September 30, 2017

Over the last 8 years, the Federal Reserve’s (“Fed”) Zero Interest Rate Policy (“ZIRP”) and Quantitative Easing Program (“QE”) have successfully helped increase asset prices and depress volatility, leaving investors with few other alternatives to equities.  Given that equity prices have increased indiscriminately, we believe the biggest beneficiary of this bull market has been passively managed index funds and ETFs. Unprecedented flows into passive vehicles have further supported asset prices, helping to drive equity valuations to extraordinary levels.  This virtuous cycle has left investors with a classic overbuild of passive investment products that hold high and unsustainable valuations in the underlying securities they hold and track – an asset bubble in passive investing.  While we acknowledge the merits of passive investing, generally speaking, we are increasingly concerned today about the impact this unprecedented passive rotation has had on equity valuations and risk appetites.  Given the lower prospective return environment, combined with investors low risk aversion, we believe it is more important than ever to pay attention to absolute risk in the context of valuation and quality.

Asset bubbles occur when there is a speculative run in prices that is not necessarily justified by the asset’s underlying fundamentals.  When this disconnect becomes extreme in both duration and magnitude, the environment is often described as speculative.  The speculation typically manifests in an overbuild, or in the market’s case, an over allocation (or crowding) towards the speculative asset.  While bubbles are typically obvious in hindsight, in the midst of the euphoria many investors rationalize their positions as a “new normal” and become reassured by other market participants that are doing the same thing.  Professional investors, in particular, are driven by a fear of not keeping up (the risk of getting fired) in strong up markets and often times abandon their risk controls.  Admittedly, today’s bubble isn’t as obvious as the previous energy, technology, or housing bubbles.  What makes today’s passive bubble less obvious – is that it isn’t in a specific asset class or sector.  Rather it is in the manner in which people invest – a passive bubble with a “passive” approach to risk management.  The fact that it is less obvious might actually make it more dangerous.



According to Morningstar, passive and quantitative strategies have doubled over the past ten years and now account for about 60% of all equity assets.  Today, there are more passive index products than publicly traded stocks.  Bank of America Merrill Lynch has noted that Vanguard owns a 5% or more stake in 491 of the 500 S&P 500 stocks – this is up from 116 in 2010.  This bull market, in particular, has been fertile ground for passive products and it has grown exponentially – clearly an overbuild that has supported the market’s excessive valuations.

When you invest in an index fund or sector ETF, you invest in all the stocks, regardless of fundamentals or valuation.  It is the ultimate play on momentum.  Price insensitive buyers like Central Banks, ETFs and index funds lift all assets in tandem.  As a result, investors are buying the most overweight and often times the most expensive stocks.  Assets crowd around similar themes and overly influence asset prices with an upward bias.  The process is self-perpetuating and the momentum nature of the indices entices even more assets, which can further push prices beyond a reasonable fundamental basis.  Only these price/valuation insensitive buyers can sustain valuations at extraordinary levels.  To make matters worse, most passive investors (particularly ETF investors) are short term oriented.  Often, they aren’t making long term investment decisions for their clients.  They aren’t allocating client’s capital away from overvalued areas of the market towards those with greater risk adjusted return potential.  Passive vehicles are investment strategies with no risk controls.  Many of these short term traders are tactically trading around algorithmic disciplines that buy what is currently working regardless of risk or fundamentals.  It should be noted, however, that these strategies might have a similar effect in market downturns and end up being a major source of downside pressure on prices during periods of increased market volatility – exaggerating the downside risks.  Crowded strategies are more susceptible to extreme drawdowns in periods of de-risking.

Based on virtually all traditional median valuation metrics, we are in unchartered territory for the S&P 500.  In particular, the all -time high price to sales ratio is alarming given that this is a fundamental that isn’t easily manipulated through financial engineering or share buybacks.  Rich valuations today however, are often justified by low bond yields.  While this is certainly a factor, we would add the following for context: current bond yields have been, at least in part, manufactured lower by extraordinary monetary policy.  The current and historic low levels may not be normal or sustainable.  The recent low rate environment was meant to be extreme and temporary to revive the economy following the financial crisis, but these levels shouldn’t necessarily be used as a discounting factor to justify current valuations, precisely because they are not “normal”.  Indeed, the Fed seems intent on rolling back financial crisis-era monetary policies with continued hikes in the Fed Funds rate and the shrinking of their balance sheet.  To put these valuation metrics into perspective, we would add the following analysis.  We’ve been in a secular bull market in bonds since the early 1980’s and today equity prices are at record high levels. Taken together in a portfolio with a 60% allocation to equities and a 40% allocation to bonds (“market portfolio”), we have demonstrated in the chart below that the market (as defined by the market portfolio) may be the most expensive it has ever been.  This data uses Robert Shiller’s cyclically adjusted price to earnings ratio (“CAPE”) and long term interest rates.  We converted the CAPE ratio to an earnings yield and added it to the bond yield (with the 60/40 allocation to stocks and bonds, respectively).  The last three times the market portfolio has been this expensive, we were clearly in the midst of a market bubble.

Market Portfolio Yield calculated by taking the inverse of a 60% allocation to Robert Shiller’s Cyclically Adjusted Price to Earnings Ratio and adding a 40% allocation to Robert Shiller’s Long Term Interest Rate.  Source: Click here to access Robert Shiller’s On Line Data.  Or go directly to:  Yields move in opposite direction to price – the lower the yield, the higher the valuation.  Monthly data series as of September 30, 2017.

The S&P 500 has been up eleven straight months – the longest consecutive streak since 1959.  We have not had a 5% correction since June 2016 – the longest streak in twenty-one years.  This is the Dow’s first 8 quarter winning streak in 20 years.  And of course, markets continue to make new record highs.  Despite this incredible and unprecedented run, the market seems to be operating with a different mindset – expensive stocks plus expensive bonds somehow equate to attractive investment opportunity via broad-based indexing.  Admittedly, high valuations and elevated sentiment measures are merely yellow flags.  Bulls can point to low risk of recession, improving corporate profits, better global growth, accommodative global central banks, a predictable and gradual US Fed, and a potential fiscal stimulus reform as supports for the market.  In some ways, there are no obvious risks, which in itself is probably a major risk because at these valuation, sentiment, and volatility levels the market could be caught off guard by an unknown risk that isn’t baked into prices.  We continue to view risk management as an important contribution of active managers in general.  Specifically our focus on risk adjusted returns for our Clients, through our valuation discipline, is an important component of our ability to generate alpha over complete market cycles.

We are now just a few hikes away from a positive real Federal Funds rate – the first time since 2008 – and the Fed is preparing to reduce its balance sheet.  Quantitative Tightening (“QT”) may ultimately be significant because directionally, normalization may bring back the traditional market forces and the price discovery needed for a more efficient allocation of capital.  This means rewarding winners and punishing losers appropriately.  As a result, we believe investors that have a proven discipline around managing risk are particularly well positioned going forward.  This should be good for active managers in general, and our Clients in particular, given our attention to high quality earnings growth, valuation and risk management disciplines.   What has worked the past eight years will not likely work in the intermediate period.  Accordingly, we are emphasizing to our Clients and constituents that now is not the time to embrace risk.