Posts tagged Us Equity Market
The equity market bulls had been running for more than five years. Over this time interest rates had come down dramatically, inflation was muted and most every fiscal quarter delivered a reasonably predictable uptick in real GDP growth. Markets had weathered a spate of political and financial scandals, as well as occasionally unnerving geopolitical flashpoints. All in all, there seemed to be no particular reason to complain or worry as summer transitioned to fall. Yet investors were edgy. A certain element of caution held in check what should have been giddy times on Wall Street, as if traders and investment bankers, contemplating their seven and eight figure bonuses, couldn’t shake the feeling that it was all a bit unreal. It’s quiet in here, said the young MBAs at Morgan and Salomon to each other as they stared at the monochrome numbers flashing silently on their Quotrons. It’s too quiet.
The previous paragraph could easily be imagined as some future market historian recalling the strange bull market of 2017 – up to the last sentence, anyway. Salomon Brothers is long deceased, and the cathode ray tubes of yesteryear’s Quotrons lie dormant in landfills, patiently awaiting the archaeologists of future millennia. No, the year in question is 1987. On October 19 of that year, a sudden flash of lightning made a direct hit on US equity markets. Major market indexes fell more than 20 percent in one day – the technical definition of a bear market. On October 20, market pros stumbled around the canyons of lower Manhattan asking: What happened?
Thirty years on, another generation of markets pros -- contemplating another secular bull amid low interest rates, steady economic growth and uncomfortably subdued volatility – asks a different question: could it happen again?
A Bear By Any Other Name
The chart below provides a quick snapshot of the Black Monday carnage – and the quick recovery thereafter.
That vertigo-inducing plunge on October 19 put the stock market squarely in bear territory, after a bull run that began in August 1982. But look how quickly the market recovered. By July of 1989 the S&P 500 had regained its pre-crash high. This new bull would go on running for more than a decade, ending only with the bursting of the tech bubble in 2000. For this reason, even though the 1987 market crash was technically a bear market event, we describe it in conversations with clients more as a disruption in the Great Growth Market that ran for 18 years (from 1982 to 2000). We think it is important to make this distinction. Secular bear markets, like the 14 years between 1968 and 1982, call for specific portfolio strategies. But there is very little that one can do about a sudden pullback like Black Monday. To respond to that question we identified above – could a 1987-style event happen again? – our answer is yes. Most certainly it could, and in the next couple paragraphs we will share our thoughts as to why. But a pullback based on some one-off exogenous risk factors – however steep – is not the same thing as a true bear market.
Portfolio Insurance: “Algo” Trading’s Beta Version
So what caused Black Monday? It took quite a while for the market experts of the day to put the pieces of the puzzle together, but in the end they identified the culprit: portfolio insurance. This seemingly benign term encapsulated an approach to institutional portfolio management that involved computer-driven signals to act as warning bells when market conditions appeared risky. Sound familiar? It should, because the crude hedging strategies that made up portfolio insurance circa 1987 were the ancestors of today’s ultra-sophisticated quantitative strategies known by those in the game as “algo” (for “algorithm”) trading.
If you look at the chart above you will see that, a few days before Black Monday, the stock market moved meaningfully lower after soaring to new record highs. For a combination of reasons involving the rate of change in the market’s advances and declines, underlying volatility and a few other factors, the portfolio insurance triggers kicked in and began selling off positions to build hedges. On October 16, the Friday before the crash, the S&P 500 pulled back more than 5 percent as the hedging begat more hedging. On Monday morning the sell orders cascaded in, but there were no buyers. That’s what brought about the carnage.
Peaks and Troughs
Given how much money is currently invested in the offspring of portfolio insurance, the really interesting question is not “could it happen again?” but rather “why hasn’t it happened more often?” For one thing, the ’87 crash did bring about some institutional reforms – operational circuit-breakers and the like – to try and minimize the damage a tidal wave of one-directional orders could bring about. These safeguards have worked on a number of occasions.
