Equity market developments since the beginning of April have been confounding. On the one hand, most of the worst predictions for the global economy have been confirmed, and most countries are in the midst of the worst economic contraction in a century. On the other hand, markets have recovered back to recent highs that were achieved at a time when the outlook was relatively robust, few had heard of Covid-19, and valuations were arguably somewhat high. What accounts for this dissonance?
There’s a view that the market is simply “looking through” the economic contraction and focussed on a rapid recovery. We find this argument unsatisfying. Markets always look forward to a recovery. But beyond expectations of a sharp “bounce” in the 3rd quarter, there seems to be little consensus among markets on the shape of the recovery. What is clear, however, is that at current US equity valuations, the market seems to be ignoring the evaporation of a significant part of 2020 earnings, and the high likelihood that 2021 earnings will not reach 2019 levels. There surely needs to be some meaningful discount to account for the fact, that earnings unlikely reach last year’s level before 2022.
Another view is that markets have been driven by a surge in participation by retail investors. Empowered by the rise of zero-commission platforms, individual investors are enjoying the adrenalin-rush of market while locked down at home. There is data to support this narrative. Surveys show that the overwhelming majority of institutional investors were caught off-guard by the rally since end-March. Meanwhile, there were several weeks where trading in New York entailed outsized volumes of trading tickets averaging $2000. In addition, April saw about $100 bn inflows into 2x levered accounts available to retail investors. This narrative could explain the perplexing rallies in certain stocks for no obvious reasons.
There is a third narrative that all of this boils down to relative valuations. The Fed’s announcements in March initiated an unprecedented expansion in its balance sheet, while reducing interest rates to zero. More importantly, unlike previous periods of quantitative easing, the Fed announced that its financial operations will provide support to businesses and backstop corporate bond markets. While signalling that interest rates will remain close to zero for some time, the Fed is also openly debating whether to target the shape of the yield curve. In effect, the Fed is suggesting that it may actively engage in financial operations to suppress longer term rates from rising. For investors, all of this implies that fixed income yields will be remain artificially compressed, leaving few options other than equity exposure.
Reality never neatly follows a single narrative, and it is more likely that market developments are the culmination of all the above factors. But what does this imply for the market going forward? There are near term and long term considerations.
In the near term, like most other managers, we have been sceptical of the rally in equities, and watched the gap between economic fundamentals and market pricing widen. There is a plethora of new commentary from TV talking heads arguing that investors should not remain overly anchored in fundamentals. I am also reminded of Nietzsche, who wrote: “In individuals, insanity is rare; but in groups, parties, nations and epochs, it is the rule.”
Arguing that markets are insane, however, is not practically helpful. And while markets can remain irrational for a long time, they do take stock of reality every so often. Optimism may abound now, but the Covid-19 crisis is far from over. The pace of the recovery remains uncertain, as new local shutdowns demonstrate. A wave of restructuring of corporate debt will be necessary, despite government support. Household-name companies have already started filing for insolvency procedures.
These factors are in fact “known unknowns”. In other words, they are things that we know we do not know. Markets will adjust to new information. But because they are anticipated, they should not come as a surprise that sends the market into the type of tailspin we saw in March. With interest rates likely to remain at zero for some time, the real return on cash is negative.
Against this background, there seems to be few alternatives to increasing equity exposure in the near term. But it would equally be folly to not be highly selective. For example, niche sectors in technology and health may not have low valuations, but are providing structural growth opportunities that are relatively resilient to the economic uncertainties. In fixed income, there are still some opportunities for spreads to decline given the ongoing action by central banks. But it is also important to avoid passive ETF exposure. Many companies are likely to restructure their debt in the months ahead.
How and whether we adjust portfolios in the short term is subsidiary to the bigger question of the medium to long term strategic asset allocation. Do recent developments warrant a revision to long term allocations? This is a question we were grappling with before the COVID crisis. Our main concern is, that it is arithmetically impossible for medium term fixed income returns to match past returns.
Having realistic expectations for the returns of each asset class is important for two reasons. First, it helps us define the optimal combination of investments to maximise return for each level of risk. Second, the exercise itself helps ameliorate some of the behavioural mistakes that have been shown to damage portfolio returns over the long-term.
There are multiple ways to help us derive return expectations. Recognising that there are valid theoretical and empirical evidence in support of different methodologies, we prefer to compare the results of two methodologies to settle on an intuitively appealing and realistic figure.
The first method identifies the different drivers of returns. For any investment, returns can be broken down into three groups –-Yield, Growth and Valuation Change. In the context of an investment in stocks (equity), Yield would include dividends and the effect of company buybacks, Growth would relate to company earnings growth and Valuation Change is the change in the market price of the asset in relation to what it is really worth. For an investment in bonds (Fixed Income), similarly we focus on coupon payments, default/downgrade risk and the total yield if the investor holds the bond until it matures.
Another methodology for deriving expected returns for equities entails constructing a discounted dividend model to determine whether a stock market index such as for the US, Europe or Emerging Markets, is priced fairly – given the cash flows that it is expected to generate. Using techniques that are often used to value single investments, we determine an intrinsic value for the whole market. This is then compared to the current price of the market, to estimate if it is under or over-valued.
The results of these methodologies are dependent on our assumptions. But even if we are generous in our assumptions on economic growth, the reality of current valuations in both fixed income and equities implies that investors should expect returns that are well below those of recent historical experience. Pockets of growth exist in certain sectors. Some leverage can be used to enhance overall portfolio returns. But all of this suggests that targeting returns similar to recent historical averages will imply living with a level of volatility that is higher than recently experienced.