The US stock market rallied 30% in 2019. A blow-off performance punctuating a decade long bull market.
Professional money managers are pissed.
The Most Hated Rally
“Smart” money said we were in the late innings. Any bit of caution in the portfolio means you are now staring at a poor comparison to the benchmarks. I suspect the quant managers who might be evaluated on risk-adjusted returns are no happier. The rally has been steady. Low volatility. The SPX has won gold in both the absolute return and Sharpe ratio Olympics.
Relative Pain
Active managers are getting rocked. The Fidelity/Vanguard/Schwab race to the bottom on fees and the merit of indexing has been delivering brutal blows to the relative return crowd (mutual funds) and risk-adjusted return crowd (hedge funds) alike. Throw in a dose of market reflexivity and you can imagine the flight to passive strategies accelerating.
Absolute Gain
If you are an individual investor, you probably underperformed, but at least you are winning. And probably a lot more than you imagined. Your investments are an extension of your savings which you’d like to see grow to meet your future liabilities whether it’s a retirement or college fund. Measured against your realistic needs, you are sitting pretty. You would have happily locked in a guaranteed 10% return for 2019 if offered the chance on Dec 31, 2018.
Even More Expensive
Now what? If smart folks, you included, thought markets were expensive last year, you can only feel more dissonant today. We’ve all seen the CAPE charts reminding us that the stock market hasn’t been this expensive since 1999. Well, that was true one year ago as well, and look how 2019 turned out. I could compile a bunch of links showing how CAPE is a useless timing tool on any sub-10 year horizon and perhaps even longer than that.
You can drive yourself crazy and get nowhere asking how long expensive markets will march higher. No serious market observer pretends to have a high confidence answer to that question. If there was an answer it is tormenting allocators and money managers alike. Like Poe’s raven call “nevermore”.
How about the question of why are they rallying? To say more buy volume than sell volume is correct, but not especially useful. Going beyond that, you will not find a shortage of theories. The most popular, based on my state-of-the-art NLP analytics (otherwise known as browsing #fintwit), is the Fed. Central bank easing, best embodied by zero or negative interest rates in Europe and Japan, seems to be public enemy number one. Another alleged culprit has actually been passive indexing itself. This makes intuitive sense as a driver of marginal demand for shares since pulling money from active managers to allocate to say the SP500 is almost certainly going to be increasing the beta of investors’ portfolios if it is done on a dollar neutral basis. Michael Burry, of Big Short fame, has even called passive indexing a bubble.
But What If We’re Wrong
I borrowed the heading from the title of Chuck Klosterman’s book urging us to soften our attachment to the premises upon which we have built conventional wisdom. If this were easy to do he wouldn’t have needed to write a book. Blind spots are so-called for a reason.
Consider the central bank recklessness and passive indexing arguments. These appear to be reasonable explanations for how the market can be artificially or irrationally expensive. They even appear to have endpoints.
Consider these un-timeable reckonings for the central bank argument:
- Asymmetric, short term nature of political incentives leads to hyperinflationary pressures climaxing in eventual fiat heat death. Creditors destroyed.
or perhaps…
- A conservative central bank, inspired by the still-vibrant ghost of Volcker, tightens in response to creeping inflationary pressures. Since soft landings don’t exist, the market crashes and our record outstanding debt now teeters on a severely marked down asset base. A deflationary spiral.
How about the “bubble in passive investing” argument?
- Eventually the inflows to passive will tip so far that active management’s price discovery process will fail to function. There won’t be enough wolves to keep the deer population in check and nature’s equilibrium will breakdown. A litany of price distortions from faulty signals will mirror how natural disasters’ can stem from unintended sequences. It’s like a climate crisis for asset pricing.
These arguments are promoted by many smart people. I’m in no position to falsify them. But I don’t think they necessarily warrant high confidence. First of all, a persistently expensive market is a complex phenomenon so there is a major burden of proof on any reductionist take that I don’t think either of these arguments has satisfied. Furthermore, the incentives of its promoters are enough to cast reasonable doubt on these arguments. To open ourselves to new reasons for the market’s relative expensiveness let’s loosen the grip on the above explanations.
