Charterholders and other managers share their views on recent market conditions that have posed severe challenges for active strategies.
- After several years of disappointing results, many managers, including some high-profile names, are questioning whether equity values have become completely disconnected from current or future profits.
- Some professional investors believe historical indicators may still be useful if the right adjustments are made.
- Even if managers trust traditional measures indicating that stocks are extremely overvalued, they still must grapple with the challenge of balancing short-term expectations with long-term risks while avoiding naïve market-timing strategies.
Generating alpha has never been easy, but seldom has it been as hard as in the past couple of years.
First came the Great Volatility Drought of 2017, in which financial asset prices rose more or less in lockstep, causing strategies premised on some securities being more attractive than others to underperform simple (and cheap) approaches, such as indexing and trend following.
This unnatural tranquility had two causes, says Don Steinbrugge, managing partner at hedge fund consultancy Agecroft Partners in Richmond, Virginia. The flow of capital into index and sector ETFs pushed up prices indiscriminately. And central bank buying of financial assets with newly created currency lent the market a steady upward bias, again without reference to relative valuation.
Investors were so transfixed by these seemingly stress-free gains that the VIX (or “fear” index) averaged a near-record low of 11 in 2017 compared with a long-term average of 20, and sentiment measures, such as the Investors Intelligence Bull/Bear ratio, skewed to their most optimistic levels ever.
The impact on active money managers was brutal. Because “inefficiencies in the markets last longer” in a low-volatility environment, as Steinbrugge notes, funds betting on quick resolutions of pricing anomalies saw their returns lag the smoothly rising market averages, causing clients to lose patience. Long–short equity funds suffered especially severe redemptions because the “short” part of the strategy was wasted effort.
David Einhorn, president of New York hedge fund Greenlight Capital, spoke for this frustrated group of money managers in his October 2017 report to clients. “Given the performance of certain stocks, we wonder if the market has adopted an alternative paradigm for calculating equity value,” he wrote. “What if equity value has nothing to do with current or future profits and instead is derived from a company’s ability to be disruptive, to provide social change, or to advance new beneficial technologies, even when doing so results in current and future economic loss? . . . The persistence of this dynamic leads to questions regarding whether value investing is a viable strategy.”
Then, just as the world seemed to have accepted the death of volatility, it returned with a vengeance. In early 2018, huge moves both up and down became the norm, with the Dow Jones Industrial Average registering two declines greater than 1,000 points in the space of three trading days. The VIX more than tripled from its January trough to its February high.
But rather than providing relief for active managers, spiking volatility proved to be just a different kind of bad. Crowded trades, such as shorting “vol” and loading up on the FANG group of stocks (Facebook, Amazon, Netflix, Google) and other big tech stocks, turned disastrous, leading hedge funds to report their worst month in two years in February. One of the many prominent victims of this mercurial new environment, John Paulson (whose epic bet against the 2000s housing bubble produced multi-billion-dollar gains) reportedly saw his firm’s assets under management fall from $38 billion in 2011 to $9 billion in late 2017. In March 2018, he announced the closure of funds
This sense of a world gone irrational is of course nothing new. Both the late-1990s tech stock bubble and the mid-2000s housing bubble made a mockery of traditional investing strategies during their heydays.
Investors now face two key questions: (1) Will this latest stretch of seemingly random market action give way to “normal” times in which active management has a chance of outperforming? (2) Are there indicators that can be trusted to give a sense of what happens next?
The conventional answer to both questions is yes. Traditional bull and bear markets, complete with exploitable patterns and valuation anomalies, will resume one of these days. In the words of economist Hyman Minsky, “Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.”
And that means historically reliable indicators will once again offer useful clues to what’s coming. As for what the best indicators are this time, experienced money managers have a few candidates.
The price-to-earnings (P/E) ratio has been around since there were public companies with earnings to measure. Over long periods of time, it has been a pretty good indicator of equity values—but only pretty good because the business cycle often distorts earnings. For example, at the nadir of recessions, corporate profitability tends to evaporate, producing extremely high P/E ratios that look like sell signals but that are actually the opposite.
Yale economics professor Robert Shiller addressed this flaw by calculating a “cyclically adjusted P/E” (CAPE) using a 10-year moving average of earnings. The resulting number has had a strong negative correlation with future equity returns, as extreme high and low readings have subsequently reverted to the long-term mean. Over the past century, high CAPEs have preceded periods of low returns for equities, periods that usually feature a dramatic bear market.
But CAPE-10 isn’t perfect, according to Lance Roberts, chief strategist with money manager Clarity Financial in Houston, Texas. Because most investors have a time frame considerably shorter than 10 years and because financial events are now moving much faster than previously, “the CAPE-10 creates a duration mismatch,” he says. The process it measures doesn’t conform to the time frame within which most asset allocation decisions are made.
To adjust, Roberts takes a 5-year rather than 10-year moving average of earnings and calculates the deviation of the resulting CAPE-5 from its long-term average. “These averages provide a gravitational pull on valuations over time,” he says. “The further the deviation is away from the average, the greater the eventual mean reversion will be.”
In historical perspective going to the 1940s, the current percentage deviation of the CAPE-5 ratio from its long-term average is striking.
