- This is the first of a multi-part series examining the use of valuation approaches to identify future outperforming asset classes.
- I discuss why value investing is an essential and useful tool for asset class traders.
- I briefly discuss the Warren Buffett approach as the purest form of discretionary value investing.
- I clarify the distinction between fair value (a concept I’ve used to discuss short-term trading edges) and intrinsic value used by value investors.
- I briefly review the vast academic literature on mechanically value-tilted portfolios. These portfolios are typically heavily weighted towards cheap and risky assets. These cheap securities are most often fairly priced to deliver long-term returns that are superior to a market cap weighted basket of similar securities.
- Finally, I introduce Asset Class Value Investing as: identifying moments in time when an asset class appears to be irrationally mispriced based on an assessment of long-term intrinsic value.
As asset class traders, we must understand the current thinking built into asset class prices. Prices are generally determined by the actions of a global set of large institutions, pension funds, endowments, sovereign wealth funds, banks, mutual fund managers and hedge fund managers considering future prospects and risks. Finding trading opportunities requires us to get into the heads of these large market players.
Many large firms specialize in one or a few asset classes, while other large institutions focus their attention at the asset class level. Most organizations are too big to actively buy and sell securities; they need to act on longer time frames.
The question of assessing an asset class’s relative value is particularly topical right now. U.S. growth stocks continue to outperform all other asset classes despite being “overvalued” for the past 5 or so years. Meanwhile, international and emerging market stocks continue to sink, despite trading at a fraction of U.S. equity multiples. Furthermore, across the global stock market, the value style has underperformed growth stocks for over a decade, despite strong evidence value stocks outperform over the long term. The current market seems a lot like the late 1990s all over again. (more…)
Large price runups, such as a gain of 100% over two years, are rare.1 In a previous blog post, I presented 10 attributes to distinguish asset class bubbles from large price runups that are justified by improving fundamentals. Those bubble attributes are:
- Heavy retail investor involvement
- New-era thinking
- Irrational valuations
- Five or more years of swiftly rising prices
- Parabolic rise in price
- Shorting is unattractive or impossible
- Social mania
- Product providers exploit excessive demand
- Leverage fuels more buying
- Bubbles are late-cycle phenomena
As asset class traders, we are especially interested in bubbles as a potential huge source of alpha when they collapse. As it turns out, bubbles are a lot tougher to exploit than it might seem. In this blog post, we’ll delve into bubble characteristics in more detail, and then investigate the best ways to trade asset classes that are experiencing a bubble.
We’ll examine bubble characteristics over the short term (plus and minus three years around the peak) and then longer term (a decade or more). When doing this sort of analysis, we need to at least acknowledge that various forms of hindsight bias can creep into such work since we are examining known price runups that ultimately crashed spectacularly.
It’s possible that we should include a few historical parabolic runups that did not ultimately pop.1 I’m hopeful that the lack of bubble attributes associated with these moves provides the justification for eliminating these from consideration, but I’m not completely sure. I may have also declared a few large up and down moves as bubbles (for instance, Chinese equities in 2007), when perhaps this price move had no more bubble attributes than a big move that ultimately didn’t end in a long period of underperformance (for example, the 1987 crash). (more…)
If you’re in the investment biz long enough, you’ll inevitably find yourselves searching for profitable ideas when an asset class is experiencing a bubble. The term “bubble” is a heavily overused term in the financial media and among professional investors. Any large price increase over a short time period, such as a 50% gain over a year, prompts a few writers, analysts or professional investors to describe the runup as a bubble. These bearish folks are typically using the term loosely without a nuanced evaluation to determine if prices have simply reflected new highly positive information.
Additionally, how many times have we heard “bubble” used for assets that have experienced long-term, secular bull markets, such as U.S. or Japanese government bonds, when current prices are not experiencing anything like the bubble phenomenon? Then other folks use the term in a variety of ways to describe investor group think, such as “hedge funds are the next investment bubble,” or “there’s currently a bubble in investor complacency.”
I’m specifically interested in those moments in time, which can last months or even years, when price-insensitive buyers become ever more attracted to rapidly rising prices, thus bidding an asset class price way above fair value. It’s a time when pricing is determined by the one-way thinking associated with the “madness of crowds,” rather than the normal, efficient markets “wisdom of crowds” effect. The massive number of performance chasers overwhelms the financial resources of professional investors and traders attempting to push prices back to fair value by shorting and selling the asset class.
Even though the gap between price and fair value grows ever larger, uncertainty about when the market will top and how much further the price will rise creates a situation where the risk-reward of shorting the asset class becomes very unattractive. The arbs, who are usually pushing prices back to fair value, then step away, or perhaps even join the crowd. Other opportunistic professional investors join the crowd by creating new products and/or new firms to exploit the attractive optionality associated with easy money raising and rapidly rising prices.
Bubbles have occurred about once a generation throughout human history, as new investors enter the market with no experience with how bubbles eventually burst. Examples of the large bubbles include the NASDAQ bubble in the late 1990s and the Japanese stock market bubble in the late 1980s. The current bitcoin and cryptocurrency craze has all the attributes of a bubble.
Many Rapid Price Increases Are Not Bubbles
Just because an asset class has a large and rapid price run doesn’t mean it’s mispriced. One or two U.S. industry groups often have a yearly gain of greater than 50%. Most often, prices have increased to reflect unexpected improved future earnings. Also, most bull market tops don’t have a bubble associated with prices. The topping process is more drawn out as the collective wisdom is formed by market players generally using reasonable judgment of future prospects. Prices ultimately collapse when investors sense an emerging bear market or recession.