Opening Our Minds
We can attack the central bank and passive indexing arguments on common ground. Both rely on a belief that the market is distorted by significant flows (whether central bank support or migration to passive). They invoke limits to liquidity and arbitrage as reasons for market inefficiency. The argument is compelling. But it’s also epistemologically diabolical in the same way that conspiracy theories recursively gnaw at the logic which allows you to dispel them in the first place.
As mathematician Jordan Ellenburg puts it:
“If you do happen to find yourself partially believing a crazy theory, don’t worry — probably the evidence you encounter will be inconsistent with it, driving down your degree of belief in the craziness until your beliefs come in line with everyone else’s. Unless that is, the crazy theory is designed to survive the winnowing process. That’s how conspiracy theories work.”
Those blaming passive indexing and central banks are almost certainly believers in efficient markets. Their arguments follow as so:
- “Markets are mostly efficient.”
- “My strategies exploit the few inefficiencies there are.”
- “My strategies don’t work anymore.”
- “The markets are inefficient because of X and Y”.
Well, the final conclusion is unmistakably self-serving. Building the argument in steps, the null conclusion should be, “the market, perhaps partially thanks to my work has ironed out the inefficiency I was exploiting.” The prize for this win is an incremental gift of price discovery to the world. And the checks they already cashed. But so much for their future prospects. They can ruminate a bit more on that on their yacht with all their newfound free time.
This Hurts All Investors Not Just Active Managers
If the market is indeed searching for a much higher setpoint then anyone young or who cares about someone who’s young should be concerned.
Investor Lyall Taylor explains:
Most stock market investors worry incessantly about the risk of a potential market melt down. I don’t. I worry about the risk of a market meltup.
For anyone trying to grow their capital; make a living off their investments; or build a business around managing (and making money for) other investors, the absolute worst thing that could happen would be if markets everywhere were to surge and become (and remain) extremely expensive. Imagine, for instance, a world in which stocks traded at 50x earnings. If you invested, you would be offered a poultry 2% earnings yield in exchange for considerable risks.
If markets were to melt up to 50x, it would feel good for a while (if you were invested). However, your future stream of dividends would not have increased, so in truth you would be no wealthier, and furthermore, you would be confronted with the reality of poor reinvestment returns on dividends and corporate stock buybacks. In the long run, this would make you worse rather than better off, despite feeling wealthier in the short run. Bond investors understand reinvestment risk, but most stock investors do not seem too. But it works the same way for stocks as it does for bonds.
If you’re invested, you are hedged somewhat against the risk of a melt up (a risk most people don’t identify). You can lock in a reasonable return at today’s reasonable prices, and would suffer only on the reinvestment side (an unhedgeable risk). The disaster situation would be to be sitting in cash while watching markets surge all the way to 50x.
If this scenario sounds implausible, consider that we are already facing zero or negative yields in large segments of the bond and real estate markets (reports of easing cap rates in coastal US cities notwithstanding).
Rehashing:
- Compared to history the market is expensive.
- The most popular explanations rely on some market- distorting mechanisms to justify valuations.
- The implication is there should be some reversion.
But as investors, we know that markets have a habit of choosing the path which causes the maximum pain for the most people. And it’s pretty clear that valuations ripping higher from here and pushing risky yields even lower would be a world of pain for investors and owners of capital.
Towards New Explanations for Expensive Markets
Option market makers use the expression “make a sacrifice to the delta gods”. In the course of market-making, option traders, despite trying to maintain a flat delta, may end up short an underlyer. When it goes against them, in a misguided effort to not lock in a loss, they will often cover a small portion of the position hoping Mr. Market makes a fool of the most recent purchase by pushing the underlyer back down thus minimizing their loss on the entire position. “I covered a part of the short at a high price but made a lot back on the rest”. Hence, the sacrifice to the gods.
Save me the lecture on investor bias. I’m just sharing what amounts to trader gallows humor. In an effort to make a sacrifice to Mr. Market, let’s see if there is a case for markets to revalue much higher. Even from here.
For such a justification to be considered, I suggest it:
- Not rely on significant claims of market inefficiency.
