If investors needed proof of the capricious nature of financial markets, you’ve had it in spades over the past seven to 10 days. It’s been bonkers.

As we write the FTSE 100 is re-adjusting to the limbo levels below 7,000. At 6,995.91, this is the first time the UK index, representing Britain’s biggest (and supposedly best) companies, has stumbled this low since…  April 2018.

That the FTSE 100 was lower than it is now as recently as six months ago hopefully puts these events into context. Were prospects so bad back then, and are they any worse today?

In this feature we aim to guide investors through this patch of uncertainty and bring a little perspective to recent declines in stock markets.

What has been going on, what does it all mean, and what can ordinary investors do to protect their investments and position their portfolios for the coming months?

IN THE EYE OF THE STORM

This latest market panic, crash, correction (call it what you will) means that hard earned share price gains made earlier in 2018 have been largely wiped out, as have capital returns booked since November 2016.

‘A five-day losing streak, capped by the worst one-day fall in the US S&P 500 index since February, has investors asking themselves whether this is just the ‘healthy correction’ so beloved of market commentators or the beginning of something more serious,’ says Russ Mould, investment director at platform AJ Bell.

The share price shake-out has been a global response. The VIX index, which measures market volatility, spiked from 11.61 on 3 October to 24.98 on 11 October. In February the VIX surged to beyond 50.

Equity markets across the globe have fallen - the S&P 500, Dow Jones, Europe’s Stoxx 50, Hong Kong’s Hang Seng, the Nikkei 225 in Japan; they’re all down, chalking-up declines in the region of 5% to 7%.

Such statistics will worry the many investors with various tracker or index-linked investments yet the scale of the sell-off has not been evenly spread and many of the individual company shares, investment trusts or funds you may own may be showing substantially greater losses.

The US Nasdaq, noted for its density of technology stocks, came off among the worst, losing 6.6% between 3 and 11 October, before staging a modest rally on the 12 October.

This will inevitably lead to claims that this is a response to bloated technology valuations. There may be some truth in that view but the main change has come in the market mood, and its response to risk - how much investors are willing to embrace risk and what price they are willing to pay for returns in the face of this implied uncertainty.

WHY ARE THE MARKETS DOWN?

There are a number of factors that have been troubling investors and investment markets, none of them particularly new. Rising bond yields, an escalation in trade hostilities between the US and China, and asset valuations to cut to the chase.

Equities have come under increasingly intense scrutiny just as we head into what looks like a very important third quarter corporate earnings season, one that could spark share price recovery, or hasten stock markets declines.

Rising bond yields have provided the kindling to spark the flames of this market sell-off.

‘Sharp rises in yields can cause market dislocations, and if the current bond market sell-off becomes more aggressive, it could begin to create genuine problems for equity markets,’ says David Absolon, investment director at Heartwood Investment Management.

Rising bond yields mean that investors can get higher returns on their invested capital from relatively safe government-backed securities.

Average yearly equity returns of 6% to 7% (the historic average) may look attractive if US treasuries (the most influential of government bonds) are offering 1.5% to 2.5%, as they have done for much of the past 10 years.

But this year yields on 10 year US treasuries have jumped, hitting 3.2% this month. Suddenly the extra risk investors must accept with equities doesn’t look so attractive. Why have yields shot up? Keeping it simple, that’s mainly because of higher interest rates and the firm message from the US Fed that this trend will continue into 2019.

Policymakers at the US central bank increased interest rates for the third time this year last month to 2.25%. The widespread belief is that a fourth hike could come through in December and the market is anticipating three rate rises through 2019. For bonds to remain attractive to investors versus cash, asset prices need to come down on fixed income bonds which pushes yields up.

Higher interest rates also work against equity markets since they push up borrowing costs for companies and individuals, potentially hurting corporate profits and curbing consumer spending.

These trends have been playing out in financial markets all year so we cannot really say that this latest correction in equities has come from out of the blue. ‘The sharp sell-off in the US has likely caught no one by surprise,’ says Paras Anand, head of asset management, Asia Pacific at Fidelity International.

‘If anything, investors have been wondering how, in the face of tighter monetary policy, a contracting labour market and rising oil prices, the US has continued to be so resilient.’

WHAT DOES THIS MEAN FOR INVESTORS?

The widespread decline in share prices has understandably made investors nervous and eager to find some way to add an element of protection to their portfolios. You can do this by making subtle shifts, perhaps increasing stakes in reliable income-bearing stocks, funds and trusts that will help improve diversification.

But we do not subscribe to the idea that most investors should rip up their portfolios en masse and start wearing their tin hats, especially if you are investing for the medium to longer term.

WHAT SHOULD INVESTORS DO NOW?

Remaining invested in the market has historically been the best course of action if you’re in it for the long haul. Stock markets have a
tendency to recover faster than you think, although precisely predicting when that may happen is impossible.

You might reasonably ask whether the fundamentals have changed for your investments, and if they haven’t deteriorated, it’s probably
best to do nothing. If they have, you need to do further research and ask whether you should still own that investment.

But it is also advisable to remain open to the possibility that for many good quality companies, little has really changed except the valuation. That could mean a rare chance to invest in a business at a price discounted to levels seldom seen.

‘We are closer to the end of the current cycle than the beginning,’ says Karen Ward, the chief market strategist in JP Morgan Asset Management’s Europe, Middle East and Africa unit.

But that is not to say the best of the investment profits from equity growth have been had, far from it. ‘Late cycle returns can be spectacular,’ she stresses.

It is worth noting that UK stocks had already been lagging the performance of other major markets before the current market sell-off. The FTSE 100 had actually declined 1.8% year to date as of 3 October and hasn’t made meaningful ground in 15 months.

Since the sell-off began on 4 October (the first day share prices were affected in the UK) the index has fallen 6.7%.

We are taking a front foot approach. We have noted several excellent companies with very strong investment credentials that are now looking attractive. So we have extended our weekly Great Ideas section to give readers a handful of opportunities to get on board, if they choose to.

They may not all be super cheap, but these are high quality businesses with great prospects whose shares are now available at valuations not seen in some time.

You can read that companion piece by clicking here.

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