“The year-end 2017 CAPE-5 was 44.19% above the post-WWII average of 17.27 times earnings,” says Roberts. “Such a level of deviation has only been witnessed three times previously over the last 70 years—in 1996, 2005, and 2013.” (The 2013 ratio was distorted by the spike and subsequent plunge in oil prices and can therefore be ignored, according to Roberts’s analysis.)The current bull market might have a bit further to run (as it did in 1996), but “If you’re expecting the markets to crank out 10% annualized returns over the next 10 years, it is likely that you’re going to be very disappointed,” says Roberts. Put another way, indexing and trend following are about to lose their mojo.
Enterprise Value to Free Cash Flow (EV/FCF)
One potential problem with P/E ratios, adjusted or otherwise, is that “earnings can be and frequently are manipulated,” says Kevin Smith, CFA, CEO at Crescat Capital in Denver, Colorado. He believes a more accurate measure of corporate health is free cash flow (FCF), “because at the end of the day this is what companies can actually use.”
Smith smoothes FCF over 3 years, which is “better for tactical portfolio management than 10 years while still being long enough to account for outlier cyclical years.” In the numerator, he uses enterprise value (EV), which includes debt along with equity market capitalization. In an era of record corporate borrowing, this gives a more accurate measure of the true worth of a public company, according to Smith. He excludes banks from his universe because “for them, free cash flow and EV are less relevant.”The early-2018 reading exceeds those prior to the previous two bear markets. “The US stock market is at all-time high valuations, with median cyclically adjusted EV to FCF for non-banks at an insanely high 41 times,” says Smith. “US large-cap stocks are the most overvalued in history.” The other indicators he follows, including EV to sales and EV to EBITDA, give more or less the same wildly overheated reading.
High-Yield Credit Spread
The general picture of late-cycle excess is found in fixed income as well, according to Shane Shepherd, head of macro research at investment firm Research Affiliates in Newport Beach, California.
The yield curve is flattening as short-term rates rise faster than long-term rates. “The markets are concerned by evidence of wage growth and inflationary pressures,” notes Shepherd. This is leading the Federal Reserve to raise the federal funds rate, “and if they overdo it, there’s a risk of recession where consumer spending contracts and corporate profits fall, which is a negative for corporate bonds,” says Shepherd.
Another useful measure of the state of fixed income is the credit spread (i.e., the yield differential between investment-grade corporate bonds and Treasuries). “Currently, it’s below the long-term average, which means you’re getting paid less [for the related risk] in corporate bonds than in the past, indicating that those bonds are expensive,” says Shepherd.
The signal is even stronger in high yield, the riskiest part of the quality spectrum. Shepherd compares the yield on junk bonds with that of Treasuries and isn’t reassured. “Those spreads are much narrower than they’ve been historically,” he says. “Right now, [high-yield bonds] are pretty expensive.”
There are reasons for high-yield bonds’ currently rich prices, according to Shepherd. “The economy is doing well, and corporate earnings are growing. That’s good for high-yield bonds since it allows companies to pay off debt,” he says. As a result, default rates are extremely low for sub-investment-grade yield borrowers at the moment.Still, history says there’s a limit to spread compression. “Typically, from here, you’ll see the yield on corporate bonds rise [which is to say their prices will fall],” says Shepherd. This throws the virtuous cycle of the past decade into reverse, as tighter money causes high-yield borrowers to start defaulting. He cites 2008 as an example. “Yields on both investment-grade corporate and high-yield bonds soared, up to 20% on some high-yield indexes, while Treasury yields dropped,” he says. “Junk bond losses in 2008 weren’t as bad as in equities but were still very extreme.”
Investing for What Comes Next
The plethora of indicators showing extreme overvaluation could point to another “big short” opportunity on the horizon. Einhorn has responded with a “bubble basket” portfolio of high-flying short-sale candidates including Amazon, Tesla, and Netflix. “Our view is that just because AMZN can disrupt somebody else’s profit stream, it doesn’t mean that AMZN earns that profit stream,” Einhorn explained in his letter to investors.
For the majority of money managers who can’t simply short everything in sight, the options are more nuanced. “If I start shorting and buying defensive stocks and am too early, I’ll underperform so badly that I’ll lose clients,” says Roberts. His solution is to “manage in the short term with a long-term view of the risks.”
Roberts will stay long equities “until the market breaks,” which he defines as the S&P 500 piercing its six-year moving average. “That would require a 12% retracement [from year-end 2017 levels],” he says. “When the trend turns negative, I want to be in cash and fixed income.”
As for which part of fixed income, with spreads back to 2007 levels, “Corporate bonds [both investment grade and junk] are expensive,” says Shepherd. “We’re underemphasizing them, paring them back towards zero.”
Treasury yields are negatively correlated with both corporate credit risk and equity prices, Shepherd points out. “If we hit a recessionary environment and stocks and corporate bonds sell off, the Fed will step in and start cutting rates, and [Treasury prices] will go up,” he says.
The flattening yield curve traditionally implies that investors aren’t well compensated for the risks inherent in longer-term paper, according to Shepherd. “What you’re getting in long-duration bonds isn’t that compelling [relative to the risk–return profile of short-term Treasuries],” he says. “We’re not seeing a ton of value at the long end of the curve right now.”