Equity investors are faced with a dramatic dislocation between fundamental economic data and corporate valuations, so how do they navigate such an uncertain economic outlook?
Equities remain a cornerstone for many institutional investment portfolios, particularly defined benefit (DB) schemes which are still open to new members, such as the local government pension scheme (LGPS) pools, and the rapidly growing defined contribution (DC) market.
But the combination of a decade of quantitative easing and the Covid-19 crisis has created a challenging environment for equity investors. When stock markets around the world crashed in March, billions of dollars were instantly written off share prices. But it is remarkable that these sudden price movements did not result in significant changes to the level of available capital.
Similarly, when markets suddenly started rising again in May, the inflows and outflows of global equity ETFs remained more or less stable, according to BlackRock. And while European investment fund association EFAMA reported €176bn (£156bn) in net outflows from liquid UCITS funds in the first quarter, the effects on the net asset value of these funds were only marginal.
“Total net assets of UCITS and AIFs declined by 11.6% in the first quarter,” says Bernard Delbecque, senior director for economics and research at EFAMA. “The sharp fall in global financial markets following the Covid-19 outbreak explained 94% of the decline, with the rest due to net outflows.”
The Shiller PE index, which is based on inflation-adjusted earnings from previous years, would struggle to capture such a dramatic change. Long-term investors are now left to grapple with the puzzling effect of dramatic price movements on their portfolio.
By mid- August, the S&P500 was trading above 3,300 basis points, compared to 2,300 months earlier, which could mean that the value of their investments suddenly increased by millions of dollars, even if they held the same portfolio as they did four months ago.
This could be a good reason to try and grapple with the drivers of absolute movements, the market beta, rather than focussing on relative price movements.
The most common explanation for the recent rally in risky assets is that stock markets look beyond weaker business figures and economic data to position themselves for sunnier days in the future. Current stock market valuations could, therefore, reflect an expectation that the effects of Covid-19 will reside and company revenues and profits will stabilise.
There are indeed some indications that the sell-offs earlier in the year might have been excessive and that firms were trading below their intrinsic value. But identifying this intrinsic value remains a challenge. Equity investors continue to work with indicators such as the Shiller PE Index but are faced with the challenge that the situation of stock markets 12 months ago offers even less insight into a company’s current financial health than a forecast for their future does.
“When we try to predict the future for the coming months or even years, we have to take into account that this is a completely different situation compared to previous downturns,” one asset manager said.
“Many businesses are now confronted with a situation where they book either no, or significantly less profits than they have ever had before.”
Shell, for example, has cut its dividends for the first time since the Second World War, leaving investors with a return of $0.16 per share, compared to $0.47 during the previous quarter.
Fundamental challenges
Changes to the market structure have made fundamental valuation of share prices more difficult. Indicators such as PE ratios would have allowed the impression that share prices in April offered fair value, given that prices have been adjusted, but earnings had not yet been reduced. Even cyclically-adjusted returns, as the Shiller PE index offers, do not help if the market environment is historically unique.
Another challenge for fundamental approaches to stock market valuation is the fact that discounted cash-flow models make little sense in a low-interest environment. “The textbook idea is that the expected cash-flows of a company can be discounted until infinity, but if interest rates are currently below 1%, it means that next year’s €100 dividend will be worth €101 this year, so the model simply doesn’t work,” says Christiaan Kraan, managing director of business development at Seeyond.
One way to circumvent this challenge is to focus on the historical risk of a stock because past levels of volatility tend to be a more reliable indicator than future return expectations. Stocks which have been less volatile in the past tend to be less volatile in the future. Another approach is to consider relative valuations.
Compared to returns on 10-year US treasuries, it could be argued that the S&P500 is still relatively attractively priced. Nevertheless, current levels of uncertainty are extremely high and investors appear to respond with a reluctance to take on long-term positions. Markets have responded to a lack of medium-term visibility by shortening their investment horizon, one commentator believes.
That explains the focus on immediate economic recovery and the comeback of cyclical stocks, but also the extreme fragility of stock markets. One potential indicator for longer-term investment returns could be to combine the cyclically-adjusted CAPE index with economic forecasts.
One asset manager that is pursuing this approach, gives a rather pessimistic outlook, predicting that average S&P 500 returns will be 4 to 6 percent over the next ten years, giving a range from minus 2 to 8 percent.
