Pity the diversified investor in 2013. Who needed international equities or fixed income or real estate when the stock market only traded to the upside? Not only were domestic stocks among the best performing asset classes last year, they also boasted minimal volatility, making them the no-pain, all-gain investment.
The first six months of 2014 looked like a repeat performance. So is it time to take money off the table or press one’s bets? Based on the current macroeconomic climate, I believe there are three reasons why it makes sense to reduce equity beta in favor of a more all-weather portfolio. After making this case, I will show how a few forward-thinking advisors are using liquid alternatives to position their clients for a more challenging environment ahead.
Reason 1: The (Eventual) End of QE
In normal circumstances, the Federal Reserve controls the money supply by setting short-term interest rates. Short-term rates control the cost of loans, mortgages and the rates earned in savings accounts. When the economy is overheating, the Fed typically raises rates. That makes loans more expensive, which reduces the amount of money corporations are willing to borrow, thus dampening growth. Higher rates also encourage savings, since the amount of interest paid on CDs and other short-term instruments is higher.
When the economy sputters, the Fed lowers rates. This encourages spending instead of saving, and the amount of borrowing tends to increase. But when rates are very close to zero, the Fed’s effect on the economy becomes limited. So the next tool is to directly inject the economy with fresh cash. Quantitative easing is this process, and is accomplished when the Fed buys assets (usually Treasury and mortgage debt) with new money it creates by increasing the size of its credit account. The result is lower yields on U.S. debt securities and reduced borrowing costs.
Since its inception in 2009, quantitative easing has been a huge driver of risk asset appreciation. Stock prices have more than doubled since the start of QE, while cash on corporate balance sheets has expanded dramatically. Although gains in the employment rate and the degree of economic growth have been disappointing to some, many economists believe that the Fed’s strategy to lower rates prevented the global financial crisis of 2008-2009 from spreading. What no one knows is how the end of the policy will affect the capital markets.
Why the uncertainty? There are no examples from any time in history to use as a gauge for what may happen or how market participants may react to the eventual end of QE. Beyond the obvious effects of inflation or currency devaluation, the long-term result of this rather unorthodox economic policy is hard to pin down.
Reason 2: The Return of Volatility
Market volatility is at rock-bottom levels. While some think such complacency may herald a pullback, others see it as a part of the investment landscape that is here to stay.
Volatility measures the amount of dispersion of price movement for a given security or market index. It is usually expressed as the standard deviation of returns. Regardless of the time frame used, this metric is at historical lows. Theories abound over why volatility has dried up. Some cite the lack of trading volume, as many investors (large and small) have largely stayed out of equities since the global financial crisis (lower than normal volumes have also been blamed for a dramatic reduction in trading profits of Wall Street firms over the last year). Others point to the artificially low interest rate environment.
Volatility is used to calculate the Sharpe ratio, which measures the risk-adjusted return of assets. The current investing environment has propelled this measure to extreme levels.
The chart above shows that over the past 24 months, an investor has received nearly three units of return for every unit of risk. Even the most risk-managed strategies struggle to have a Sharpe ratio of 1. For an unmanaged equity index to be much above this number is highly unusual.
It’s likely that today’s low-volatility, high-return scenario will attract new money from those sidelined after the 2008 market rout. Since that time, investors have pulled a net $247 billion from equity mutual funds, according to the Investment Company Institute. Will their frustration culminate in a mad rush into stocks, only to end in a painful correction after all the retail money on the sidelines has been committed?
Reason 3: Stock Market Valuation
While there is little agreement on how pricey stocks are today, few analysts think the market is fundamentally undervalued. Indeed, most view stocks as the “best house in a bad neighborhood,” thinking that money flows are attracted to asset classes that stand the best chance of generating a decent return. With yields so low, investment-grade credits are not attractive to many income-oriented investors. And with Europe and Japan printing money at a furious pace, the long-awaited end of monetary stimulus may not be as sudden as some expected last year.
Most bullish analysts pin their hopes on continued improvement in corporate health. As of July 11, FactSet projected that the companies in the S&P 500 will report year-over-year earnings growth of 4.6% in the second quarter of 2014.
After a shaky first quarter, GDP growth is expected to rise at about a 3% annualized rate, according to most estimates. Consumer spending is leading the way, rising 4.6% year-over-year, the highest rate since 2011, according to ICSC-Goldman. Business spending is also set to improve. According to the Philly Fed, nearly half of all firms expect to increase their total capital expenditures in the current year.
Even so, the current market is one that seems priced for perfection. If the U.S. economy keeps plodding along, and if geopolitical pressures stay at reasonable levels, and if rates stay low, stocks should continue performing. But that seems like a mighty narrow ledge upon which to pin one’s hopes.
Participate in Upside, but Protect From Pullbacks
The current state of the markets isn’t lost on the dozens of advisors with whom I have spoken. Many of them are using liquid alts in an attempt to reduce portfolio risk while generating the returns clients need to meet their objectives.
Mercer Treadwell is one example. A CFA who is chief investment officer of Broad Street Capital Advisors, a $700 million firm in Athens, Georgia, he sees his approach as a risk-driven way to ensure clients generate the cash flow they need.
“We try to remove the emotional burden of investing for our clients,” Treadwell said. “Investors tend to make decisions that are not in their best long-term interests during extreme market stress. Reducing market exposure by using liquid alternatives is a great way to participate in the upside of equities, while giving some protection from market pullbacks. We may be giving up some upside, but in the process our risk profile is much more tenable.”