One of the big ironies in financial markets is that very expensive assets often exhibit very low volatility. This creates the impression that risks are low in spite of prices being high.
The US stockmarket today is a case in point. Since Donald Trump was elected in 2016, the market has not experienced a down month. Returns have been terrific and volatility has been very low. So low, in fact, that in the last year the S&P 500 has produced a spectacularly high Sharpe ratio of approximately 4.5! To put this into context, a good long-term Sharpe ratio would generally be something that falls between 0.5 and 1.0 on an annualised basis. Indeed, the average for the US market between 1928 and 2016 is only 0.4, and it has never exceeded 3.0 in any calendar year. So, suffice to say 2017 has been an outlier.
How expensive is the US stockmarket? Well, that depends on your valuation metric, as some (like the popular price-to-earnings ratio) are easier to stage-manage than others. An alternative measure, such as price-to-sales, paints the picture of a market where the median stock now trades at a 50% premium to the valuation extremes attained at the 2000 peak. The scope of such high valuations is much broader today too.
Danger of chasing historical performance
So, we have a situation where the colossal liquidity afforded to the market by central banks has, in recent years, helped produce the best risk-adjusted returns for index replication (passive) strategies in at least 100 years.
Today, many investors are chasing that historical performance, just at the point when valuations have seldom been higher. We are entirely sympathetic to the notion that valuations are often temporarily irrelevant if investors are in sufficiently speculative mood. However, with quantitative easing now unwinding in the US and tapering underway in Europe, we know liquidity conditions are gradually shifting less favourably.
In our view, passive investing now largely represents a momentum play on liquidity conditions. We think investors will be better served pursuing an active approach for the balance of this cycle. Whether 2018 will prove a defining year in this respect is ultimately a moot point. There is far more risk embedded in passive strategies than suggested by their track records of recent years.
Will value’s underperformance finally end?
Moving on, we’d note that 2017 authenticated the trend of ‘growth without inflation’, superseding that of ‘secular stagnation’, which for many years had been the market’s primary narrative. Both have led to outperformance for the “growth” investment style. Value investing, at the other end of the equity spectrum, is enduring its largest and longest period of underperformance in over 40 years, including the six years which climaxed in the dotcom bubble.
Although we are relatively cautious in our outlook, we think advocating a value bias within equity portfolios makes sense at this point. In prior writings, we have mused about what would catalyse a sustainable turn in favour of value investing. Having previously advanced that a rise in nominal GDP ought to do the trick, 2017 has demonstrated that inflation is perhaps the ultimate key. After all, this year we have witnessed a synchronised acceleration of global growth, but without a commensurate synchronised move higher in global bond yields – something that we suspect would benefit value over growth.
Inflation may accelerate
The question, therefore, is whether we expect a cyclical acceleration of inflation over the coming year? Consider the following:
- China’s labour surplus has turned into a secular labour shortage
- Labour markets in many developed economies are drum tight
- Wage growth is accelerating (albeit gradually)
- Oil and other commodities continue to bounce from their summer-lows
- President Trump is attempting to enact a fiscal stimulus with the unemployment rate at a lowly 4.1%
For these reasons and more, we are not confident with the consensus assumption that inflation in the major economies will remain low and stable through 2018. As well as having a big impact within the equity market, a pick-up in inflation would clearly be a headwind for the bond market as well. Hitherto, we haven’t spent much time on bonds, not least as our cautious views have been previously well telegraphed. But it remains the case that we continue to live in this slightly warped era of depression-level interest rates and boom-time equity values, which ultimately feels unsustainable.
To that end, Deutsche Bank published an interesting report in September looking at the long-term history of asset prices going back over 200 years. It looked at an equally-weighted index of 15 developed market government bond markets and 15 developed equity markets, ranking valuations in percentiles versus history. Currently this valuation measure is at a record high, in the 90th percentile. Previously, the combined valuation of bond and equity markets has never made it beyond the 80th percentile. While bonds have been expensive at times, and equities at others, the peculiarity this time is that never before have bonds and equities been so expensive simultaneously.
Look for a margin of safety
And therein lies the challenge for multi-asset portfolios in 2018 and beyond. High valuations are widespread and largely inescapable. For some, there may be no alternative to speculating in risky assets regardless of their valuations. We consider overall risk within the context of capital preservation, so our perspective is somewhat different. As a consequence, we continue to look for value and a margin of safety, while importantly carrying defensive hedges.
We’ll finish with a recent passage from Howard Marks of Oaktree Capital:
“I have quotes from the Nineties about how we will never have recessions again. I have quotes from the Twenties about the fact that we are in an era of permanent prosperity. It’s all wishful thinking. This discussion that current conditions are permanent always increases at high market levels. And when people encourage others to be optimistic, it’s always at high levels. But the people you want to follow in this world are the ones that encourage optimism at low valuation levels; those who say “cool it” when prices go higher and higher”.
We would agree wholeheartedly.
A related article published today, which may be of interest, was Outlook 2018: Multi-asset, by Johanna Kyrklund, Global Head of Multi-Asset Investments.
 The Sharpe ratio is normally used to measure a fund’s risk-adjusted returns. The higher a Sharpe ratio, the better the returns have been relative to the risk taken.