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So too is Mr. Market today making fun of global equity investors. 2018 was a year of rotations, corrections and volatility. The year rounded out with an overwhelming general bearishness with many believing more downside lay ahead.
In the hit TV series, The Marvelous Mrs. Maisel, Miriam “Midge” Maisel – married, mother of two from the Upper West Side of New York City – discovers a hidden talent for stand-up comedy. Her natural, unexpected wit creates twists and turns with laughter and tears for her audience.
So too is Mr. Market today making fun of global equity investors. 2018 was a year of rotations, corrections and volatility. The year rounded out with an overwhelming general bearishness with many believing more downside lay ahead. But, as with Mrs. Maisel, should we expect the unexpected from Mr. Market?
In the Whitepaper that follows, our analysis shows that global equities have arguably become less risky, not more risky, over the last four years. And there remains plenty of opportunities to exploit for high-quality active fund managers.
Furthermore, we examine the idea that algorithmic trading is creating unusual geographic and inter-sector rotations. If it is true that the algos are causing Mr. Market to become increasingly erratic, this creates a double-edged sword for investors. On the one hand, non-fundamental moves in stocks create mispricings which can be exploited by discerning active fund managers. This is great news for the patient, long-term investor who can tolerate some short-run volatility. But it also means that short-run performance metrics are less meaningful.
Section I – Did Mr. Market Run Out of Steam Four Years Ago? Over the last four years, global equities have delivered a real return of approximately zero… True or false?
Before you scream “false”, let us mount an argument as to why it may be more believable than you think. First, we observe that the MSCI World Net Total Return Index has delivered +4.5 per cent per annum over the four-year period to 31 December 2018. This return is clearly above any global average rate of inflation suggesting real global equity returns have been positive over the period.
By far the most substantial contributor to the MSCI World’s return was the +7.2 per cent per annum return generated by US equities – as measured by the S&P 500, in this case. Now, the US accounts for approximately 54 per cent of the MSCI World Net Total Return Index, so this substantial return drove more than 80 per cent of the total return of the MSCI World over this four-year period.
But what is sometimes forgotten is that US domiciled businesses benefited from a significant reduction in their corporate tax rate, from 35 per cent to 21 per cent, as part of President Trump’s famous Tax Cuts and Jobs Act of 2017. This reduction in the corporate tax rate effectively provided a one-time rebasing of US corporate earnings upwards.
We thought it might be interesting to consider what US equities may have delivered absent the Trump tax cut. Our analysis is simple in that, assuming a constant valuation multiple, we crudely deflate the US equity index by the degree to which US corporate earnings rebased upwards (which we assumed was 21 per cent). We believe the results of our analysis are informative, notwithstanding its simplicity.
The analysis is summarised below which shows that approximately 70 per cent of US equity returns over the last four years was driven by the reduction in the US corporate tax rate. Absent this tax cut, US equities would likely have delivered an average return of 1.9 per cent per annum– exactly the same as the average yield of the 5YR US Treasury Bond over the same period.
Now, upon adjusting the MSCI World Net Total Return Index for the Trump tax cut, the four-year annual return of +4.5 per cent reduces to just +1.6 per cent per annum. Arguably this return is in line with global inflation suggesting real global equity returns over the period have been approximately zero.
What conclusions should be drawn from the above?
First, proponents of passive index funds should send President Trump a Thank You card. Absent the US corporate tax cut, passive global equity returns over the last four years would have barely beaten inflation, as shown above.
A corollary here is that high-quality active funds management that can generate outperformance above average equity returns, or “alpha”, is worth a lot more to investors in a lower returning equity environment. By way of comparison, our global equity long-short strategy, Montaka, delivered a US dollar equivalent return of 6.3 per cent per annum, net of fees, over the three-and-a-half year period to 31 December 2018, despite an average beta of approximately 0.3.
Now, you might be wondering: why bother with equities at all? This is a valid question in light of the last four years of equity returns. Why take equity-risk to generate the return of a risk-free Treasury Bond? Of course, this risk/reward equation makes no sense – but this is what happened effectively over the last four years when we deduct the one-time benefit from the Trump tax cut.