For another, the vast diversity of quantitative strategies itself is a kind of check and balance. Every algo program has its own set of triggers: buy when the German Bund does X, sell when Janet Yellen says Y, write a bunch of straddles when China’s monthly FX reserve outflows top $100 million. Put all these out there in the capital markets and they act sort of like the ocean when the peak of one wave collides into the trough of another – they cancel each other out. But that is reassuring only up to a point. It is not hard to imagine that a perfect storm of signals could converge and send all the algo triggers moving in the same direction – everyone wants to sell, no one wants to buy. Crash!
Lessons from the Crash
So, if such a perfect storm were to happen and blindside portfolios with massive short term losses, are there lessons to be learned from 1987? Quite so. It should be clear from the above chart that the worst thing an investor could have done on October 20, 1987 would have been to sell in a panic. In fact, those of us who have been at this long enough to remember the day (and do we ever!) recall that Wall Street’s trading rooms were never more frenzied with buy orders than in the weeks after Black Monday. Portfolio managers may not have yet known exactly why the crash happened – but they knew that the macroeconomic context hadn’t changed, that there were no new geopolitical crises, and that stocks with stratospheric P/E ratios after a long bull run were suddenly super-cheap. That, largely, is what explains the quick recovery, explains why 1987 was not a “real” bear market and explains why, all else remaining more or less unchanged, the prudent response to an out-of-the-blue event is to stay disciplined.
Talk of endurance is all the rage these days. Fall race season looms for runners and triathletes contemplating their next attempt at 26.2 or 140 or whatever mileage benchmarks await the end of the arduous training programs through which they (we!) have been slogging all these humid summer months. In markets, too, endurance is the word of the moment, and not just in stocks. Sure, we’re into the ninth year of the equity bull market that began in March 2009, which counts by most calculations as the second-longest running bull on record. But that pales in comparison to the granddaddy of all distance runners. The bond market produced yields in the stratospheric heights of 20-odd percent in 1981, then rallied as the Fed broke the back of double-digit inflation. We’ve been in a bond bull ever since.
New Challengers Emerge
Alongside these elite harriers we have a couple other asset classes looking to break through more modest distance goals. The long-beleaguered euro limbered up back in January and started to chase its longstanding nemesis, the US dollar. The euro is up around 16 percent versus the dollar year-to-date, a surprising turn of events for those caught up in the hype of the so-called “Trump trade” that followed the election last November. In commodity-land, copper and other industrial metals have gained more than 20 percent. While the China demand-fueled “supercycle” for commodities is deemed long dead, the future for a select group of metals, including copper, may well be bright if forecasts about the demand for lithium ion batteries (key components of electricity-operated vehicles) prove to be accurate. For the moment, non-US currencies and industrial metals are still microtrends, unproven at longer distances, but it will be worth keeping an eye on their progress.
A Flat & Forgiving Course
Distance runners tend to do their best work on predictable, smooth courses with a minimum of steep hills or unexpectedly rough, slippery terrain. Which brings us back to stocks and the nine-year bull. There really haven’t been too many Heartbreak Hills since the summer of 2011, when the simmering Eurozone crisis and the US debt ceiling fiasco took stocks into a vortex that stopped just short of a bear-level pullback of 20 percent. The tailwinds have come courtesy of the central banks and their monetary stimulus programs, along with an economy that has delivered steady, if modest, growth, an improved labor market and muted inflation. Corporate earnings have done well in this environment, so that even if stocks are expensive by most valuation standards (they are), they remain well below the bubble levels of the late dot-com era.
Now, anything can disrupt the equilibrium at any time. There are always risk factors lurking under the surface that, if actualized, would create havoc in asset markets. Think back to the longest bull on record: that of 1982-2000. Technicians would dispute our labeling this entire period a bull market, as it was punctured by the sudden cataclysm of Black Monday 1987, when the Dow and other major US indexes fell more than 20 percent in one day. We don’t think of the 1987 pullback as a bear market in the classic sense, though, because (a) it was entirely unrelated to broader economic trends, and (b) it was over almost as soon as it began. The 1987 event looked nothing like the last real bear market, a long stretch of misery that endured from 1968 to 1982. We bring this up because, based on everything we see in the economic and corporate profits landscape today, any potential pullback in the immediate future would more likely arise from the sudden emergence of a hitherto dormant risk factor than from a structural change in conditions. The course, in other words, remains flat and forgiving, but runners should always be aware that lightning can strike.
