be patient and to ride through short-term volatility. Our analysis confirms the wisdom of this approach.

It shows that an investor who has been fully invested for the past 15 years since May 1993 would have grown an initial £1,000 investment to £3,588.97. If the same investor had tried to time the market but missed the ten best days over that same period, their investment would have only grown to £2,363.34 and if they had missed the best 40 days in the market they would actually have lost money, ending up with just £974.49.*

The importance of this in today’s markets is that the best days very often follow immediately after the worst although, of course, past performance is not necessarily a guide to what might happen in the future.

Our approach to investment has always been to focus on finding the best individual investment opportunities in all market conditions and we see the current volatile market as part and parcel of the normal investment cycle. In the short-term, volatile markets throw up attractive investments because investors invariably over-react to both good and bad news.

So don’t expect a calm passage in the months ahead but keep your eyes on the horizon. It’s an unusual voyage that doesn’t suffer the occasional squall along the way.

† Source: Datastream May 2008

* Source: Fidelity May 2008

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