To help make sense of the current situation, consider the following thought experiment. You can buy one of the following two securities:
Which is more appealing? We think Security A by a mile – and that is why we own Facebook (NASDAQ: FB) in our global portfolios today.
Let us now take the thought experiment one step further. Let’s say we buy Facebook today and we wake up in five years’ time with a total return on our position of just 1.6 per cent per annum – equivalent to what the MSCI World delivered over the last four years, excluding the Trump tax cut. The implication here is that, absent a significant downgrade in earnings expectations, the P/E multiple in five years’ time must have become around 40 per cent cheaper. This would mean that Facebook would be trading at less than 10x forward P/E ratio! Such a seemingly absurd valuation multiple for such a high-quality business gives us comfort that our return on this investment will likely be materially higher.
The key idea here is as follows: as earnings grow without commensurate growth in total shsareholder return, then equities are essentially becoming cheaper, absent some material change to the trajectory of future growth or cost of capital.
Over the last four years, global equities have effectively drifted sideways (absent the one-time Trump tax cut); but pre-tax earnings have been increasing! In the US, for example, S&P 500 pre-tax earnings have increased by 16 per cent over the last four years. Said another way: global equity markets have actually become cheaper, or less risky, over the last four years.
Now, you certainly would not think that stocks have become less risky if you read any financial press. The conventional wisdom is that equities are heading for a prolonged “bear market” – perhaps like what was observed at the beginning of the century. Between 2000 and 2002, the S&P 500 TR Index roughly halved. But it is worth noting that the forward P/E ratio of the S&P 500 today is the same as where it was at the bottom of the 2002 bear market – and roughly half of where it was at the top, in the year 2000.
We have no idea where global equity markets are going to go in 2019 or beyond. But we do know that, as stock prices fall, the probability of higher future investment returns increases. And in the second half of 2018, stock prices fell.
The benefit of a “variable net” long short strategy, such as Montaka, is that the portfolio’s net exposure to the overall equity market can be varied according to prospective risk/ reward profile. This is achieved through some combination of increasing long exposure and/or covering short exposure. As can be observed by the chart below, we increased Montaka’s net exposure as stock prices became cheaper in the fourth calendar quarter of 2018. And should stock prices fall even further, investors should expect Montaka’s net exposure to increase yet again.
One final point needs to be made here. While the focus of this Whitepaper has been on aggregate equity markets, readers should remember that we do not invest in markets. We invest in individual high-quality businesses when we believe they are materially undervalued. And we short businesses which are structurally challenged, misperceived and overvalued. While it is the bottom-up process of identifying new long and short opportunities that is the primary driver of changes in Montaka’s net market exposure, we also exercise top-down judgment to determine where the portfolio’s net exposure should be at any point in time. This top-down judgment is informed by analyses such as those contained in this Whitepaper and is typically consistent with what our research team is observing on a bottom-up basis.
To conclude this section, our message is that it is far from clear that we are heading into a prolonged bear market. Of course it is possible. But our analysis suggests the probability of such a prolonged bear market has actually reduced since four years ago. And should the market continue to move sideways, highquality active funds management should be able to exploit plenty of mispriced stocks to generate superior returns relative to their passive counterparts.
Section II – Is Mr Market Becoming More Erratic?
In 2018, global equity investors experienced a return of market volatility. This is not a bad thing – after all, it is during periods of market volatility that equity mispricings tend to be at their highest. And mispricings are the core ingredient for active managers to generate outperformance, or alpha, over time.
But in 2018, global equity investors were not just faced with volatility, they were faced with unusual geographic and intersector rotations. Many of these moves, it must be said, appeared non-fundamental in nature.
It is impossible to know what causes short-run moves in equity prices. In recent months, it was interesting to listen to an interview by Stanley Druckenmiller. His observations of current market conditions in the context of his 35 years’ experience as a top professional investor struck a chord with us.
“The algos have taken all the rhythm out of the market and have become extremely confusing to me.”
Druckenmiller reflected on a dynamic he observed in 2018. Interestingly, similar observations had been made on multiple occasions during the year inside the Montaka research team. Unlike Druckenmiller, however, we had no sensible explanation for what we were observing.
