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Since the global financial crisis of 2008, markets have for the most part been a one-way train. Even the precipitous decline of the Covid-crash of early 2020 was erased so quickly that several months later it seemed like little more than a bad dream.
In such a favourable and long-lasting environment, risk management has increasingly become regarded as a four-letter word. Any attempt to mitigate risk and protect investors from large losses has been a money losing proposition. It has been a drag on returns and has done little to reduce volatility. Simply stated, risk management isn’t of much use when there has been no risk to manage.
Defining a Bubble: Like Catching Water in a Net
There is no universally accepted definition of a bubble. Identifying one is part art and part science and can only be done with certainty in hindsight once a bubble has become a matter of record.
Parabolic gains in markets in and of themselves may or may not signal a bubble. Similarly, situations where valuations stand significantly higher than their long-term historical averages cannot be conclusively classified as bubbles.
Further complicating matters, bubbles tend to be accompanied (if not caused) by a broad-based mindset among investors, which by definition is difficult, if not impossible to measure or define.
Behavioral Characteristics of Bubbles: Zero Fear & Speculative Frenzy
One of the most common and powerful characteristics of bubbles is a widespread belief that stocks can only go up. Aided and abetted by historical precedent, many investors have become emboldened by growing faith in a perpetual Fed “put,” whereby the central bank will move aggressively to support (and even reverse) any significant decline in markets.
Relatedly, this complacency has led to a surge in speculative madness during which a growing number of investors have piled into riskier assets, causing parabolic gains. One does not have to look far to see several signs of such behaviour, including:
- Meme stock madness: GameStop and AMC, two companies in declining industries which respectively rocketed up 120x and 38x from their post-pandemic lows to their 2021 highs.
- Crypto craziness: Dogecoin, which was originally conceived as a parody, went up nearly 300x to a market cap of $90 billion, spurred by tweets from Elon Musk.
- Electric vehicle ecstasy: Hertz’s stock surged by simply announcing that it would purchase a fleet of Teslas. Similarly, Avis tripled in a day based on the mere suggestion that it might follow suit!
The Daunting and Consistent Math of Bubbles: It’s A Long Way Down
In the world of statistics, a 2 sigma event refers to something that occurs only 5% of the time. Using this framework, a market that is 2 sigmas above its long-term trend can be considered to be in bubble territory (or at the very least quite frothy). Using the same logic, a market that stands at 2 sigmas below its long-term trajectory can be thought of as mouth-wateringly cheap (or at least as somewhat of a bargain).
Founded in 1977, Boston-based Grantham Mayo Van Otterloo (GMO) is an investment management firm with roughly $75 billion in assets under management. It is well-known for its strong track record of asset allocation. The firm successfully identified and navigated both the tech bubble of the late 1990s and the real estate/financial bubble of 2006-7.
GMO analyzed the available data over financial history across all asset classes and identified more than 300 2 sigma observations. In developed equity markets, every single one of these observations over the past 100 years has fully deflated with prices falling back to their long-term trends. This pattern strongly suggests that:
- The higher markets go, the lower their expected future returns.
- The higher markets go, the longer and greater pain investors will have to endure to get back to trend.
Importantly, if you think that the recent decline in stock prices presents a golden opportunity to scoop up cheap assets, the fact that the S&P 500 currently stands about 40% above its long-term trend should be cause for sober second thought. This prospective downside is corroborated by Warren Buffett’s favourite valuation gauge, otherwise known as the Buffett Indicator, which is the ratio of the total value of the U.S. stock market to GDP. The indicator currently stands at 193%, which is approximately 50% above its historical average.
Make Mine a Triple
Using the 2 sigma definition of a bubble, in early 2021 it looked as if we might have a standard bubble. However, as the year progressed, the 2 sigma deviation progressed into an even rarer 3 sigma anomaly, which comes with an associated increase in potential pain.
Adding to concerns, real estate assets have arguably joined the bubble-party in stocks. Houses in the U.S. stand at the highest multiple of family incomes ever: even ahead of levels that prevailed prior to the housing bubble of 2006-2007. Alarmingly, this lofty multiple is lower than the corresponding level in other countries (Australia, the UK, China, and our very own Canada).
Lastly, global bond markets currently offer the lowest yields (and highest prices) in history. At best, this leaves investors with little chance of reaping any returns, and at worst leaves them facing a strong likelihood of suffering losses (particularly in real terms).
Taking these three observations together, the possibility that we are in the midst of three coinciding bubbles multiplies the potential for a major shock in the future, particularly if they burst simultaneously.
The Wizard of Oz and Valium: Where Markets Stand Today
The relentless printing of money and excessive liquidity with which central banks have flooded economies have functioned as Valium for markets by suppressing volatility. Ever since rates fell below the level of inflation following the global financial crisis of 2008-9, volatility levels have remained far below their historical averages. Over the past several weeks, the inflation genie has started to rear its ugly head, replacing the Valium of low rates with the amphetamine of rising rates, causing a spike in volatility and a decline in stock prices.
Nobody including ourselves can be certain regarding the future path of stocks, rates, or any other market. That being said, we are confident that the low volatility, one-way street markets of yesterday will not return for the foreseeable future. To quote Dorothy’s famous line in The Wizard of Oz, “Toto, I’ve a feeling we’re not in Kansas anymore.” From an investing perspective, it has become increasingly likely that for the first time in over a decade, we have entered an environment in which risk management may no longer be a four-letter word.
Every Dog Has Its Day, Even Wallflowers
Unsurprisingly, the recent uptick in inflation has been a boon for the TSX Composite Index due to its relatively heavy weighting in sectors such as energy and materials, which tend to outperform when inflation and rates are on the rise. In January, the TSX Index declined 0.4%, as compared to a fall of 5.2% in the S&P 500 Index, marking a stark reversal from its consistent underperformance since the global financial crisis.
The Outcome Enhanced Dividend Fund returned 2.4% in January, outperforming the TSX Composite Index by 2.8%. These results mark a continuation of the fund’s longer-term outperformance. According to the most recent S&P Index vs. Active Canada Scorecard, the fund has outperformed over 99% of its peers since its inception in October 2018.
The Outcome Global Tactical Asset Allocation (GTAA) fund has delivered mid-single digit returns while protecting our clients from large losses, both during the challenging markets of Q4/2018 and the Covid crash of early 2020. According to Wikipedia, a wallflower is “someone with an introverted personality type who will attend parties and social gatherings, but will usually distance themselves from the crowd and actively avoid being in the limelight.” During the one-way street of rising markets since the Covid crash, the GTAA’s return profile may have made it appear as a wallflower. However, when markets become less cooperative (as we expect to be the case going forward) these very same characteristics will prove remarkably attractive.
As Chief Investment Officer of Outcome Metric Asset Management, Noah Solomon has 20 years of experience in institutional investing. From 2008 to 2016, Noah was CEO and CIO of GenFund Management Inc. (formerly Genuity Fund Management), where he designed and managed data-driven, statistically-based equity funds.
Between 2002 and 2008, Noah was a proprietary trader in the equities division of Goldman Sachs, where he deployed the firm’s capital in several quantitatively-driven investment strategies. Prior to joining Goldman, Noah worked at Citibank and Lehman Brothers.
Noah holds an MBA from the Wharton School of Business at the University of Pennsylvania, where he graduated as a Palmer Scholar (top 5% of graduating class). He also holds a BA from McGill University (magna cum laude).
This blog first ran in the January 2022 issue of the Outcome newsletter and is republished with permission.