June 21, 2017
In our quantitatively-focused approach we don’t try to explain why the prices of securities are what they are. We just try to be going in the right direction on the right train. Even so, I cannot help but wonder about the fundamental causes of what seems like the “Bizarro World” of investing we find ourselves in these days.
On average, the fastest aspect of internal performance in US companies is the growth of debt, while the largest external (market) performance aspect is multiple expansion. Price to earnings, price to sales, price to GDP and price to most anything else are at historically high levels. This makes sense when the government depresses interest rates and management wants to meet EPS targets, while sales and earnings are stagnant in most companies. Multiple expansion is further fueled by the massive flow of funds from actively managed investment to passive index investing approaches, largely via ETFs. Whereas active managers scrutinize the performance and prospects for every company they own, indexers just buy and sell shares when they need to in response to the money flows, in what are really thought-free investment decisions. So when the money flows are positive, as is the case now, stock prices go up. Since prices are determined by the marginal buyer, as long as the indexing bid is there, prices will rise with or without growth or improving profitability. Nice. But what happens when the fund flows from active to passive slows down? Will the marginal buyer shift from the automatic bid of the indexer to the scrutiny of an actual investor? Oh, horrors!
I suspect that, as long as the central bankers keep interest rates near zero, investors will be leaving fixed income and allocating greater amounts to stocks, and most of that to index approaches. Why? Because it is darned hard for any active stock manager to beat the index. This is because of the increased degree of concentration of stock market returns in fewer companies. Aggregate returns are being driven by the few companies making huge gains, and if the active manager doesn’t own them, they under-perform. The indexers own everything, so they will catch the waves of the big winners. I guess that is why so many active managers have been accused of being “closet indexers.” I doubt a major market shift is likely until this dynamic changes.
Meanwhile, the bond market is telling an opposite story. Stocks reflect a belief in a growing and strengthening economy. Rising bond prices based on low expectations for inflation (in the face of several Fed rate increases) reflect a low growth consensus. When a major correction does eventually arrive, it doesn’t seem that diversified US stock and bond portfolios will be benefitting from the presumed non-correlation of price changes. If diversification doesn’t manage risk in diversified passive portfolios, then a lot of people are going to get bruised.
When both stocks and bonds look pricey it may be time to consider a liquid alternative for at least some portion of your portfolio. Since cash deposits are offering no return, an allocation to a reliable absolute return strategy would be a timely choice.
Looking down the road, I think the larger question for us all will be how our government responds to the next stock market correction. Will it be another “financial crisis” if Wall Street bonuses are in jeopardy? Will we further extend the national debt to protect the prices of financial assets? Have we decided that lofty stock prices are the objective of monetary and possibly fiscal policies? Maybe. Why not? I mean, what could go wrong?
In the new world of central-bankers-gone-wild, Japan’s BoJ makes all the others look like pikers. After fully monetizing Japanese government bonds, it opened up the QE spigot on the equity market. The BoJ has become the largest shareholder in 55 of the 225 companies in the Nikkei Index and owns over half of all the ETF shares in the nation. For those who think that the US should attempt to bail out the US stock market the next time it wobbles in order to sustain the presumed “wealth effect,” consider how this kind of policy has worked out for the Japanese. The Nikkei 225 Stock Market Index has been in drawdown for about 28 years and is trading at about half its December 1989 high.
Trendhaven is a registered investment advisory implementing a tactical investment strategy in separately managed client accounts with an absolute return investment goal. www.trendhaven.net.