“The pharmaceuticals, which you would think are the most predictable earnings streams out there, so there shouldn’t be a whole lot of movement one way or another. From January to May, they were massive underperformers. In the old days, I would look at that relative strength and I’ll go: ‘this group is a disaster’… They were the worst group of any I follow from January to May. And with no change in news, and no change in Trump’s narrative and, if anything, an acceleration in the US economy, which should put them more toward the back of the bus than the front of the bus because they don’t need a strong economy, they have now been about the best group from May until now [September]. And I could give you about 15 other examples. And that’s the kind of stuff that didn’t used to happen.”
Now, we do not know for sure that algos are the source of the dynamics being observed. But we do know for sure that these dynamics are being observed. We recently witnessed significant outperformance of Utilities at a time when interest rates were increasing – a nonsensical move for sectors which are often treated by investors as “bond substitutes”.
So what to make of a global equity market that can be characterised as having pockets of non-fundamental moves in prices at different times?
First, this is great news. Non-fundamental moves in stocks’ prices create misalignments between price and intrinsic value which can be exploited by active managers who are sharply focused on such mispricings.
But there are other corollaries as well. For instance, how meaningful is short-run investment performance in the current environment? Here is the thought experiment: imagine a magic investment manager who always bought stocks at prices below their intrinsic value. By definition, this manager must outperform the market in the long run. But what about in the short run? Given the non-fundamental moves in groups of stocks at different times, this manager will experience periods of short-term volatility and underperformance. Imagine a scenario in which an undervalued business is purchased – only for that business to subsequently experience a temporary, nonfundamental move to the downside. A continuation of a diligent, well-thought out investment process may appear fruitless in the short-run due to these non-fundamental stock price swings.
Or take portfolio risk management. Many investors – especially institutional investors – require investment managers to decisively reduce portfolio risk during periods of draw-down. The simple logic can be understood as follows: in periods of draw-down, the market is signalling to the manager that the portfolio positioning is inappropriate for the current market conditions. But how valuable is this market signal in a market construct which includes non-fundamental moves in different pockets in the market at different times?
This feedback from the market is something that investors, including Druckenmiller, used to rely on as some form of confirmation of one’s investment thesis. Under the current market conditions being observed, investors and risk managers alike need to reconsider the weighting they apply to such market signals. And arguably, the importance of thoughtful and accurate fundamental analysis, combined with a disciplined investment framework, has only increased in this new market environment.
The best predictor of higher investment returns tomorrow is lower prices today. This is sometimes forgotten – especially when prices are falling and bearishness takes over. An environment of falling stock prices is always uncomfortable. But there is a silver lining: lower stocks prices mean these stocks are now less risky, not more.
In this Whitepaper, we show that global equities have delivered real returns of approximately zero over the last four years (excluding the Trump tax cut). Yet, over this period, pre-tax earnings have grown significantly. This implies that stocks are relatively cheaper and have arguably become less risky, over the last four years, not more.
In a lower-returning and more volatile equity market, investors should favour high-quality active fund managers over their passive counterparts. Only active managers can exploit stockspecific mispricings to generate outperformance to the average equity market return (or alpha). Furthermore, we believe the current environment favours “variable net” strategies, such as Montaka, that can vary the degree of portfolio net market exposure based on the risk/reward profile of the opportunity set at the time. We show that Montaka’s net market exposure has increased as stock prices have reduced. And should stock prices fall further, investors should expect Montaka’s net market exposure to increase further still.
Finally, we observe – as do others – unusual rotations in global equity markets from time to time, possibly driven by algorithmic trading. If it is true that the algos are causing Mr. Market to become increasingly erratic, this creates a double-edged sword for investors. On the one hand, non-fundamental moves in stocks create mispricings which can be exploited by high-quality active managers. This is great news for the patient, long-term investor who can tolerate some short-run volatility. But it also means that short-run performance metrics are less meaningful. What should matter most to investors today is a thoughtful and disciplined fundamental investment process.
Want to get in contact with the team at Montaka?
Please contact Matthew Briggs, Institutional Sales on +61 2 8046 5023 or email@example.com