How to prepare for the bear

Rarely has there been a less auspicious start to the year for global stockmarkets. In the first five trading days of 2016 the global FTSE All World index lost 6% as concerns about China, the collapsing oil price and, to a lesser extent, geopolitical tensions in the Middle East, rattled investors' confidence.

The pain was far worse in China: the CSI 300 index lost 15% in six days, a bone-shaking fall that reverberated through Asian and emerging markets. In the all-important US, the S&P 500 suffered its worst-ever opening week. Europe including the UK matched the US, but Germany, which exports plenty to China, fared worse than the UK.

This was a very swift resumption of the volatility I was concerned about last month, and it raises the question of whether the experience of the first week in equity markets presages more of the same.

Ominous sign

We'll have to wait to see whether the old adage "as goes January, so goes the year" comes to pass. But there is arguably an even stronger correlation between the first week's trading in January and a market's value 51 weeks later.

Research from S&P Dow Jones Indices suggests that years that have started badly in the first week tend to end that way. Investors can be forgiven for not wishing to wait until the first week of September, the best indicative week for calendar year performance, for confirmation of the trend.

One reason for fearing that volatility (essentially a euphemism for falling equity markets) is becoming entrenched is not entirely to do with China.

That country's bloated financial sector, stuttering economic growth, botched attempts to control the stockmarket and devaluation of the renminbi are certainly causes for concern.

But these are mainly local problems and something of a sideshow. The main event that is wracking investors' nerves is the failing health of the developed world's corporate sector.

Mark Burgess, chief investment officer for Europe, the Middle East and Africa at Columbia Threadneedle, sums up the situation facing investors in a nutshell.

"Until the very recent past, markets could rest easy in the knowledge that they could drink from the punchbowl of quantitative easing (QE), and that this would boost asset prices while also reducing volatility - QE was the rising tide that lifted all boats.

"Indeed, such was the power of QE that many market participants would see 'bad' economic news as 'good' news, because it meant more QE and thus further boosts to asset prices.

"We are now in a world where bad news is bad news, because policy tools are exhausted and the US Federal Reserve wants to raise rates. Moreover, the geopolitical environment is deteriorating in a manner that has surprised some investors."

How to respond?

How should private investors respond? Barely four months ago I suggested investors could make a quick gain from China-inspired weakness.

That was a profitable trade back then. Markets were expecting the US Federal Reserve not to raise interest rates and the European Central Bank to open the liquidity taps by ramping up QE.

Also, the Chinese authorities had pretty much ordered equity markets to head north - and they obliged - but belatedly realised the market can only be rigged to a degree.

Now QE-driven market liquidity is drying up, growth in global corporate profitability is stagnant, commodities are falling and credit markets - usually a reliable leading indicator for equity markets - suggest a torrid time ahead. Technical market indicators for the S&P 500 index predict much the same.

I'm not suggesting investors buy into weakness now, and where they do, they should be very selective. The bear's claws are not yet fully extended - we should all be prepared for a mauling.

Focus on equity income

Sustainable equity income remains one of my main themes for 2016, because dividends will likely be the main component of total return.

But as I highlighted last year, investors will need to be selective and, in the UK at least, favour equity income investment trusts with decent revenue reserve to keep the dividends flowing. Some big, open-ended funds, which must pay out all of their income, could disappoint on the income front in 2016/17.

In the UK, trusts that I expect to hold up well include City of London, Edinburgh and Troy Income & Growth. For trusts that have exposure further down the market capitalisation scale, consider Diverse Income and Lowland.

Overseas equity income plays to consider include investment trusts Schroder Oriental Income, Murray International, North American Income and European Assets.

Among open-ended funds, I like Artemis Global Income, Newton Global Higher Income, CF Morant Wright Nippon Yield, FP Argonaut European Enhanced Income and JPM US Equity Income.

But if medium-term capital preservation is more of a concern, then investment trusts Capital Gearing, RIT Capital and Bacit deserve your attention.

A focus on asset classes that have already been significantly derated will pay off, eventually. Check our sister magazine Money Observer's Rated Funds in the Asian Equities and Global Emerging Market Equities asset classes for ideas on where to drip-feed some of your cash when the volatility dies down.

Andrew Pitts was editor of Money Observer between May 1998 and September 2015.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.