The very strong equity market gains and low volatility in Q3 made it a quarter in which few hedging strategies of any sort could demonstrate their benefits, continuing the trend that began in Q4 2012 with the latest round of quantitative easing(QE). As you know, we have studied the recent periods of QE in depth and have assessed their impact on U.S. equity market dynamics and on our strategies. We thought it important to share with you some of the evidence of this impact. Our view is that Federal Reserve Bank (FRB) liquidity has been a major driver of stock market gains since 2009, and it has dampened volatility to a level not consistent with long run stock market behavior. It has also altered the relationship between volatility and returns. We believe this effect is temporary and that more typical levels of volatility will return with the advent of the FRB’s eventual taper. In the meantime, this quarter we have enhanced our Navigator and Mariner strategies to minimize the negative impact of QE on their performance. Finally, we make the case in this note that stocks are not likely to continue their blistering pace of 2013, and that they could experience a meaningful correction once the taper is underway.
First, consider the chart above. The green line is the ‘Securities held outright’ portion of the FRB’s balance sheet (left axis), which represents the cumulative dollar value of easing, and the purple line is the S&P 500 index (right axis). Cumulative asset flows into domestic equities via ETFs and mutual funds (blue and red lines respectively) have been negative since January 2008 and are therefore unlikely to have been the driver behind stocks’ gains during this time. However, returns in U.S. equities correlate remarkably with the FRB’s three QE programs. The mechanism by which QE drives positive returns across asset classes, particularly equities, is called the “Portfolio Balance Channel,” and was described by Ben Bernanke in his 2012 Jackson Hole speech:
“Federal Reserve purchases of mortgage-backed securities (MBS), for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields decline as well. Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy.”
Returning to the above chart, notice that since the S&P 500 bottomed in March 2009, the two steepest corrections have occurred coincident with termination of previous FRB easing programs. Significant negative economic news contributed to these corrections - the emergence of the Eurozone debt crisis in April 2010, and the U.S. credit rating downgrade in July 2011. However, we believe that the termination of FRB easing was a significant contributor, and that the upcoming taper of QE3 will be accompanied by a similar equities correction.
Second, QE has had significant impact on stock market volatility. Each of the three QE programs caused volatility (as measured by the standard deviation of S&P 500 daily returns) to fall by more than a third relative to the non-QE period preceding it, while simultaneously causing average daily returns to increase significantly. In fact, both QE2 and QE3 caused volatility of daily returns to fall below 0.80%, well below the pre-crisis level of 1.00% (measured from 1990 through 2007).
The following chart demonstrates that QE has also altered the relationship between volatility and realized returns.
We sorted every two-week period from Jan 1990 through Sep 2013 into deciles by volatility of daily returns, and then plotted the median daily returns of each decile. The blue bars represent all periods occurring outside of QE programs; the red bars represent all periods occurring during QE programs. The non-QE periods (blue bars) show a relationship that one would expect - average realized returns are worst, and negative, in the most volatile periods. In fact, this relationship between volatility and returns is a key attribute that our system exploits - it is designed to position our clients defensively during periods of market stress, therefore capitalizing on these negative returns. The red bars show something very surprising - when QE is in effect, the highest volatility periods result in strongly positive returns. It is this unexpected impact of QE that we referred to in our last quarterly note as ‘a temporary repeal of market forces.’
Current economic environment
We do not make investment decisions based on our assessment of macroeconomic conditions. However, we do follow them closely. At certain times we think it useful to review conditions for our clients and to offer our opinion of what the future holds for equities and for our strategies. Despite the strong stock market performance throughout 2013, underlying economic performance this year has been mixed, and we believe stocks are becoming overvalued as a result of ongoing QE. Our view is that, with profit margins at historic highs, revenue growth virtually flat in 2013, and S&P 500 P/E multiples at levels normally seen only in periods of simultaneous strong economic growth and falling interest rates, stocks are vulnerable to a correction.
July economic data were mixed. Positive data included a return of U.S. automakers’ sales to pre-crisis levels, and a healthy 56 reading for the services PMI index. However other data made it clear that the economy was still struggling. As the second quarter earnings season got underway, the negative pre-announcement ratio of 6.5 (6.5 negative pre-announcements for each positive one in the S&P 500) was the worst it has been since Q1 2001. New home sales fell 13.4% in July and June new home sales were revised down steeply. New job creation was weak at 162,000 jobs; unemployment fell to 7.4%, driven mainly by declining workforce participation.
In early September, a wealth of economic releases suggested the economy was continuing to improve at a slow pace, but without benefit to employment. Personal incomes grew at their fastest pace in six months, consumer spending increased, and both the services and manufacturing PMI indices rose to new highs. Once again, unemployment declined slightly due to a further shrinking workforce. Later in September, the FRB announced that it would not yet begin to taper QE3, and it reduced by 0.3% its projection of U.S. GDP growth in both 2013 and 2014.
Mark Hulbert, editor of the Hulbert Financial Digest and a frequent investing columnist for Barron’s and the New York Times, has produced two separate assessments of current stock market conditions and the potential for a correction. In a July 2013 analysis of P/E ratios using Robert Shiller’s (this year’s Nobel laureate) database of historical domestic equity returns, Hulbert determined that trailing P/E ratios have averaged 17.5 during secular downtrends in long term interest rates, and 12.8 during uptrends. The implication is that, with a secular uptrend in rates likely to commence concurrent with the FRB’s QE taper, stocks could correct quickly to a lower multiple.
In a Barron’s article that same month, Hulbert compared the current bull market to 35 bull market tops dating back to the 1920s. He found some important similarities to today’s market:
The average bull market has gained more than 21% over the 12 months prior to a top, versus the S&P 500’s 23% annual return as of July
Trailing P/Es at bull market tops average to 18.7, vs. the S&P 500’s July reading of 17.9
Low price/book (P/B) stocks outperform high P/B stocks in the 12 months preceding the top by an average of 2:1. As of July, this outperformance for the S&P 500 was closer to 3:1.
Finally, we point out a valuation metric reportedly favored by Warren Buffett, the ratio of total U.S. market cap to U.S. GDP (see below chart, from Vectorgrader.com, comparing this metric to the S&P 500).
Past peaks in the ratio have coincided with 4 the onset of bear markets. This ratio is currently exceeding its second highest peak period since 1950, surpassed only by its level achieved in the technology bubble. We see this as an indication that U.S. stocks are richly valued, although we recognize that the growing importance of international revenue to S&P 500 companies may also be contributing to this elevated level.
In sum, we believe that ongoing FRB liquidity is distorting equity market behavior and valuations in meaningful ways. Our strategies, and the protections they aim to provide, continue to be an important part of an investor’s portfolio.