For starters let’s interpret central bank behavior as symptomatic, not causal. It’s not a stretch to believe this. Many believe demographic-induced secular stagnation stalks developing economies starting with Japan, China, and Europe before coming to the U.S. It’s not impossible to see accommodative policy as being correct given the perceived determinism of shrinking workforces. Taylor actually warns us that focusing on central banks may obscure what is happening. A classic red herring.
Indeed, the ability to blame central banks for any and all bubble-ish behavior may have created a blind spot in markets, and resulted in investors overlooking the other contributory factors I discuss below.
After all, rates that are ‘too low’ are supposed to end in inflation, not deflation. So far they haven’t – in almost a decade – resulted in inflation, which suggests rates may not have been too low after all.
- Incorporate observations of current market dynamics.
For example, seeing how money managers are throwing in the towel, which is what you would actually predict as they are compared to the market’s amazing risk-adjusted returns. A process that deepens as Soros’ reflexivity sucks remaining investors into passive indexing.
Let’s try to understand what the market is telling us with these high valuations.
Expensive Markets = Cheap Capital
The flip side of lower rates of return is a low cost of capital. Instead of asking why the market is so expensive, let’s ask why is the price of capital so low? For the same reasons that prices are ever low. Some mix of weak demand and ample supply. Capital is subject to the same economic forces as anything you can touch and feel.
Taylor explains:
In short, a combination of a growing supply of savings/capital, and falling demand for the usage of those savings. The scarcity of capital is falling. Scarcity is the foundation of returns in capitalism.
Historically, capital has been scarce (sometimes more than others), and high returns/interest rates have therefore been required to ration it to its most productive uses. However, there is no guarantee that will continue. There is no rule of the universe that says capital is entitled to a decent return (or any return).
Let’s start with the weak demand for capital.
Reduced Demand For Capital
The nature of the real economy has been changing which has reduced the capital intensity of industry. The term “data economy” is often used to signify how we have shifted from moving atoms to moving bits. Back to Taylor:
The world (or the developed world at least) is heading into something of a post-industrial era, where a lot of tangible capital is no longer needed to drive growth in productivity. Innovation is instead happening in technology, software, and services, etc, while incremental consumer demand is for relatively intangible services/experiences/entertainment, rather than ‘stuff’. These two factors are together reducing the demand for new tangible capital stock.
Productivity gains are poorly accounted for justifying the valuations. The growing power of technology is all around us. The only place it is invisible is in the productivity statistics – in my opinion because rapid productivity growth is deflationary, and because new technologies are now resulting in whole industries being demonetized. However, corporations are investing less and less in hard assets because there are comparatively limited opportunities or need for them to do so vis-à-vis the past – particularly with slowing population growth. In short, the ways in which capital can be usefully deployed has been declining, and it is probably structural.
Increasing Supply Of Capital
Taylor provides some economic explanations for the surplus of capital invoking what might be expected from mature economies that have had a good run.
Meanwhile, savings are at elevated levels, and have been for quite some time. This may be for merely cyclical reasons, but it could be partly or wholly due to structural reasons as well. One of the reasons is that wealth and income inequality have been rising rapidly over the past 30 years (something that could be cyclical, structural, or both). The more one earns, the higher one’s propensity to save, and wealthy individuals seldom consume their capital (as opposed to a portion – usually small – of the returns from their capital). Consequently, rising inequality has been increasing the world’s private-sector savings stockpile. In addition, savings-heavy economies such as China have been integrated into the world economy over the past several decades, which has further added to the world’s savings surplus (which was arguably a major contributor to the build up of economic imbalances prior to the GFC).
A Lower Discount Factor
If it weren’t enough that both the supply and demand forces were coordinating to cheapen capital, a lower perception of risk is boosting investment demand. Greed and performance-chasing are timeless behaviors that we would expect a decade into a bull market. Beware. Those explanations, like the Fed excuse, can blind us from looking further. We needn’t look far. The explanation can easily hide in plain sight.
Progress
Markets are becoming more efficient. There’s a saying that information wants to be free. It wants to get out. It takes energy to keep useful information private. And if a group has an edge in information, it will be difficult to scale since achieving anything grand requires more people. More people means more leak points. So when we combine information entropy with an explosion of interconnectivity and permissionless platforms, is it any wonder that data, intelligent analysis, and best practices become table stakes?
