3rd Quarter 2017

What the wise do in the beginning, fools do in the end.
– Warren Buffet

The third quarter saw a continuation of the themes that drove performance throughout the year – technology, healthcare, foreign and emerging markets. The S&P 500 returned 14.2% year-to-date, but that was eclipsed by the 20.0% return of the MSCI EAFE Index and 27.8% return of the MSCI Emerging Market Index. Within emerging markets, as in the US, technology dominated. The sector now comprises 25% of the index, higher than the 22% weight in the S&P 500, and contributed about 40% of the year-to-date return. Alibaba, Tencent, Samsung, Taiwan Semiconductor and Baidu currently are the largest weights in the sector, and the first four names are also the largest in the index as a whole.

The passing this October of the tenth anniversary of the market top prior to the 2008 Financial Crisis focuses attention on how long this bull market will last.

While nothing appears as crazy as Internet stocks in 1999 or home mortgages in 2007, signs of excess can be found. In 2007, the banking sector was excessively leveraged, much of which only became apparent in hindsight after the exposure of the levels of off-balance sheet liabilities.

Today, financial sector leverage remains modest but debt levels of ‘main-street’ businesses are increasing, surpassing levels seen in 2007. This trend is not simply a matter of the large tech companies borrowing against un-repatriated offshore cash as it is apparent broadly across the S&P 500 and in Federal economic data. The median stock in the S&P 500, excluding financial stocks, now has debt ratios above 2007 levels. Private equity transactions are occurring at both record levels of valuation and financial leverage. The fuel for much private equity is the availability of easy credit, which today is increasingly furnished by alternative, private lending funds. Scarcely a week goes by that we are not pitched a new fund promising high single-digit yields (what unlevered high yield bond funds used to deliver) by levering up illiquid loans to private equity-backed companies. Many private equity firms increasingly are also playing the leverage game with their investors, using subscription lines of credit to delay calling investor capital as long as possible in order to goose IRRs and the accompanying performance fees. Within private equity, attractive investment opportunities can still be found, but they require increased oversight and due diligence rather than allegiance to a brand name and past track record.

Unlike the frenzy for technology stocks in the late 1990s, today’s enthusiasm for ETFs and index funds can hardly be called a bubble, but it does contain worrying aspects. With 40% or so of the US market now passively managed, the key question becomes at what level does a key underlying premise of the Efficient Market Hypothesis – the idea that today’s stock price is anyone’s best guess to the true value because so many smart people are researching and trading based upon their perception of value – begin to break down? Rather than abstract pieces of paper (an anachronistic analogy in today’s electronic age), stocks represent ownership in organizations run by humans whose personal interests may differ from shareholders. Active stock investors serve as the primary check on corporate management’s tendency to entrench and enrich themselves at shareholders’ expense. Vanguard, State Street and Blackrock the big three of indexers claim to follow corporate governance and vote proxies responsibly, but their influence is limited, as ultimately management knows they cannot sell their stock as long as it remains part of an index.
Arguments for indexing also rely on the mathematical truism that the index return must equal the return of the average investor in stocks within the index before fees. The proliferation of sector and income focused ETFs leads to an erosion of this identity.

Due to the popularity of sector and income focused products, index funds and ETFs in aggregate are overweight the Real Estate and Utilities sectors relative to active investors. Utility stocks and REITs currently trade record valuations, and the Utilities sector currently pays out more in dividends than it earns. An investor in a broad index, such as the S&P 500, therefore has more invested in these sectors than does the average active manager.

However, none of these risks matter as long as markets continue to grind upwards at record low levels of volatility. The question becomes then a) what could disrupt the current benign environment for risk assets and b) what is the best positioning today while the music is still playing? The disruption could come in two forms, either a traditional recession accompanied by a bear market or a market dislocation within a continued economic expansion, such as the 1987 crash or the 1998 collapse of Long Term Capital Management.

With the economy currently in as robust of an expansion as seen since 2008, the near-term risks of recession appear low. Despite some signs of excess, no obvious speculative bubbles comparable to technology stocks in the 1990s or housing in the mid 2000s exist. Given this, most economists would place the start of the next recession sometime out past 2019.

However, the second scenario – the short term dislocation – appears a growing risk. The 1987 and 1998 crashes occurred during the midst of an economic expansion and had little impact on the broad economy. Both saw over 20% declines. In each case, flawed investment structures created brittle market conditions where an initial downturn in prices created vicious feedback loops that cratered asset prices. In 1987 it was a hedging strategy called ‘portfolio insurance’ that triggered the crash. Embraced by large institutional investors such as pension plans and university endowments, the idea was that by selling S&P 500 futures as the market declined, these investors could cap their losses. The problem became that the amount of funds employing this strategy in 1987 was sufficiently large to create a feedback loop so that every new price downturn triggered new selling which in turn generated more selling. Retail investors, panicked by the downturn, liquidated more stocks than the institutions employing portfolio insurance strategies. No attention was given to fundamental values in this decision process. In 1998, the forced sales of the assets of the highly levered hedge fund Long Term Capital Management led to lower prices which in turn begat more selling from levered investors accompanied by panic selling from retail investors.

A presentation at a recent conference in New York from an options expert and founder of Taconic Management Frank Bosens, estimated the amount of potential forced selling following a 4-6% one day decline could be over three times that of 1987, after adjusting for current capitalization levels. This pressure comes from a variety of strategies, including levered ETFs, structured variable annuities and risk parity. In 1987 a retail investor had to pick up a newspaper to see prices then call their broker to sell. Today, it is a simple click on a smartphone to sell an ETF.

Despite increased risk and lower potential returns, stocks probably will continue to outperform safe assets over the next couple of years, so what should investors do? Maintaining a strategic, diversified allocation remains the best answer. In the backdrop of the rally over the past few years, market leadership has rotated between growth and value, and foreign and domestic segments. Given drawdowns in inventories and continued economic expansion, Energy – this year’s laggard looks posed to shine in 2018. MLPs – owners and operators of pipelines, storage facilities, natural gas processing and most every other asset that connects the well to the power plant or the refiner – remain both the most frustrating and promising allocation in portfolios. With yields near 7% and sustainable high single-digit distribution growth, they remain one of the few assets whose current valuation supports a double-digit return. Reactive investment decisions, whether made to increase risk during the later stages of an expansion, or reduce risk in the midst of a downturn, tend to destroy wealth. Knowing what you own and why remains the best defense for successful investors.

Stephen C. Browne, CFA
Chief Investment Officer
Chief Compliance Officer


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