Let the good times roll. From April 2009, just after stocks bottomed, through July 2018, the NASDAQ 100 advanced by 548%, the S&P 500 CCC and Lower HY Corporate Bond Index gained 473%, and the Russell 3000 returned 335%.
Unemployment remains near the lows of 2000 and 1970, and second quarter real GDP grew 4.1%. On top of that, with about 90% of S&P 500 companies having reported Q2 earnings, sales are coming in at 11% higher YOY, the beat rate on earnings is at a historic high of 78%, and operating margins are at 11.6% versus a 20-year average of just over 8%.
With such encouraging data, it’s no wonder that the stock portion of investor portfolios is near its all-time high of 62.5%, and that allocation to cash (9.9%) is at a low going back 15 years, according to BofA Merrill Lynch data. Investors weren’t even this fully invested in 2007 before the financial crisis.
It’s easy to get carried away by the headline numbers indicating just how good things are at present. It’s just as easy to forget that all that good news is already priced into the market. Investing is always a forward-looking endeavor, and therefore, the only question that really matters is, what’s the market missing?
According to Morningstar, as of July 31, investors added $159 billion to stock funds and ETFs over the past year, which when combined with market performance, put overall stock allocations in the aforementioned spitting distance of their all-time highs. Now in fairness, investors do appear to have been thinking about diversification, as they’ve also added $272 billion to bond funds and ETFs. Investment grade debt, which accounts for most of those inflows, has traditionally played a crucial role in diversifying equity risk. But that was when investment grade debt offered a meaningful real return on an ex ante basis; we can’t say that today.
While the alternative mutual fund categories haven’t exactly lit it up over the past year, the Managed Futures (+0.7%), Long/Short Credit (+1.2%), Market Neutral (+1.2%), Options Based (+5.1%), Long/Short Equity (+6.0%), and Multialternative (+2.0%) categories have all outperformed Intermediate-Term Bond (-0.7%) — the single largest fixed income category.
We’re not saying that any of these strategies have comparable risk profiles to investment grade debt and are therefore appropriate one-for-one replacements. Rather, that there are many tools with which an investor can build a diversified portfolio. Some of those tools offer risk-reduction relative to equities, some offer return enhancement relative to fixed income, etc.
But for investors to understand the benefits of using an expanded tool kit, they have to start with a goal for the portfolio and then consider how each component helps them achieve that goal.
All things alternative, save for private equity, have been shunned for an extended period, as beta 1.0 products have taken center stage. But unless you believe this market has another significant leg up and you’ll know when to get out:
- You should consider de-risking at least some of your long-only equity exposure in favor of long/short equity.
- You should consider de-risking at least some of your credit exposure in favor of long/short credit.
- You should consider trying to earn a more meaningful real return than what is offered by investment grade debt in a true market neutral strategy that might benefit from rising rates. Or in a managed futures strategy that likewise could benefit from rising rates and/or rising volatility.
Life’s been easy as a beta 1.0 investor, and we’ve seen this movie before. According to Vanguard, investors had the same high proportion of stocks that they have today back in September 2007. Then, due to market declines and panicked selling during the crisis, that exposure sank to 38% in January 2009, just before markets went on a historical run. Stressing a more defensive posture now may allow for a better pivot to offense when conditions are again in investors’ favor.
Cliff Stanton, CFA, is Co-Chief Investment Officer of 361 Capital.