How to make the best of it in the bad times

With a gloomy outlook, what strategy should investors take? By James Daley

Global equity markets saw another torrid few days last week as billions of dollars were wiped off the value of many of the world's largest companies. The FTSE 100 index of UK blue chip companies and the S&P 500 index of leading US shares both finished the week some 10 per cent below their mid-October highs, while the Japanese Nikkei 225 index is now down more than 20 per cent since October.

With the UK and US housing markets in decline, global economic growth slowing and the aftershocks of the credit crunch being felt across the financial sector, analysts and professional investors are now polarised between those who believe that the conditions present the perfect buying opportunity and those who think it makes more sense to seek shelter until the storm has passed.

Here we take a look at each side of the coin, and present some possible strategies for both the bulls and the bears out there.

The aggressive investor

Chou Chong, the head of Pan Europe and Developed Markets at Aberdeen Asset Management, is excited by the opportunities in the volatile markets and says his funds will remain fully invested rather than increasing cash positions, or shifting into lower risk stocks. One of his team's favourites is the housebuilding sector, which has been seriously out of favour with investors over the past six months, as fears of a housing crash and economic slowdown have grown.

"Some housing stocks have fallen 50 or 60 per cent in a short period of time," says Chong. "After those kind of falls, we're likely to see two or three years of recovery. The key is to take a two-year plus outlook – that's when the real money can be earned."

Chong believes that, ultimately, the fundamentals of the UK housing market look promising and that even though prices are currently falling this is more than accounted for in the current share prices.

"We are experiencing a slowdown – but the reaction of the market due to the presence of a much greater volume of short-sellers, has meant the correction is much more severe," he says. "Any investor with experience and knowledge should be looking into it again."

Chong says his fund managers have begun building positions in stocks such as Persimmon and Barratt, which they believe present some of the best value. "When you look at the price of Persimmon or Barratt, you're almost assuming that no one's ever going to buy a property again," he says. "But people will start borrowing from the banks again and will buy houses."

He draws a parallel with the market's appetite for airline stocks after the 11 September terrorism attacks, which saw such sharp downgrades as to suggest most people would never fly again. In the years that followed the industry returned to record growth.

Chong says his team is also interested in some commercial property stocks, such as Hammerson and Land Securities, where share prices have also plummeted. These stocks now trade at a discount of around 35 per cent to their portfolio's net asset values.

Although the banks also remain cheap, Chong says he believes there is still not enough certainty to encourage him back into the sector. He believes that once the 2007 annual reports have been produced this spring, confidence in the sector may begin to return.

For those who'd rather invest in funds, such as unit trusts, rather than direct stocks, Darius McDermott, the managing director of Chelsea Financial Services, the independent financial advisers, believes the best place for the aggressive investor in 2008 is emerging markets. While economic growth is slowing in the developed western economies, emerging markets continue to remain resilient.

"Historically, if the US went into recession, emerging markets would be hit," he says. "But as the US began to slow down last year, that didn't happen – emerging markets continued to rocket. Over the next 12 months they'll be the best place to be."

McDermott points to Lazard's emerging market fund as one of his preferred investments, which is one of the more conservative funds in a high risk sector.

"We also like Allianz BRIC stars, which invests in Brazil, Russia, India and China," he adds. "That's up 12 per cent in the past three months. And the fund that I have personally been buying has been Neptune's Russia fund."

If you want to stay closer to home, McDermott points out that the US market tends to hold steady in election years. He picks Martin Currie's North American fund as one of the best choices in this sector.

The defensive investor

Mark Lyttleton, manager of the Black Rock UK Absolute Alpha fund says he has been shifting his portfolio to more defensive positions for several months, and hasn't finished yet.

He says the best place to be investing now is larger blue chip companies whose incomes are not so sensitive to the ups and downs of the economic cycle.

"We have been trying to pool the portfolio into more defensive positions," he says. "We believe the outlook for the UK economy is going to be quite tough over the coming months, so we don't own any retailers and we don't own any banks or any housebuilders.

"And while everyone's talking about sub-prime, no one's talking about increases in bad debts, which are likely to come. It's difficult to know when it will be safe to invest in the banks."

In the UK, Lyttleton's fund has been investing in miners and oil stocks, as well as businesses with longer order books such as defence, engineering and support services. His fund's biggest holdings include Xstrata, BAE Systems and Compass Group.

He has also been looking to invest in stocks that glean most of their earnings from Asia and other emerging markets. Prudential, whose Asian business accounts for more than a third of its profits, is another of the fund's largest holdings.

Unlike regular long-only funds, Lyttleton's fund also has the ability to make a profit on stocks that he thinks will fall in value, using short-selling techniques. This gives his fund a much better chance of outperforming in all markets.

Ultimately, the safest way to protect money in a falling market is to put it into cash. If you're willing to take a bit of risk, Brian Dennehy of Dennehy Weller, suggests that absolute return funds may be a good option as they aim to produce steady returns with low levels of volatility. He recommends the JP Morgan Cautious Total Return fund.

Dennehy adds that investors should not aim to second guess the equity markets. Instead, he recommends making monthly contributions into an equity fund. "Remember, if the market is falling, then you're merely buying more at a cheaper price each month," he adds.

For those in search of a solid equity fund in the UK, Dennehy recommends income funds, which invest in stocks with high yields. He recommends the Newton Higher Income fund. For a fund investing in larger companies, he picks the M&G Recovery fund.

If you'd rather steer clear of the equity markets but don't want to put your money into cash, Dennehy says there are some good opportunities in the corporate bond fund arena. He recommends Artemis's Strategic Bond fund, which invests across high quality investment grade bonds and higher risk junk bonds.

To find an IFA in your area, visit www.unbiased.co.uk