Even Ultramarathoners Tire Out
And that, in turn, brings us back to that superstar distance runner, the bond market. Because if anything could potentially make that flat course hillier and more unpredictable, it would be an end to the “lower for longer” assumption about bond yields that is baked into every asset class with a risk premium. The risk premium for any asset starts with interest rates; namely, the prevailing risk-free rate layered with additional quanta of risks deemed pertinent to the asset in question. Upsetting the applecart of low rates would reverberate throughout the capital markets in a uniquely pervasive way.
For now, the bond market would appear to still be a ways away from its last legs. Both the Fed and the ECB will likely try to provide reassuring guidance over the course of this fall as to how they plan to move towards a more “normal” monetary policy environment with a minimum of disruptive surprises. We don’t expect much disruption to ensue from the upcoming September meetings of either central bank. But we have to pay close attention to any unusual wobbles or other signs of fatigue along the way.
It’s that time of year again. Here in the mid-Atlantic region we are getting the first taste of dry, cool nights in place of midsummer’s relentless humidity. High school cross country teams are running through our neighborhoods to get in some practice before the season’s official start in a few days. And, of course, investors across the land are wondering what mix of surprises are in store for the deviously tricky stretch of the calendar between Labor Day and Thanksgiving. The sense of expectation is palpable; it seems like an eternity since anything has penetrated the smug, self-satisfied forward motion of the S&P 500. Will the good times continue to roll?
There are of course many variables at play, and a broad spectrum of possible outcomes. We think these can be broadly divided into two high-level narratives: (a) nothing new here, carry on as before, or (b) signs of wear and tear in the long-running bull that could spell trouble. We look at each of these narratives in turn.
Narrative 1: Nothing New Under the Sun
Over the course of the year we have been treated to numerous explanations of what’s been going on in markets by the furrowed brows of CNBC analysts and their ilk. But when you stand back from all the earlier, furious rotation – into and then out of financials, into and then out of tech, into and then out of healthcare – the easiest explanation for the positive trends of 2017 is the near-absence of anything new. The US economy has been growing at a slow rate, with low inflation, a decent labor market and favorable corporate earnings, for most of the second decade of this century. Within the last year and a half or so our modest growth has been joined by that of Europe and Japan. There are no glaring trouble spots in emerging markets, with China and Southeast Asia reclaiming the lion’s share of global growth. The global economy appears serenely detached from the chaos of worldwide political dysfunction.
Almost no headline data points have challenged this macro-stability narrative thus far this year. And under the placid surface, of course, remain the central banks whose actions over the past six years have put a supportive floor under asset prices. Sure, there’s some debate now about how the Fed and the ECB steer their policies towards something more “normal,” whatever that is. But almost nobody expects that the bankers would sit back and watch from the sidelines should risk assets suddenly hit a nasty and sustained patch of turbulence. This attitude may appear complacent, but it is also entirely rational given all the evidence accrued over the past few years.
Narrative 2: Be Careful What You Wish For
Calm, gently upward-trending asset markets are an investor’s dream. But all dreams eventually end and the dreamer wakes up, remark observers skeptical that the Goldilocks conditions of the year to date can last much longer. Do the naysayers have anything substantial to present as evidence for a sea change in market trends, apart from simply repeating “no free lunches” ad nauseum?
Well, perhaps they do. As Exhibit 1, the Cassandras may trot out the performance of recent small and mid caps. Both the S&P 400 Mid Cap index and the S&P 600 Small Cap index are trading below their 200 day moving averages, more than 5 percent down from the year-to-date highs both attained in July. And while on the subject of 200 day averages – a subject about which we have had remarkably little to say for a very long time – the number of S&P 500 stocks trading below their 200 day averages is close to 50 percent. The current stage of the bull, in other words, is not particularly broad-based. A trend of narrowing outperformance has in the past been a frequent sign of impending market reversal (though, we should note, it is not particularly useful as a market timing measure).
