The Price of Growth

 

“To act wisely when the time for action comes, to wait patiently when it is time for repose, put man in accord with the tides. Ignorance of this law results in periods of unreasoning enthusiasm on the one hand, and depression on the other.”  – Helena Blavatsky, Russian esoteric philosopher, and author who co-founded the Theosophical Society in 1875

 

“Intelligence is the ability to adapt to change.” – Stephen Hawking

 

“As soon as you stop wanting something, you get it.” – Andy Warhol

 

One of the universally accepted ideas in sport is that of home court advantage. The idea, after all, is not a difficult one to accept: Home teams have the crowd behind them, cheering them on, filling them with confidence; visiting teams, on the other hand, have to deal with the home crowd’s hostility, which saps energy. And the stats seemingly reinforce the idea. For example, over the course of the NBA’s history, home teams have won roughly 60 per cent of the games played in almost any given season.

The crowd is powerful.

When it comes to capital markets, the crowd has unquestionably been cheering on growth and mocking value. Leaving many a value investor confounded by the apparently unstoppable rise in the likes of Netflix, Amazon, and NVIDIA. While valuations may be stretched and fundamentals in some cases appear questionable, if we take a step back and consider the secular trend, the continued outperformance of technology becomes less puzzling.

Plotting total business sales of US corporates against the ratio of Nasdaq 100 Index to the S&P 500 Index, we find a strong correlation – 74.1% using monthly data – between the two data series. That is the outperformance of the technology focused Nasdaq 100 Index relative to the broader S&P 500 Index is positively correlated with US business sales.

Total US Business Sales versus Nasdaq 100 Index to S&P 500 Index Ratio Business SalesSources: Federal Reserve Bank of St. Louis, Bloomberg

Given the latency between data releases, this relationship does not provide a trading signal. The relationship, however, does appear to suggest that US business sales growth has largely been dependent upon the growth in sales at technology companies and the market accordingly has rewarded technology stocks.

Our goal here is not to espouse the merits of investing in technology or in growth. Instead, we want to focus on what we consider to be the most interesting part of the above chart – the period from 2003 through 2006. During this period US business sales grew strongly yet the ratio between the two indices flat lined i.e. the S&P 500’s price performance roughly matched that of the NASDAQ 100.[i]

Digging a little deeper, we plot the ratio of per share sales of the S&P 500 to per share sales of the NASDAQ 100 against the relative price performance of the NASDAQ 100 Index to the S&P 500 Index. Zooming in on the period between 2003 and 2007 we find that the comparable price performance of the two indices during this period coincided with the quarterly fluctuations in per share sales also being comparable. Similarly, during the years of significant relative outperformance by the NASDAQ 100 Index, we find that per shares sales of the index were increasing relative to the per share sales of the S&P 500 Index.

Nasdaq 100 Index T12M Sales to S&P 500 Index T12M Ratio (Quarterly Data)Per Share RevenueSource: Bloomberg

Next, we consider the relative performance of S&P 500 Growth Index to that of the S&P 500 Value Index. Comparing the performance of these two indices we find that while the Nasdaq 100 Index and S&P 500 Index achieved comparable performance during the period from 2003 through 2006, the value index significantly outperformed the growth index during this period. The value index peaked relative to the growth index in 2007.

 

Ratio of S&P 500 Growth Index to S&P 500 Value Index (Monthly Data)growth to valueSource: Bloomberg

At the time of the dotcom bubble the ratio of the growth index to the value index, on a monthly basis, peaked at 1.56. Today the ratio stands at 1.47.

The crowd may well be at the cusp of switching loyalties.

We look for clues in and around the period between 2003 and 2007 to help us determine whether the time for value is coming or not.

The cyclical low in the effective US Federal Funds Rate registered a cyclical low in 2003.

US Federal Funds Effective RateFed funds rateSource: Bloomberg

The Commodity Research Bureau All Commodities Spot Index registered a cyclical low in 2001 and MSCI Emerging Markets Index started its multi-year ascent in 2003.

CRB Spot All Commodities IndexCRBSource: Bloomberg

MSCI Emerging Markets IndexMSCISource: Bloomberg

The US dollar had its cyclical peak in 2002, the same year in which the Bush Administration imposed tariffs on imported steel.

In 2004, Congress approved a one-time tax holiday for US corporations repatriating overseas profits.

In 2005, George Bush signed a USD 286 billion transportation bill.

If we compare the events and market action that preceded and coincided with the relative outperformance of value during the years from 2003 to 2007 to that of today, we find many similarities across both policy-making and market action. With growth’s outperformance relative to value reaching levels last seen during the very same period, the signs are difficult to ignore. It may not be time to bail on growth as yet, but it certainly is not the time to have a 100 per cent allocation to it either.

 

Investment Perspective

 

Human nature is such that we desire that which is rare and take for granted that which is common. In the recent past growth has been elusive – and that which has been available has been heavily concentrated in the US and in technology. It is no wonder then that investors have rushed into US technology names without abandon.

Growth is no longer as elusive. We can find growth in Asia, Europe and other parts of the emerging world and across both old industries and new. With its abundance the price of growth should de-rate. Value, however, has become hard to find and it is this scarcity of value, we believe, that will bring about the inevitable shift in market leadership away from technology to other sectors.

Forewarned is forearmed.   

