By Justin Pawl, CFA, CAIA
In this week’s edition: Numerous market segments are overextended, increasing the importance of managing risks through true portfolio diversification.
Last Week Today. Japan posted a shocking -6.2% growth rate for Q4 2019. In late September 2019, the government increased its VAT (value-added tax) on nearly every good and service in the country from 8% to 10% to fund social services and pay down the country’s enormous debt load, a move economists forecast would only have a modest effect on the economy. | China reported car sales were down 92% in the first half of February due to Covid-19 quarantines and plant closures. | U.S. Markit Purchasing Manufacturing Indexes were lower than expected, with the services PMI falling below 50 (i.e., contraction) for the first time since 2013 as new orders declined in response to the spread of Covid-19. | The Atlanta GDP Now model’s forecast of Q1 GDP increased from 2.4% to 2.6%, while the “Blue Chip” economists average estimate is closer to 1.5%.
In a holiday-shortened week, domestic financial markets illustrated the dynamic tension between investors’ concerns about Covid-19’s effect on the global economy and the ability for central bankers to overcome those effects. Domestic equity markets hit record levels before falling to end the week in negative territory. International stocks followed a similar path (though they remain well below historic peaks as shown below). U.S. treasuries also hit an all-time high in the form of rising bond prices producing the lowest yield on 30-year treasury bonds in history (1.91%), and the yield on the benchmark 10-year bond moved back below 1.5%. Moreover, the U.S Treasury yield curve moved further into inversion – a sign that bond investors believe the Fed will cut interest rates.
For detailed weekly, MTD, and YTD financial market performance, click on the table below.
Stranger Things. Our investment team has had a lot of internal discussions of late, highlighting various extremes we’re witnessing in the financial markets. Extended moves are not without precedent, as financial market prices do not fit a normal bell curve (or for those who remember Statistics 101, a Gaussian distribution). However, financial markets are also known to mean revert. That is, prices move to extremes (high or low), and then revert to a level that resembles the long-run average. Mean reversion is a well-known phenomenon, and below, we’ll discuss how to take advantage of it in your portfolio, but first, let’s take a tour of some of the stranger things we’re seeing in the markets today.
Whether you consider Tesla, Inc., a car company or technology company, the stock price of Tesla has gone parabolic. Tesla’s market capitalization is now larger than Ford and General Motors combined.
Sources: Bloomberg, L.P., and Covenant Investment Research.
Market breadth is a measure of the number of stocks advancing relative to those that are declining in a given index. Positive breadth means more stocks are rising than falling and is generally considered a bullish indicator. Breadth over the past six months has been the narrowest since at least 2005, with only 38% of S&P 500 constituents outperforming the index, yet the market has risen more than 10% over this timeframe.
Higher stock market prices are stirring FOMO (the Fear of Missing Out). Call options (which give the owner of the call the right to buy stocks) are one way for investors to bet on higher prices. Speculative positioning in calls is the highest since…ever.
Turning our attention to relative valuations, two anomalies stand out. First, the valuation of U.S. stocks vs. foreign stocks is historically wide when measured by the Cyclically Adjusted Price-to-Earnings (CAPE) ratio. The CAPE ratio is simply the average inflation-adjusted P/E ratio looking back 10 years. A variance of this extreme last occurred when Japanese stocks rose 244% from 1985 – 1990. Since the Financial Crisis, domestic stocks (as measured by the S&P 500 Index) have gained 269% vs. 75% for international stocks (MXEA Index).
The other relative value relationship of interest is Growth vs. Value. Investors pursuing a Growth style of investing seek companies offering strong earnings growth potential. In contrast, Value investors pursue stocks whose prices appear to be selling at a discount in the marketplace. Throughout history, there is a fairly regular rhythm of one style outperforming the other, but the relative outperformance of Growth over Value is more extreme now than at any time since the Dot.com Bubble.
Finally, while U.S. stock markets hit new highs last week, bond investors are less optimistic, pushing yields in the belly of the Treasury curve lower than the front end. It’s also worth noting that the yield on the 30-year U.S. Treasury hit an all-time low of 1.91% on Friday. There are a lot of factors contributing to the unusual shape of the yield curve and historically low rates. In sum, bond investors are telling the Fed that monetary policy is too tight and forecasting slower growth and lower inflation ahead.
So, what is the point of sharing all this data? The point is to highlight that extreme moves in markets generally mean revert to historical levels. To be clear, this is not a call that financial markets are about to crash. It’s not an all-clear sign either. Financial markets can and do crash, often without warning.
Instead, this message is intended to illustrate that many markets and market segments are overextended. While the natural pull for investors is to invest in what’s worked lately, over the long run, you will be better off diversifying your portfolio beyond the confines of domestic growth stocks and traditional fixed income. For example, the chart below illustrates the performance of what most consider a diversified portfolio consisting of 60% S&P 500 stocks and 40% traditional bonds. On an inflation-adjusted basis, this well-respected portfolio strategy delivered flat or negative returns regularly over the last 120 years. “Lost Decades” of flat portfolio returns may not seem important, but when one is withdrawing capital to fund their lifestyle or retirement, flat portfolio performance translates into negative wealth creation. Note also, that when viewed on a risk-adjusted return basis (e.g., returns vs. volatility) the last ten years are tied for, if not the best performance ever, for a 60/40 portfolio. Will the next ten years be the same, or might there be a reversion to the mean?
The desire for portfolio diversification has waned as few investments, active or passive, have kept pace with domestic growth stocks. Reflecting the human tendency to think the future will look like the recent past, investors are increasingly shunning diversification. After all, if equities have been good recently, why allocate to investments that haven’t? While we understand this motivation, running away from diversification, particularly at present, is a dangerous idea. Rather than concentrating further in domestic growth stocks, we favor increasing portfolio exposures to include real estate, private equity, uncorrelated trading strategies, long-volatility positions, private lending, Value styles, and international equities.
Diversification, as a theoretical concept, is not controversial. In practice, however, building and maintaining truly diversified portfolios can be more challenging as behavioral biases, and career risk concerns filter into the investment decision-making process. The magnitude of these non-productive influences increases in proportion with domestic equity market performance, making the latter stages of market and business cycles challenging for investors. It is worth keeping in mind that diversification is most powerful when a cycle ends, not in the final stages leading to the end of the cycle. Unfortunately, these latter stages of a cycle are precisely when it is most intellectually challenging to stick to a plan by resisting the “Siren Song” to increase exposure to what has been working recently.
In the current environment, investments that have been working recently have largely become expensive. No one knows what markets will do or when they will do it. But, unless you believe this time is different, history shows that markets tend to mean revert. Investors must make a decision. Invest as they have done recently and hope for the best, or move to embrace the wide variety of alternative investments available in the market today.