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Good morning. Neither the S&P or the Nasdaq hit an all-time high on Wednesday. Is something wrong? Email me: robert.armstrong

Retail flows (part 2)

Way back on Tuesday I wrote about the spectacular surge of investor flows, particularly retail investor flows, heading into stocks. Here is yet another chart, this one from Strategas, that indicates how extraordinary the trend is. It compares flows into equity exchange traded funds for each of the past 15 years.

One of these years is not like the others, and it is 2021. And this is happening at a time when equity mutual funds are not losing assets to ETFs as quickly as in most years, making it all the more remarkable. Here is how Todd Sohn of Strategas described the phenomenon to me: 

It’s the persistency of the equity rally, up 100 per cent since last March with barely a pullback. It’s everybody into the pool, it’s everything, every region, every sector.

It’s not quite every sector, Sohn allows. The cyclical sector ETFs that started the rally as rates were rising have seen flows cool lately, consistent with the whiff of fear around the edges of this rally. But the size and direction of the trend remains remarkable.

Indeed, investor positioning and sentiment is bullish enough that it has many Wall Street strategists spooked. I asked Sohn if the pool party worried him. He said the thing he watches is market breadth. When the indices keep going up but are supported by only a few names (the Faangs, say), he gets nervous, pointing to 2015 as an example of breadth collapsing and a sharp correction following. One measure of breath is the portion of stocks hitting three-months highs. On this measure, this market looks so-so at best (see the bit at bottom right):

I also asked Nikolaos Panigirtzoglou, the JPMorgan strategist who was the source of Tuesday’s charts, about the stability of a market amped up on huge flows. His view is that portfolio rebalancing by big institutional investors could ultimately constrain the market.

As the retail frenzy drives share prices up, institutions find themselves inadvertently overweight equities, so they are more than usually likely to sell stocks, taking profits, to hold cash or buy bonds. Here is Panigirtzoglou’s estimate of the composition of the global portfolio, that is, all the stocks, relative to all the bonds and cash:

Panigirtzoglou told me:

If you look at this chart there have been diminishing peaks. Yes, there is a lot of liquidity in the system, but relative to the size of the equity market, it is actually pretty low, and that is a warning sign. [The share of wealth in equities] can keep going up, but we are reaching territory where if sentiment changes for retail investors the vulnerability is very high.

Attentive readers will notice that the share of equities declined sharply from its 2018 peak, even before Covid came along, and markets remained stable. But this was because bonds rallied, too, saving investors the work of rebalancing. Things may be different this time.

I’m not quite sure how much these observations about market breadth and rebalancing add to the simpler points that the bull market is old, valuations are very high, and massive inflows cannot last for ever. But I’ll be watching both indicators. 

Final comments (really) on private equity

Two last thoughts on PE before I leave the topic alone for a while.

PE as regulatory arbitrage. I have described PE as “leveraged equities”, and I had heard it said that the reason that many institutional investors don’t simply lever up their equity portfolio and skip out on paying 2 and 20 to a PE manager is that the law forbids it. But I didn’t know the details. Edward Finley, finance professor at University of Virginia, JPMorgan alum, and former trust and estates lawyer, filled me in on the details. There are several levels:

  • Whenever a tax exempt entity, such as an endowment, earns income using debt financing, that income must be reported to the Internal Revenue Service as unrelated business taxable income (UBTI), which is a massive hassle to monitor and report. Hire PE and you skip all that. 

  • A law called the Uniform Prudent Management of Institutional Funds Act contains vague language about limits on the amount of leverage charities can use in their investments. If a charity does want to use leverage, it has to hire a lawyer to figure out if they are in bounds, and it might not be. Hire PE and you skip all this, too.

  • IRS rules say that if a non-profit has a substantial amount of UBTI, that entity loses its tax-exempt status (this is to prevent charities from simply buying operating businesses and competing unfairly with taxpaying ones). Of course, “substantial” is not defined, so its back to the lawyers. Why not skip it and get PE leverage instead? 

So, if you want leveraged equity returns in your endowment fund, it’s much easier to get them through PE. But I don’t imagine that would be the biggest barrier to an endowment manager borrowing to buy stocks. The biggest barrier would be having the, ah, guts to walk into the boardroom and propose leveraging the University’s equity portfolio by 60 per cent. Even if that hurdle were passed, the manager would have to live with massive daily volatility which would have been hidden if they had done the easy thing, and handed the money over to PE, and paid 2 and 20.

The persistence of PE returns. When Unhedged pointed out that PE returns over the past decade look, on average, just like public market returns, readers objected, saying one must invest with top-tier managers to get outperformance. This implies you can tell in advance which managers are top tier; that is to say, it must be that a manager whose last fund outperformed has a better-than-average chance of outperforming in their next fund. This is called “persistence”.

Is this true? The most recent study I could find on the topic was this one (from Harris, Jenkinson, Kaplan & Stucke). It looks at data on cash flows from 2,200 funds through to the end of June 2019. The interesting thing about the study is that it looks for persistence based on data that would be available to investors at the time they invested in a given fund, not all the information available after the fact about all fund returns. In other words, PE manager X markets its most recent fund when its previous fund is only partway through its life; the study considers whether the partial results from the prior fund(s) provide a clue to the performance of the next one.

They don’t. While persistence is visible in the after-the-fact data, it is invisible from investors’ real-time point of view:

For buyout funds with post-2000 vintages, performance persistence based on fund quartiles disappears. When funds are sorted by the performance quartile of the general partner’s previous fund at the time of fundraising, performance of the current buyout fund is statistically indistinguishable regardless of quartile.

Be careful out there.

One good read

Brendan Greeley on 9/11.

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