The other evidence our skeptical friends may muster in support of the case for correction is the very absence of volatility so celebrated by the bulls. There was a stretch recently when the S&P 500 went 15 days in a row without moving more than 0.3 percent up or down – a 90-year record for low volatility. That serenity would appear to misprice the inherent risk in holding common shares – which, as any finance professor will happily tell you, represent a completely unsecured claim, junior to all other claims, on a company’s residual assets. When common stocks exhibit the volatility properties normally associated with fixed income securities, that would seem to indicate that the market has something wrong. Be careful what you wish for! And these arguments, of course, take place against the backdrop of a market more expensive, by traditional valuation measures, than any other than those of the bubbles of 1929 and 1999-2000.
The thing about each of these narratives is that they are entirely plausible. The worrying trends highlighted by the skeptics are believable and suggest caution…but so is the seemingly fixed-in-stone macroeconomic context of slow, reliable growth and benign conditions for corporate earnings. We also imagine that, if we do see a pullback or two of any size in the coming weeks, a quick, Pavlovian buy-the-dip response would be more likely than not. That in turn may afford some additional intelligence on whether conditions going forward appear wobbly enough to support building up some additional defenses.
Investors tend to be predisposed to a “follow the leader” mentality -- to latch onto a narrative that purports to explain why company ABC or sector XYZ is running out ahead of the pack. Unfortunately for those in search of a leadership theme on the cusp of the summer of ’17, there really isn’t one anymore. There was one until last week: the mega cap stocks led by Facebook, Amazon, Alphabet (Google) and Apple took the helm back in the first quarter as the “reflation trade,” the previous narrative, faltered. The chart below shows the ascendance of these FAGA stocks when financials, the reflation trade’s leader, turned south in March (represented by XLF, the SPDR ETF). The chart also shows the carnage of June 8, when those high flying mega caps suddenly got pummeled on an otherwise nondescript trading day. They have continued to struggle in the days since.
The fizzling out of the reflation trade (or the “Trump bump” in the vulgate) as a leadership theme is easy to understand. The financial sector led that narrative, along with materials, industrials and (for a while late last year) energy. The premise was that a burst of pro-growth fiscal policy, headlined by tax reform, deregulation and a massive infrastructure stimulus would unleash an inflationary tsunami. Financial institutions would benefit from improved net interest margins, while industrial producers and resource firms would ride the infrastructure bandwagon. That premise, never particularly strong in a reality-based sense to begin with, looked increasingly like a bad bet as the legislative degree of difficulty presented itself to a team of political novices. Financials and other reflation-theme names topped out in early March and the broader market drifted for a spell.
FAGA (the aforementioned mega cap stocks) and their fellow travelers in the tech sector picked up where the Trump trade left off. What was the narrative driving this leadership rotation? Little, in our opinion, other than a general go-to argument that these enterprises are part of an elite cohort able to deliver consistently fast top-line growth in a world of modest economic prospects. The FAGA trade is sort of a lazy, modern take on the “Nifty Fifty” of days yore: in the absence of any other overarching narrative, go with the brand-name leaders of the day. And what, exactly, was the catalyst for that mass exodus from FAGA on June 8? Again, nothing that is glaringly obvious. Pundits put forth the “crowded trade” theme, which may be as good a reason as any. But they are not especially overvalued; Apple still trades at a P/E discount to the broader market, and the P/E premia of the other three FAGA names to the S&P 500 are well below their highs for the past five years.
Whatever the reasons were for bailing from tech on June 8, it is by now evident that it was not a one-day event; the sector has underperformed in the days since, as the above chart illustrates. The question now turns to the prospects for the broader market absent another leadership story. Candidates for such a story are rather scarce. The many ills plaguing the retail sector again came into sharp relief this week when supermarket chain Kroger’s radically cut its earnings outlook and saw its stock price get beaten down more than 18 percent. Healthcare waxes and wanes amid a fog of fundamental, sector-specific uncertainties. Financials face the headwinds of lower than expected inflation and the attendant opinion by many that the Fed was mistaken to move ahead with its rate cut this week.