Increasing Efficiency
- Charley Ellis of Greenwich advisors on the evolution of investment analysis:
The number of people involved in active investment management, best I can tell, has gone from less than 5,000 to more than 1 million over 56 years. A major securities firm might have had 10 or a dozen analysts back in 1962. What were they doing? They were looking for small-cap stocks and interesting companies that might be interesting investments for the partners of the firm. Did they send anything out to their clients? No, not anything. Goldman Sachs didn’t start sending things out until 1964 or 1965, and there was just one salesman who thought it might be an interesting idea to put out. Today, any self-respecting security firm is worldwide with analysts in London, Hong Kong, Singapore, Tokyo, Los Angeles. 400, 500, even 600 people trying to come up with insights, information, data that might be useful to clients. Anything that might be useful. Demographers, economists, political strategists, portfolio strategist and every major industry team. Every major company will have 10, 12, 15 analysts covering that company. And of course, then if you go to the specialist firms, there are all kinds of people and then there are intermediaries with access to all kinds of experts in any subject you might like. We’ve got 2000 experts. And anytime you want to talk to any one of them, just let us know. Glad to provide an unbelievable, flourishing amount of information of all kinds, all of which is organized and distributed as quickly as possible. Instantaneously, everybody.
2. Now combine this transparency with what pseudonymous writer Jesse Livermore refers to as “networks of confidence.”
Valuation is a function of required rate of return to which liquidity is an input. Imagine a pre-Fed wildcat bank. You would not accept such meager real rates of return because you do not have the confidence in the liquidity of your deposit. So much of our required rates of return come down to confidence. The progress of finance has been towards greater networks levels confidence which creates downward pressure on required rates of return.
3. Finally economist Ed Yardeni describes how capital is so efficiently dispersed throughout the system that distressed funds are on standby waiting to provide liquidity as quickly as opportunity emerges. This private version of plunge protection is like a Nasdaq level 2 bid below the current NBBO. He thinks that absent a broad recession, the market may be able to quarantine sector downturns. Instead of a great recession, we simply adapt to “rolling recessions”. When the US energy sector collapsed in 2015 the fallout was limited as capital was callable on relatively quick notice. If the risk of spillover from sector downturns is limited we can expect fewer recessions, which is what Yardeni attributes any sustained bear market to.
First, we need a quick aside on the fact that stocks have historically been a good investment. The excess return of stocks over risk-free rate is known as the “equity risk premium”. The fact that stocks are volatile is used to justify the excess return. Academics often refer to this equity risk premium as a “puzzle” since the return has historically been in excess of what their models would predict. Breaking the Market actually shows that the puzzle is simply an artifact of a false comparison. Academics use index returns as a proxy for “equity returns”. But an index is actually a weighting scheme that rebalances. It’s not the same thing as “stocks”.
“Stocks” and the “Stock Market Index” are not the same thing and never have been. One is an asset class, the other is a trading strategy of that asset class. They don’t behave the same and don’t have the same properties, return, or standard deviation. You can’t use one to replace the other.
When you compare the geometric return of stocks, not a stock index you do not find an ERP!
Ok, with that out of the way, is it now crazy to think that the passive indexing trend which became popular because of its post-fee performance (Ellis reminds us that less than 20% of active managers have beaten passive allocations) will lead to lower excess returns? If they were too high to begin with, increasing access to that strategy should lead to yet lower yields going forward. But here’s the critical point — there’s no reason to expect the yields to revert to the excess levels of yesteryear. Indexing is a simple word for a weighting strategy that periodically rebalances. The strategy is cheap to implement AND happens to generate an excess return that academics consider excessive. So excessive they call it a risk premium.
So if it’s not stocks that have an ERP but the strategy of stock indexing that actually holds the premium, how is it persisting? The mass adoption of passive you are witnessing is the invisible hand wringing the equity index risk premium out of the market. The lower forward returns the hand leaves behind will be its proof-of-work. According to Vanguard, in the early 1950s, 4.2% of the population held stocks, and the median number of stocks held was two. The delta from today’s level of investment adoption, especially on a cost-adjusted basis, is a degree of progress more typically associated with tech or medicine.
