In order to revive their economies and strengthen their financial markets after the crash, the world’s central banks have pumped huge amounts of liquidity into the system by keeping interest rates at very low levels and buying up assets such as government bonds.The end result, experts say, is that investors have been forced out of defensive assets into the equity market.
Investors who have bought into the market have been well rewarded, as both the FTSE All Share and S&P 500 have returned more than 100 per cent over five years.
Performance of indices over 5yrs
Source: FE Analytics
Gray, who manages the CF Miton Special Situations Portfolio, says that as a result of central bank intervention, equity markets now look very dangerous as the rally has only really been driven by re-ratings, not underlying earnings.
He says the current environment feels very similar to the build-up to the financial crisis in 2008, as investors are still piling into equities despite very high prices, because they are gambling on the belief that central bankers will be able to continue to support the market.
“If you were looking back at recent times, I think it is beginning to feel a lot like 2006 to 2007,” he said.
“It’s never, ever the same, but there was a long-term build-up of nervousness at the time and while I’m not for a moment thinking we are going to have something like Lehman Brothers' bankruptcy, I do think it’s a pretty dangerous environment.”
“Most of this has been driven by central bankers as they are making investors do more with their capital,” he added.
Unsurprisingly given his view of the market, Gray is keeping a very defensive portfolio. His CF Miton Special Situations Portfolio currently only has 35 per cent in equities.
Instead, the manager has more than a quarter of his portfolio in cash, a position he has had for the last three years.
“I can’t see any value anywhere,” Gray said.
“I’m really struggling to find value in any asset class, be it equities or bonds, and so I am happy to hold a lot of cash. However, I am really struggling to see where the long-term value is in equities.”
“If you didn’t like equities 18 months ago, then I can’t understand why you would now, given their current P/E ratios,” he added.
Gray’s high weighting to cash has hurt the fund’s relative performance recently.
According to FE Analytics, his CF Miton Special Situations Portfolio was a bottom-quartile performer in the IMA Flexible Investment sector in both 2012 and 2013.
This means that over a rolling three-year period it has only returned 5 per cent compared with 14 per cent from the sector.
Performance of fund vs sector over 3yrs
Source: FE Analytics
However, Gray's record over the long-term is very good. It is the best-performing fund in the sector since launch in December 1997, with returns of 295.95 per cent.
As a point of comparison, the sector has returned 122.05 per cent in this time.
Gray also has a proven track record of protecting his investors' capital in falling markets. Our data shows that in 2011 when the eurozone crisis intensified, his fund returned 1.79 per cent while the sector lost 8.73 per cent.
Then during the crash of 2008, when markets tanked and liquidity all but dried up, Gray delivered a 7.26 per cent return while the sector was down more than 25 per cent.
Performance of fund vs sector in 2008
Source: FE Analytics
There are signs that investors are starting to lose patience with the fund, as it has decreased in size by 7 per cent over the last six months and currently stands at £821m.
However, Gray says that he will not try to chase returns by increasing his equity allocation.
“Earnings growth hasn’t come through and, generally speaking, the recent reporting season was disappointing. Multiple expansion is driving everything. We have basically seen negative earnings growth, but the market keeps rising,” Gray said.
Given his concerns, the manager says that a major correction is inevitable.
However, he says it is difficult to forecast what could spark such volatility.
“The major risk will probably be some sort of left-field event that will surprise the market or it may be something bloody obvious,” he said.
“We are in a low-growth environment but then P/E ratios are very high, or well above long-term averages. That is very dangerous.”
“Current valuations just aren’t justifiable. We are getting asset price inflation by central bankers, but for how long can they keep easy liquidity going? People are taking a lot of comfort in the belief that central banks will provide a floor to equity markets.”
“Investors taking that view are essentially gambling, markets just aren’t driven by fundamentals anymore,” he added.
While Gray is very bearish on the likes of the UK, US and Europe, he is more positive on Japan.
The manager says that while the Bank of Japan has also embarked on a huge stimulus package, he says it is the only market where P/E ratios are justifiable because companies in Japan are actually delivering earnings growth.
For that exposure, Gray favours FE Alpha Manager Stephen Harker’s GLG Japan Core Alpha fund and also uses investment trusts such as JP Morgan Japanese IT, JP Morgan Japan Smaller Companies IT and Baillie Gifford Shin Nippon.
Gray’s CF Miton Special Situations Portfolio has an ongoing charges figure (OCF) of 1.86 per cent and requires a minimum investment of £1,000.