The antidote for the confusion is TINA – There Is No Alternative. Forget the Trump trade, or tech stocks, or any other leadership narrative. It’s enough, this argument goes, to stay in the market when there are no compelling reasons to get out. As long as there is growth, however modest, and as long as there are central banks with the means to limit the downside, there should be no need to start building up the cash position. That logic has served investors well to now. But watch those narrowing spreads between short and intermediate term bonds. They don’t necessarily signal anything in terms of a major market shift. But they are not moving in the right direction.
Every profession has its core mantra. The mandarins of medicine solemnly invoke the Hippocratic oath (first of all, do no harm). “Equality under the law” say the Doctors of Jurisprudence. In the practice of investment management, generations of money men and women since the 1930s have been trained thus: “in the long run, value outperforms growth.” The value effect has gone through some iterations since Benjamin Graham and David Dodd bestowed their masterpiece “Security Analysis” on the investment world in 1934, but it has largely stood the test of time. It’s not a difficult premise to grasp: buying stocks whose price is relatively cheap when compared to certain fundamental valuation measures – like book value, cash flow or net earnings – is on average a better long term investment approach than favoring the more expensive stocks that get red-hot and then flame out just as quickly.
Anomaly, or New Normal?
So far in 2017, value investors are taking cold comfort in the time-tested wisdom of their philosophy. The Russell 3000 Value index, a broad-market measure of value stocks, is up 2.50 percent for the year to date. Its counterpart, the Russell 3000 Growth index, is up a whopping 13.68 percent. That is the kind of performance gap that will make the most lackadaisical of investors do a double-take when their quarterly statements show up in the mail. And their value fund managers are reliving the nightmare that was the late 1990s, when ticky-tack dot-coms regularly crushed “old economy” stocks and made instant (if very short-lived) experts out of amateur punters the nation over.
Now, we all know that it is inadvisable to draw larger conclusions from a relatively small time window. But the value effect’s failure to stick the landing extends much further than the current market environment. The chart below shows the relative performance of these same two Russell value and growth indexes over the past fifteen years.
These fifteen years encompass multiple market cycles, from the depths of the dot-com crash to the commodity boom cycle of the mid-2000s, then the 2008 market crash and subsequent recovery (which itself contains at least three sub-cycles). As the chart shows, investors who stuck with a growth discipline performed substantially better than their value counterparts over the course of this period.
The Fleetingness of Factors
Is the value effect dead? Or is it “just resting,” like the Norwegian blue parrot in the Monty Python sketch? When we look at the long-term durability of factors, we tend to follow the methodology of prior generations in using a 30 year window of analysis. When Eugene Fama and Kenneth French (then at the University of Chicago) produced their groundbreaking analysis in 1992 of the value effect and the small cap effect (“The Cross Section of Expected Stock Returns”, published in the Journal of Finance), 30 years was the duration of their time series. Fama and French concluded that both value (defined as low market-to-book value) and small market capitalization were long-term outperformers relative to the broad market.
Looking back 30 years from today, value still retains a small edge over growth, while small cap appears to have lost the performance edge that Fama and French reported. The chart below shows the performance of the Russell 3000 Value and Growth, along with the Russell 2000 Small Cap index, over this 30 year period from 1987 to the present.
Value stocks (the blue dot just up and to the left of the broad market benchmark) returned 9.99 percent per annum on average over this 30 year period, which amounts to 0.21 percent more than the broad market. Now, 21 basis points per annum is nothing to sneeze at, particularly as it came with slightly less volatility. But, as the earlier 15 year performance chart showed, growth stocks have outperformed consistently over virtually the entirety of the period from 2009 to the present. The 1992 insights of Fama and French do appear to have diluted somewhat over time.
It’s too early to pronounce the value effect as dead. But factors – even the most durable ones – are never a guaranteed win. Today’s investors on the receiving end of pitches by “smart beta” managers – those sexy factor-based approaches that are currently all the rage – should always remember what is in our opinion the only investment mantra worth its salt: “there is no such thing as a free lunch.”