In contrast, Tilmann Galler, a capital market strategist, predicts that the sudden short-term fall in share prices could have a beneficial effect on long-term returns. “While the current recession is likely to lead to a drop in profits, continued reliance in government aid and dividend cuts, we believe that the underlying trends and margin forecasts will remain stable,” he says.
But this view should be taken with a pinch of salt for several reasons. One is that the strong performance of stocks over the past 10 years was heavily driven by the US market. In 2007/ 2008, the market capitalisation of the US stock market was 60% of the country’s GDP, compared to 150% today. This suggests that stock market growth has become increasingly detached from the real economy. There is also a positive correlation between share prices and sovereign debt, with US sovereign debt increasing dramatically over the past 10 years.
While Trump’s corporation tax cuts have indeed provided a boost to share prices, it has not resulted in increased fiscal income as a result of economic growth, as promised. The growing dependence of equity markets on political support might turn into a risk factor, given that Trump’s opponent Joe Biden has already announced a planned increase in corporation tax.
This in turn could reduce profits on S&P500 investments by $20 per share in 2021, one report predicts. But taxes are not the only factor to overshadow future equity returns. Tim Hodgson, head of the Thinking Ahead Institute, argues that past returns were inflated because they did not factor in the costs of externalities of production, such as CO2 emissions and plastic pollution.
He predicts that it will no longer be possible to discount those externalities from the production process and that returns will therefore be lower. Given those increased challenges to provide accurate valuations, it is no wonder that quantitative and passive strategies now account for the vast majority of all trading activities. A US financial giant estimated in 2017 that only 10% of all traing activities were due to fundamental investors while quant and passive strategies accounted for the remainder.
Musical chairs
What then, drives the persistence to remain invested in equity markets, despite uncertain valuations? Research of trading patterns in private markets suggests that persistence to remain invested is by no means due to blindness or stupidity. In a 2014 study, MIT scientists Catherine J. Turco und Ezra W. Zuckerman assessed the behaviour of market participants throughout the private equity boom of the 2000s.
The scientists describe the behaviour of market participants as an “optimal dancing model”. Given the lack of opportunity to express dissenting opinions, many decided to participate in the upswing, with the expectation of exciting the market on time as soon as it crashes, akin to a game of musical chairs. A game that is heavily reliant on market liquidity.
The authors discount the behaviouralist explanation of “animal spirits” as driver for investor behaviour and argues instead that private equity investors in the mid-2000s knew what they were doing. There are some indications that this could also apply to today’s equity markets. Based on a BoFA survey of fund managers in June, almost 80% argue that equity markets are currently overpriced, the highest level of pessimism since the survey started in 1998.
Nevertheless, this growing pessimism has not necessarily coincided with a reduction of risk in portfolios. The average cash level in investment funds has been reduced to 4.7% from 5.7%. The conclusion, based on Turco and Zuckerman’s approach, is that even investors who consider asset prices to be inflated pursue an “optimal dancing” rather than a “rational sitting” strategy. In other words, they invest with the hope of being able to exit the market when liquidity dries up.
There are multiple explanations for this pattern, from the current lack of rational feedback mechanisms due to central bank distortions, which have left short-sellers in trouble due to the TINA (there is no alternative for stocks) narrative.
The key driver to the recent surge is likely to have been the fear of missing out on future gains. Not being invested at the end of March while other asset managers were soon to book significant profits due to relatively attractive PE ratios is a stance that few equity investors would have been able to justify. Even veteran value investor Warren Buffet currently faces strong criticism because his investment firm, Berkshire Hathaway, has amassed a $137bn (£102bn) cash mountain.
The pressure to be invested is likely to be even more pressing for lesser known fund managers. In 2007, former Citigroup chief executive Chuck Prince famously told the Financial Times: “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.” But the current market tango involves another dancing partner: The gradual uptake of Covid-19 infection rates above the R1 value.
In mid-March, it appeared as if the music had suddenly stopped. Central banks stepped in swiftly by providing new stimulants and turning up the bass and the party appears to continue. Unlike in 2008, when the increasingly absurd presumption of efficient markets resulted in marginal regulatory tightening, optimal dancing to the central bank’s tune appears to have become the modus vivendi of today’s stock markets.
This story originally appeared in portfolio institutional’s German publication portfolio institutionell.