Eugene Fama, the Nobel-Prize-winning champion of the efficient markets view, believes there is no such thing as bubbles. Bubbles are only known after the fact, when there’s been a large collapse. Careful analysis of large price increases shows that many, perhaps even half, are never followed by a collapse.1 Simple price formulas for defining a bubble, even the approach used by the famous bubble studiers GMO,2,3 are not enough. We need more information. (more…)
Often in trading we become totally engrossed in searching for short-term opportunities with a hyper-focus on news flow and daily price movements. Occasionally it’s good to drastically alter time frames, especially if your creativity has dried up on short-term ideas. One way to search for new trades is to scan asset classes that have performed the worst over the previous decade. This is especially interesting when there’s been a large divergence of performance in asset class returns over the previous 5 to 10 years.
Table 1 shows a ranking of the worst-performing ETFs by 10-year annualized returns as of October 31, 2017. When tabulating this ranking, I excluded the ProShares daily leveraging funds and commodity exchange traded notes. For comparison, the S&P 500 returned 7.51% per year during this time frame. This list contains many ETFs in the energy space, with a few niche asset classes (clean energy, gold miners, steel and nuclear), country funds (Russia, Italy and Brazil) and two currencies (British pound and Canadian dollar).
Table 1: Worst-performing U.S. ETFs based on 10-year annualized returns, as of October 31, 2017. (Note: S&P 500 return over same period was 7.51%/year). Source is Morningstar.
Often these asset classes were popular many years ago, but as the terrible performance persisted over a decade’s time, more and more traders and portfolio managers shifted their focus to better-performing asset classes. With a niche asset class, such as gold mining or solar energy stocks, the last remaining holders are the enthusiasts (gold bugs), index funds and retail investors owning such a small position that to them it’s easier to ignore rather than take a loss on a sale. (more…)
Does experience trading the markets provide an actual trading edge? Surely an investor who’s seen many bull and bear markets has an advantage compared to a novice just starting out in the field. The beginner is an alpha source for seasoned traders as the former pays their “tuition” associated with learning how to trade. The counterargument, using efficient markets logic, suggests that if a great number of portfolio managers (PMs) have significant experience, then the performance benefits of experience become arbitraged away as prices quickly incorporate the collective wisdom of the pros and experts.
Fund marketers ignore the efficient markets logic and advertise portfolio manager experience because it’s very convincing to most customers. I’ve traded asset classes for about 20 years. I’ve experienced two major and several minor bear markets, and seen a variety of bull markets. When I assess my current trading edges, I admit I’ve started putting “experience” as an edge – although at times with a question mark behind it.
Studies show that manager tenure and experience has little impact on mutual fund performance.1 I’ll speculate that the constraints associated with mutual fund portfolio management greatly inhibit the use of experience as an edge. Prospectus limitations on what securities can be purchased and the requirement to stick with an established investment discipline limit the flexibility to use experience to add value. Career risk can also drastically alter a PM’s personal risk-return profile, inhibiting the use of experience to benefit clients.
Seasoned relationship managers and investment advisors can be highly valuable to their clients since they draw on experience to help a client weigh the pros and cons of making a decision – especially in stressful moments. Of course, their job is not about adding alpha, although many claim they can. Just because a person has 20 to 30 years in the industry doesn’t mean they automatically have an “experience edge” that translates into superior performance. Many PMs are not intentional in how they learn from their experience. They’re lazy.
As an asset class trader, free to shift to any asset class and any investment style at any time, experience can become an impactful trading edge. Intentionally developing an “experience trading edge” requires a carefully planned personal mastery process. Much like a training program used by elite athletes, this mastery process is used to successfully play the asset class trading “meta-game” to better assess what approach works best at a particular moment in time. The mastery process is never-ending and consists of learning, practicing, recording results, reflecting and incorporating feedback to get better. To ignore the process is a huge missed opportunity to get better at this game, and perhaps develop an “experience” trading edge. (more…)
The massive migration of assets from actively managed equity funds to index funds has attracted a lot of attention lately.1-6 The discussion varies, including worries about the future of active managers, concerns about market efficiency, and claims that active managers are about to outperform, and a variety of social impacts caused by this trend.
The flow of assets among U.S. equities is massive and may be a sea-change inflection point in the financial markets. The transition toward indexing has accelerated in the U.S. as more and more professional investment advisors have finally acknowledged the failure of active management. New Department of Labor fiduciary rules also make it more difficult for investment advisors to recommend active managers without exposing themselves to potential litigation risk. Figure 1 from a recent Wall Street Journal article, using data from Morningstar, shows the accelerating trend.1 Similar trends are occurring more slowly among bond funds and international equity funds.
Many articles, mostly wishful thinking from those selling active stock picking, suggest the “performance pendulum” will eventually swing back in favor of active managers outperforming. John Rogers, a highly respected portfolio manager for the Ariel Funds, recently captured active stock pickers’ common sentiment about active versus passive management.
“This is going to be the decade for stock pickers. … It’s been a long trend we’ve gone through where active managers have underperformed. We know in 30 years of doing this … we have gone through these waves. Things become very popular, very hot and everyone follows that concept. What’s worked yesterday gets everyone excited and people give up on what’s not working and often that’s where the opportunities are.” 6
Barron’s seems to be hot on this idea, with multiple articles suggesting active stock picking will make a comeback.7,8 Perhaps they’re nostalgic for the investing world of the 1980s and 1990s when stock pickers were the investment stars.
A much talked about research piece out of Sanford Bernstein, titled “The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism”, lamented a world where indexing dominated the markets.4 Figure 2 shows the parabolic rise in the number of indices used to track various slices of the markets. (more…)