07 Aug 2019
Paul Casson, manager of the Artemis Pan-European Absolute Return Fund examines whether crowding in ‘quality growth’ stocks represents a new source of investment risk.
The history of stockmarkets is littered with bubbles, all of which – as bubbles do – have burst in due course. In my career, spanning the last 22 years, I have seen a few first-hand. They have all tended to be concentrated in certain sectors, like the 'TMT Bubble' of 1999/2000 or the 'Banking Bubble' which led to the Global Financial Crisis of 2008/9. The one we are currently watching inflate is a bit different. It is a 'Style Bubble'.
What do I mean by this? Instead of focusing on sectors which characterise the winners and losers in equity markets, the dominant feature of this period is factors. It doesn’t much matter which sector a stock is in as long as it ticks the required boxes to be attractive to trend-following quantitative models. Low volatility, momentum and ‘quality growth’ are the holy grail nowadays. Active and passive fund managers are getting in on the act too. Positioning has become very crowded. In my opinion this has now become a source of risk, despite the fact that including low volatility stocks in portfolios is commonly seen as a way to reduce risk in an equity portfolio. The risk is in the crowding.
In the early stages, a lot of what has now been pursued to extremes made sense. The immediate aftermath of the Global Financial Crisis left a lot of scar tissue and investors favoured safer stocks. Central banks' action in the form of 'Quantitative Easing' suppressed interest rates and growth, enabling stocks which could generate growth to trade at a premium. If bonds were trading on very expensive implied valuations of 'earnings', then stocks that looked like bonds could too. Ideas and investments become trends which attract further investors and eventually momentum takes over. Once this happens, momentum is the reason for a trend to continue, as it departs further and further from the fundamental support which gave birth to the idea. This is where we are now, and the air is getting thin. The converse is that anything to do with Value is hated, leaving many lowly rated stocks languishing at levels which assume very negative – and quite unlikely – outcomes.
Imagine a balloon being inflated inside a box. The more the balloon inflates, the less space there is in the box being occupied by anything other than the balloon. Finally there is only room for the balloon. In market terms this is known as capitulation. The 'hope balloon', the bubble, has inflated to the point where there is no room for anything else. Resistance becomes very painful for the dissenters. We can see evidence of this at present in the relative valuations of perceived winners and losers in the market. For the winners, with momentum, ‘quality’ and growth on their side, there seems to be no upper bound for valuations. For the losers there is no lower bound. The bifurcation in valuations is extreme. Such polarised views can be a sign that bubbles have formed, that extrapolation of trends is firmly entrenched. Morgan Stanley recently reported that on their measure the percentile valuation of Momentum is at 99%, the highest since December 1989. It's hard, of course, to get a higher number than this.
The arguments for why this is all fine have been written about widely. I do not intend to cover the same ground here, apart from to say that they all depend on a very unusual set of monetary circumstances continuing far into the future. And I do mean far into the future, because a stock trading on 35x earnings implicitly assumes a superhuman ability to forecast from long distance. Who really knows what the investment universe will look like 35 years from now. Did anyone forecast the current situation 35 years ago? Or even 10? Of course not. Which presents a problem, because committing capital to very expensive stocks requires everything to go well just for the share price to stand still. When things don't go perfectly, the de-rating effect of a lower multiple of lower earnings can create significant losses. I have no problem paying a premium for growth – but that premium must be justified by the earnings. If share prices are rising and earnings are not, an air pocket is created. This is exactly what has happened recently with rising share prices against a backdrop where most European sectors are suffering downgrades to their earnings. This is not a sustainable equilibrium.
I'm not quite sure what people are telling themselves to be able to justify paying ever higher prices for the same thing. But it strikes me that it might be more behavioural than analytical. The following quote from American psychologist Rosenhan is worth considering:
“Whenever the ratio of what is known to what needs to be known approaches zero, we tend to invent 'knowledge' and assume we understand more than we really do.”
Could this be happening in the ever more difficult quest to explain the continuation of current stockmarket trends? It is worth at least asking the question.
The final quarter of 2018 isn't so far away but it seems to have been forgotten. The US Federal Reserve had been raising interest rates from historically low levels. They had also begun a modest reduction in the size of their balance sheet. Simultaneously the cost of borrowing US dollars rose and the availability of US dollars fell. The result was an abrupt change in liquidity and a sharp fall in global stockmarkets, which in the end verged on panic just before Christmas.
To be clear, these were not extreme actions from the Fed. They were simply the early stages of progressing from the abnormal world of QE back towards the more usual behaviour of central banking. Yet it proved too much. Markets propped up by friendly central bankers couldn't cope with normality, or anything close to it. In the end the Fed choked at the prospect of a confidence-sapping fall in markets translating into the real economy. They promised not to raise interest rates and are instead on the verge of cutting them. This is not healthy. Rather, it is a clear demonstration of the fragility of the world we must make our investment decisions in.
