Will twenty-twenty see a one-eighty?

QUAERO Capital - Value
Photo by Nick Youngson. CC BY-SA 3.0. Alpha Stock Images

On the long run, financial markets are driven by two major, opposite forces: value and trend. As we are crossing into a new decade, we might be at a turning point, when the former overcomes the latter.

On medium to long time scales, there are two major, opposite, drivers of financial asset prices: value and trend. The first one is what differentiates financial markets from a casino: when an asset is cheap with respect to its fundamentals, one should expect that its price will eventually go up; similarly, one should expect that when an asset is expensive its price will eventually go down, or stagnate until the fundamentals catch up. This is basically what financial markets are all about: if they are to play any role in efficiently allocating savings to investments, they cannot be a pure random game; there must be a pretty tight link between fundamental value and price. And there is: financial markets do price at any time virtually all financial assets at the correct order of magnitude, typically with no more than a 50% error. This may look like a shockingly large inaccuracy, especially if one thinks about the accompanying risk of loss in case of mispricing. However, to put it into perspective, if I were to ask someone about the volume of water in the oceans or the number of ants on Earth and they gave me an answer which was less than 50% off the right value, I would say they are pretty spot on. Similarly, if I were to ask about the price of 500g of bread in Switzerland, I am very likely to get answers that vary by more than 50% from each other (typically between 2 and 4 francs), but at least I would know it is not 30 cents or 30 francs.

One of the most enduring and universal features of financial markets is that price movements tend to persist

Now, given the size of the financial sector and the enormous amount of resources, both human and technological, that it has at its disposal, one could expect a bit more accuracy, especially for very liquid assets that trade at a micro-second scale. This brings me to the second price driver: trend. One of the most enduring and universal features of financial markets, which has been observed for more than 200 years across all asset classes, is that price movements tend to persist: if the price of an asset goes up, it tends to keep on going up for a while, and similarly on the way down. This is also true cross-sectionally, i.e. when looking at an asset or a group of assets against another. This observation clearly goes against the Efficient Market Hypothesis and is generally explained by behavioural elements. Typically, humans, and therefore investors, tend to be gregarious: given the fact that the real fundamental value of an asset is anyway not a sure thing, it makes sense to remain close enough to the rest of the crowd so as not to be left alone underperforming. This is even more true for professional intermediaries who want to manage their career risk. A related reason for the presence of trends in markets is that of extrapolative expectations: when trying to forecast the future of a complex world, many people apply a heuristic method that basically linearly projects the past into the future. Another explanation for this anomaly is related to conservative biases, which tend to make investors underreact to new information, which therefore only gradually makes it into prices, rather than instantaneously.

Correctly identifying the changes of direction in financial markets is the holy grail of asset allocators

Whatever the reason for the presence of trends, it makes sense for rational investors to give themselves some margin of error before placing a contrarian trade. Consequently, small deviations from fundamental value are unlikely to be arbitraged away, which allows for trends to push prices significantly off their “correct” level before value investors start seeing an opportunity and trend-followers a risk. At that point the tug-o-war between trend and value starts to stabilise and eventually drifts in the opposite direction. Correctly identifying these changes of direction is the holy grail of asset allocators and is objectively impossible to time perfectly. That being said, a patient investor – but can you really be an investor if you are not patient? – should not worry too much about the risk of starting to invest before the exact turning point, as these tidal changes typically start with very large moves over a relatively short period of time, typically several standard deviations over a few months.

As we are entering a new decade, we might be facing one of these pivotal moments

As we are entering a new decade – technically-speaking, the end of the second decade of this millennium is actually the 31st of December 2020, but that is irrelevant to my point – we might be facing one of these pivotal moments, not for one but for several asset classes and factors. By and large, during the last 10 years a few market trends have pushed absolute and relative asset valuations to extreme corners, with 2018 and 2019 representing their last, exacerbated stand. Most significantly, global short-term and long-term interest rates have been trending downwards reaching during the last summer levels that would have been deemed unconceivable not so long ago. This is even more noteworthy because rates are not only extremely low on a nominal basis, but real rates are also very low, especially in Europe where they are well below zero. Obviously, this is to some extent the consequence of central banks’ market interventions. However, investing is ultimately about relative preferences. Consequently, relative performances do tell you something about investor-driven trends irrespective of liquidity injections. In that respect a less-mentioned trend is that, despite a very strong equity rally, global bonds have actually outperformed equities on a risk-adjusted basis, especially in Europe and Japan, creating a massive valuation gap between bonds and equities. Then, within equity markets, it is quite clear that investors have preferred safety, i.e. large caps, low volatility stocks and quality companies (that is companies with high profitability, low leverage and stable earnings). They have also looked for sources of growth in a low global growth environment, favouring US equities and growth equities. These preferences have generated such strong trends that today we are in a situation where relative valuations are at multi-decade extremes. It is worth mentioning a few examples. The ratio of European equities’ price-to-book ratio to that of US equities has nearly reached 0.5, a level well below anything seen in more than thirty years. Price-to-earnings ratios of growth stocks relative to value stocks are also at historical highs, especially in Europe where they have reached levels reminiscent of the dot-com bubble. Globally, when looking at price-to-book ratios, growth and quality equity indices are more than twice as expensive as they were 5 years ago, whereas value and small cap companies are pretty much priced at the same level. And the list goes on.

If asset prices are extremely low or high, they do revert even in the absence of a clear trigger

All these market movements have been consistent with investors looking for what they considered to be the best assets in a precarious economic environment. As these trends have now led to extreme relative valuations, any change in the macro-economic outlook might be the trigger for a trend reversal. So, what could such a trigger be? In my opinion, the most likely would be the prospect of a bigger-than-expected fiscal stimulus in Europe, possibly related to a “Green New Deal”. Another possible trigger would be higher long-term rates due to a pick-up in global inflation. And what should you buy in that case? Exactly what investors have shunned in recent years: for example, European, small-cap, value stocks, ideally with underappreciated “hidden” qualities, a space we know very well here at QUAERO CAPITAL. But to be fair, irrespective of your scenario for the future, at some point, if asset prices are extremely low or high, they do revert even in the absence of a clear trigger, just on the mere basis of their relative appeal or unattractiveness. And as a matter of fact, for the last few months, some of the trends of the last decade have already stabilised or even reversed: long-term rates are up since their summer trough, low volatility stocks have underperformed in the last few months, whereas small caps have performed in line with large caps. Will you wait for these new trends to be confirmed before modifying your portfolio allocation or, have you already started to buy low as you are confident that you will eventually sell high? I guess the answer depends on whether you are a trend-follower or a value investor.

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