While democratizing indexing seems like a gift to investors its euphoria will be short-lived. Indexing, by lowering risk discounts, is a more permanent boon to companies and those who need capital. Financial innovation reduces financing friction. Livermore sees this as the march of progress we expect in any other industry. It’s just that the efficiency has been accruing in the direction of those who need capital. Those who supply capital were earning an inefficiency premium. They lacked information, means to diversify, and bore high transaction costs:
The takeaway, then, is that as the market builds and popularizes increasingly cost-effective mechanisms and methodologies for diversifying away the idiosyncratic risks in risky investments, the price discounts and excess returns that those investments need to offer, in order to compensate for the costs and risks, come down. Very few would dispute this point in other economic contexts. Most would agree, for example, that the development of efficient methods of securitizing mortgage lending reduces the cost to lenders of diversifying and therefore provides a basis for reduced borrowing costs for homeowners–that’s its purpose. But when one tries to make the same argument in the context of stocks–that the development of efficient methods to “securitize” them provides a basis for their valuations to increase–people object.
Those who need capital ate the cost of the inefficiencies that the underwriters sought payment for via fatter WACCs. The ironing of those inefficiencies is a permanent asset to borrowers and equity issuers.
If technology has subsidized indexing from the supply side, the “privilege of knowledge” is sparking demand. This privilege, a term coined by writer and data scientist Nick Maggiulli, recognizes that the dominant strategy of buying and holding a rebalanced index was not known until the past 30 years. As Maggiulli explains:
From 1871-1940, the U.S. stock market grew at a rate of 6.8% a year after adjusting for dividends and inflation. No investor in 1940 could’ve known this, because the data going back to 1871 wasn’t compiled by Robert Shiller and his colleagues until 1989…[if] buy and hold might seem obvious now, that’s only because we have the benefit of hindsight, ubiquitous data, and modern computational resources.
Those same resources that lowered the costs of diversifying also helped spread the word of its efficacy. Indexing is like a technology all its own. Better and cheaper. When you put a product with those features into the world, you are not surprised when it’s pulled not pushed.
Expensive For A Reason
The prospect of a sustained reversion in investment yields likely extends beyond the horizon of bargain-hunters’ binoculars. We may look back at historical returns and wonder why investors ever got to have it so good. We will look back and think how inefficient it once was. Can you believe people earned 8-10% in stocks and thought it should last? We may look at equity returns for the past century the way people now look at home prices. Remember when a house only cost 3x annual income? That was cute. As you look ahead, keep Taylor’s scoffs in mind:
Indeed, when you think about it, why should an index fund holder be able to lie on a beach all day and earn 10% a year? If the world needs savings, sure, that’s fine, but if it does not, then those savings ought to earn a materially lower return, if any return at all. And that is the direction the world has been going in.
What can you do about it?
If you have you participated in the re-pricing thus far, congratulations. Now what? Just as adding a 20th pound of muscle takes significantly more energy than the first, the next thousand basis points are going to require way more risk than you’ve endured until now. But to participate in the melt-up scenario the market demands you accept more risk for the same rewards. And if you abstain, Taylor reminds you of the reinvestment risk:
The disaster situation would be to be sitting in cash while watching markets surge all the way to 50x. What would you do then –particularly if the alternative was zero (or negative) rates in the bank? You’d be pretty much stuffed. If you kept holding cash, you’d have to settle for watching your capital slowly dwindle, and if you capitulated and invested, you would risk a major and permanent loss of capital if markets eventually did resettle at lower levels. I have never seen anyone worry about this risk. But they should.
If you are restricted to passive, vanilla strategies you may choose to hold your nose and stay long. I’m not qualified to advise you. But I’ll say that this is a fairly blunt hedge for a melt-up. It’s like tenting your house to get rid of ants. Consider the distribution more closely. If the market is expensive but the price of capital still has ample room to fall, it feels as though both the left and right tail are fatter. This is the solution options were built for. I don’t need to fumigate my house, I just need to shell out for some ant baits.
Evaluate Your Options
1) First the bad news. Listed financial options are probably not the answer. Why?
