Since March of 2009, investors have become accustomed to owning equities passively and cheaply. But the rising stock market has been accompanied by a rise in both correlation and valuation.
Savvy investors — who know from experience that no bull market lasts forever — are looking for different ways to be prepared when this one ends.
It’s clear that equity investors have experienced outsized returns since the end of the credit crisis. The S&P 500 has compounded at 18.22% per year since 2009, far ahead of its 80-year average of 10.43%. Face it, returns have run amok. The reasons for this outsized performance could be a result of several different, yet related, fundamental drivers:
- Quantitative Easing (QE): As the U.S. Federal Reserve bought trillions of dollars in government bonds, long-term interest rates fell.
- Low interest rates: The Fed lowered short-term rates to nearly zero, and engaged in QE.
- Stock buybacks: Corporations took advantage of these lower interest rates and refinanced their corporate debt. This enabled them to free up cash to fund massive stock buybacks. S&P 500 companies have bought back more than $500 billion of their own stock in the last 12 months and a total of $2.1 trillion since 2010.
As these factors snowballed, stock prices have essentially risen in tandem with the expansion of the Fed’s balance sheet (see “What’s driving the market?” below).
High correlation results in fewer options for returns. As a result, investors seeking more diverse sources of returns in this equity bull market have few options besides allocating more to equities, of course. This rising equity tide has lifted all boats indiscriminately; which stocks you own has mattered less than how much stock you’ve owned.
In response, many investors have favored passive exchange-traded funds (ETF) over active mutual funds. Since 2007, more than $680 billion has left domestic equity mutual funds and more than $640 billion has gone into domestic ETFs. Because there has been little difference, or dispersion, between one stock or another (between companies that are growing market share and companies that are headed for bankruptcy) correlation between stocks has gone higher and higher.
Equity Lift-Off or Lag?
While this was going on, longer-term valuation of stocks has continued to rise. The median S&P 500 stock is trading at some of the highest price-to-revenue levels in history — higher than the peak of both the dot-com bubble in 1999 and the real estate bubble that peaked in 2007 (see “Bubble anyone?” below).
At these valuations, long-term equity bulls are betting a lot on the continued benefits of QE, low interest rates and corporate buybacks. There are signs that this logic might hold; for example, the forecast for a probable Fed rate hike remains low.
But even if that is the case, it’s prudent to pay attention to what has worked in the past when equity markets were highly valued. To do that, investors will need the courage to look beyond the typical one-, three- and five-year performance benchmarks to find strategies that have performed when valuation matters and not all stocks are rising as one.
One option to explore is value investing: An active investment strategy where stocks selected trade for less than their intrinsic values.
Over time, value investing has produced attractive returns. There are times, however, when value has been out of favor as investors were more focused on growth. This has happened six times since 1945, and is happening now.
The performance of value investing during the last six years is disappointing, as the S&P 500 Value Index has underperformed the S&P 500 by 1.41% per year. However, looking at the same indexes since 2000, the Value Index outperformed by 0.78% per year (see “Value’s turn,” below).
How To Access Active Strategies
One way to seek returns via value investing is to capture the difference, or dispersion, between higher quality companies and lower quality companies. An active investment strategy that can produce attractive returns is long/short equity, which invests in stocks that are expected to increase in value while shorting stocks that are expected to decrease in value.
The Credit Suisse Long/Short Equity Index has outperformed the S&P 500 by 1.2% per year since 2000.
But just like value investing, long/short equity has been out of favor for over six years. This is because as equities have become more highly correlated, there’s less dispersion for long/short equity investors to capture. The Credit Suisse Long/Short Equity Index has massively underperformed the S&P 500 by a whopping -8.4% per year for the last six years.
Will equity valuations continue to rise while the Fed maintains low rates? Perhaps; but longer-term historical trends show the path forward looks less certain.
It’s uncomfortable to look beyond the last six years, but it is very possible that in this highly-correlated equity bull market — where investors have become accustomed to paying little for equity exposure — active becomes the new alternative.