Nor is it the only one. Economic indicators are signalling more difficult times ahead. Until recently, Europe and parts of Asia looked worst, with OECD confidence measures, manufacturing and purchase manager surveys all weak. The US was the last haven of growth, but even here the outlook is now deteriorating as evidenced by the Cass Freight Index. I would postulate that even the lacklustre levels of economic growth we have witnessed in the last 12 months aren't as good as they look. The reason is high levels of inventory. Companies in the UK and Europe have boosted inventories to guard against Brexit-related disruptions. US companies have brought forward demand to buy ahead of tariffs on Chinese goods, also adding to inventories. Chinese inventories have risen in the technology area in advance of the US ban on shipments to Huawei. All of this inventory building has contributed to growth while it occurred, but when those inventories are returned to more normal levels it will act as a drag. Demand has been shifted in time, not increased.
Another support that is difficult to repeat is the level of share buybacks. Gluskin Sheff estimate that since 2010, $4 trillion of corporate debt has been issued and used to buy back shares in the US. This obviously increases earnings per share but becomes increasingly difficult to repeat as corporate debt rises. Much of this debt will come due for renewal in the next couple of years, competing for corporate cashflow. Which brings us back to the factor phenomenon described above. Chasing companies with increasing earnings per share to ever higher valuations is a key outcome of the momentum factor. But what happens to those valuations if earnings growth slows, or even goes negative? Gravity beckons.
Calling time on bubbles is a risky business. Being wrong makes you look stupid. Being early makes you look wrong, which makes you look stupid. Far easier to just play along and say nothing, doing what everyone else does. But this is exactly what makes the bursting of a bubble so painful. Everyone is stuck in the same trades and trying to get out at the same time. Marginal buyers turn to marginal sellers, but they have nobody to sell to. Prices drop sharply to find the clearing level at which new investors can be tempted in. Against a backdrop of fear, that can be a long way below current prices.
When discussing what may cause the'Style Bubble' to burst, the question of a catalyst inevitably comes up. What will cause the change of direction? I can think of a few possibilities which may upset the trend and are discussed below. One or more of them may turn out to be the catalyst, or it may be something else altogether. It will be obvious what it was after the event. But not knowing precisely what the catalyst was before the event has never before been an impediment to previous bubbles bursting. And as the chart below shows, the discount of Value to Growth in Europe is already at historically extreme levels.
Source: Datastream, Kepler Cheuvreux
Nobody expects inflation. The fact that over $12 trillion of government debt worldwide is trading with a negative yield is testament to that. It may also be testament to the fact that central banks have completely lost control and are trapped in QE forever. But that is a story for another day. So what if the assumption of no inflation is wrong? This will require a response of higher interest rates, which in turn will provoke a sell-off in bonds. Very expensive stocks in the 'Style Bubble' also display the same sort of duration risk, making it likely they sell off too. After all if they followed bond prices up, why wouldn't they follow them down again?
The last decade has been spent by central bankers subsidising the capital classes using the firehose of cheap money. Workers, the labour class, have done very poorly in the same period and the gap in wealth has increased. Belatedly they have begun to figure this out and are making their dissatisfaction felt at the polling booth in most countries whenever they get the opportunity. Politics is fracturing as a result, raising the risk premium we must prudently assume. One way to swing the pendulum back is through higher rewards to workers, and higher wages. In economies where unemployment is low this is all the more likely. Rising wages need to be passed on in higher selling prices, which presents another source of latent inflation. This is already cropping up in company reports and conference calls.
It may be the credit market, which is bigger than it has ever been after a multi-decade bull market resulting in non-stop buying. What happens if buying turns to selling? Will all of these products prove to be as liquid on the way out as they were on the way in? The experience of the GFC suggests not. Or what about the ongoing saga of trade wars? These present a source of inefficiency, of economic friction. The risk to growth is clear and if growth is at risk then expensive stocks that depend on it are too. Conflict in the Middle East? Maybe. I could go on listing examples, but the picture is clear. There is no shortage of possibilities which could upset the crowded consensus.
The word recession hasn't been mentioned once in this article. It is not a necessary condition for a bubble to burst, although often one can cause the other. All that is required is for the core assumptions of extrapolation from trend to be challenged. We had warning shots in 2016 and 2018, when factor reversal occurred rapidly. After a while 'normal service' was resumed and the 'Style Bubble' continued to inflate. Are we close to the point where the next reversal is the final one? Maybe so. I believe we are certainly at the point where a bit more balance in portfolios is required. For as Stein's Law dictates, if something cannot go on forever, by definition it will not.
To find out more about the Artemis Pan-European Absolute Return Fund and its positioning visit the fund page at www.artemisfunds.com.
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