- Listed call options maturities don’t match up with long term investors’ horizon (unless you consider 3 years long term). That means this type of hedge requires you get the timing right. The last thing you want is more ways to be wrong.
- The upward-sloping volatility term structure would ensure premium pricing for the options.
- While being long the index outright is a blunt hedge, call options, for all their extra hassle, are still not a surgically precise hedge. The right tail we are concerned with is risk premiums shrinking. This can still happen if earnings fall while multiples expand. Imagine earnings falling by 20% and the index only dropping 10%. Multiples will have actually expanded by 12.5%. I admit this sounds unlikely. But we are talking about this as a right tail event. In that context, the forces which are driving the price of capital lower may even accelerate in a recession. The financial option you actually want to buy needs to be struck on the index multiple, not the index level.
So unless a liquid market develops for the SPX 10yr 40 P/E Strike Call, I don’t see a simple financial options hedge.
2) Trend-following the index to replicate an option-like payoff. This strategy has been explored extensively with many variations incorporating momentum and dual momentum. Again, not investing advice, but these are outstanding sources to learn about trend strategies:
The strategies come in many forms but the gist is they keep you invested until the tide turns thus limiting your drawdowns.
Be warned. Trend is not a miracle-drug. You pay for this parachute in transaction costs, both explicitly and via the bid/ask spread of the signal’s entry and exit points. You can think of this whipsaw as the premium you pay for the option-like payoff. While in a financial options contract your premium is known at the outset, the trend whipsaw is a function of the asset’s future volatility and path which are unknowable. Livermore, who has also advocated for trend, makes his own disclaimers. During an interview on Invest Like the Best , Livermore cautioned that he is “agnostic” on trend. His creeping doubts about its future efficacy stem from his observation that in recent years there have been more whipsaws and less trend formation, possibly due to the so-called “Fed put”.
3) The last option is the most adventurous and the largest hassle. But it is the option that most directly addresses the root cause of this melt-up scenario. Start a company. If capital is cheap, the market is begging you to be an entrepreneur. I’ve written about this before in The Peace Dividend of Overvaluation.
No More Escape Velocity
So who has the most to gain from hedging the right tail?
The rich.
That it’s so difficult to hedge the right tail may even be a source of comfort for those given to schadenfreude. If the thought of a rentier class that sits back and compounds their wealth advantage for generations rubs you the wrong way then you are rooting for the melt-up. To arrive in a place in which there will be no return without substantial risk. Nassim Taleb has argued that the true measure of wealth inequality is the degree to which people are capable of rising or falling from classes. In a world where riskless investments yield zero or negative, nobody’s place is cemented forever. A low-yield future flattens everyone with the rich having the most to lose. Like inflation, the melt-up is a market imposed wealth tax.
Conclusion
In his January 2020 letter, investor Jake Taylor remarks,
The return for the stock market in 2019 was quite odd. The price went up by 30%, yet earnings didn’t budge. All of the change was attributable to “valuation adjustment”.
The market is expensive by any historical measure. We talked about how painful the prospects for re-investment might be if the market marched to higher structural valuations permanently. Like you sprinted out of the gate only to discover you signed up for a marathon, not a 400m dash.
It’s popular to blame central banks, performance-chasing investors, and the rise of passive indexing. But it’s dangerous to presume that these factors are not perfectly rational. If the true equity risk premium is due to re-balance and diversification and that strategy, more commonly known as indexing, is democratized then it should reduce forward expected returns. And without any expectation of reverting to times when we didn’t know better or when that strategy was expensive to access. If capital is less scarce and in less demand it’s price must decline as capital is subject to the same economic forces that set the price of pizza or airfare. If technology cycles and demographics are conspiring to suppress the cost of capital how certain are we that this is irrational?
Like Taylor, I suspect this melt-up scenario is a tail-risk. As such the proper hedge is some very dirty combination of financial calls, equity trend exposure, and plain vanilla entrepreneurship.
I will leave you with this reminder. I am probably wrong. In fact, if this story ever took hold, sucked everyone in, and instead of the market climbing a wall of worry, ripped higher in a bull capitulation, you can thank me.
My sacrifice to the delta gods brought the rain.