 

[i] The total return for the NASDAQ 100 Index for the period was 80.9% versus 74.05% for the S&P 500 Index.

 

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This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

 

 

 

The Bull Market is Not Dead.

“Bulls do not win bull fights. People do.” – Normal Ralph Augustine

 

 “Stocks fluctuate, next question.”Alan Greenberg, former CEO and Chairman of the Board of Bear Stearns, in response to questions about the crash, October 22, 1987

 

“If you have trouble imagining a 20% loss in the stock market, you shouldn’t be in stocks.” – Jack Bogle

 

November last year, in Volatility Selling and Volatility Arbitrage Ideas Using Equities, we wrote:

 

Based on the tenets of Prospect Theory, the popularity of short volatility strategies is somewhat confounding. By investing in such strategies, investors are underweighting as opposed to overweighting a low probability event (a market crash). At the same time, they are giving preference to negative skewness, favouring small gains at the risk of incurring large losses.

 During October, 2017, the VIX recorded its lowest monthly average since the launch of the index dating back to January, 1993. What makes this statistic even more remarkable is that autumn months are generally more volatile with October being, on average, the most volatile month during the year.  The average level of the VIX for October, starting 1993, is 21.8 – more than double the 10.1 averaged last month.

With all that being said, we do consider the short volatility trade to be richly valued. That does not mean we expect the equity market to crash, instead the differential between implied and realised volatility has tightened to such a degree that this gap can easily close and invert. The trade can become loss making without a meaningful correction in equity markets.

 

Poorly structured short-volatility products and the limited – almost non-existent – down-side risk to going long volatility has, in our opinion, led to the emphatic short-squeeze in volatility witnessed over the last ten days or so. The tail has well and truly wagged the dog. That is, higher volatility has led to the sharp correction in the market. Not the other way round. The late-afternoon equity sell-off on Monday 5 February is indicative of as much.

S&P 500 Index on 5 February, 2018SPX 5 FebSource: Bloomberg

XIV, SVXY and other products of their ilk are not the first, and are almost certainly not going to be the last, poorly conceived investment products to blow-up. Think back to portfolio insurance, synthetic collateralised debt obligations (CDOs) and CDO-squared as a reminder. There has been plenty of commentary, and no shortage of memes, lambasting regulators of and speculators in short-volatility products alike – many of the critics make valid arguments that should give regulators pause for thought. For investors the time, however, is not to reflect on the flaws of these products but rather to focus on whether the blow-up of these products can lead to a contagion into adjacent markets or is this just a shake-out of weak hands.

The most convincing argument for the recent correction being a shake-out of weak hands comes from the US corporate bond market. US corporate spreads have been benign in the face of the recent spike in volatility – a first in a very long-time.

US Corporate Yield Spreads vs. VIX IndexCorporate yields and VIXSource: Bloomberg

The narrative of rising inflation expectations leading to the correction in equity market has taken hold in some quarters. Firstly, looking at the USD 5-year, 5-year inflation swap rate, there has not been a sharp increase in market-based inflation expectations. In fact, the increase in inflation expectations was much sharper immediately after Trump won the election than at any time during the last year. Secondly, high inflation does not negatively affect equities. If inflation is high but stable, it is nominally positive for equity markets and is unlikely to cause any damage to the real economy. Moreover, historical data suggests that the highest levels of price-to-earnings multiples are witnessed during periods when inflation ranged from 2 to 3 per cent.

 

An unexpected acceleration in inflation followed by unanticipated changes in monetary policy, however, can have significant negative consequences for the economy. The Fed, to date, has not shown any signs of panic. As long as the Fed continues on the path of slow and steady rate hikes, we do not expect Fed rate hikes to derail the economy or the equity market. If, however, the US economy overheats in response to the recently passed tax reforms and the tight labour market, the Fed may be forced to react aggressively, which could be catastrophic for both the economy and equity markets.

USD 5-Year, 5-Year Inflation Swap Rate5Y5YSource: Bloomberg

The one change coming out of the recent sell-off, in our opinion, is that volatility has made its secular low. We suspect that retail investors are unlikely to return to short volatility in droves. We also have a hunch that private banks and wealth managers will not be offering short-volatility products to their high-net worth clients any time soon. Volatility, therefore, should stabilise closer to its longer-term average – we do, however, expect volatility to be structurally lower than the past due to the increased prevalence of passive and systematic strategies, which implicitly dampen volatility during a stable market environment.

A necessary corollary of higher volatility is that investors have to be more discerning in security selection.  Active management may soon be back in vogue.

 

 

Investment Perspective

 

In the after-math of the recent market sell-off we have heard market legends claim that “macro is back” or that it is an “exciting turn for macro trading”. At the same time, we have heard old hands speak of the trauma of 1987 and how it shaped their approach to markets going forward. What we do not hear or read of enough though is that as traumatic as 19 October, 1987 was, it was also the buying opportunity of a generation. The S&P 500 compounded at an annualised rate of 18.9 per cent over the next ten years.

We do not expect returns from equity markets for the next ten years to be like those witnessed between 1987 and 1997. We, however, also cannot ignore that global equity markets had a major break out last year.

 

MSCI All Cap World IndexMSCI ACWISource: Bloomberg

We have one simple, singular thought when it comes to equity markets today. Until we come across evidence to the contrary, we think investors should figure out what they want to own and buy it with both hands.

 

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.