Vise 2021 mid-year investment outlook: Part 1
A year ago, the biggest question for investors was how would the market and economy rebound from the pandemic. Today some of the same concerns still linger; cases of the delta variant have crept up in recent weeks and markets are unsure of what to make of the new strain. But lately, there’s also been a focus on a slew of other things like meme stock and the housing market.
In the first of a two-part series, our investment strategy team recaps the first half of market activity in 2021 and discusses what the prevailing market narratives mean for investors. You’ll learn why value was never dead, how to view meme stocks, where cryptocurrencies may fit in a long term portfolio, and much more.
Small-cap value stocks have been on a tear since last year, and now some investors may be wondering when the hot streak will fizzle out. What are current premiums telling you?
Christian Boinske: One of the biggest lessons investors can take away from the first half of 2021 is how volatile market premiums can be over short periods. Look at value versus growth or small-cap versus large-cap, for example. At their peaks this year, small-cap value outperformed small-cap growth, large-cap value outperformed large-cap growth, and small-cap outperformed large-caps by as much as 27%, 14%, and 13.5%, respectively. If you look at the year-to-date returns through today, July 27, only small-cap value continued to outperform small-cap growth. That means large-cap value relative to large-cap growth and small-cap relative to large-cap gave back about 14% and 13% in returns, respectively.
Exhibit 1. Year-to-Date 2021 Cumulative US Equity Premium Performance
This only validates how difficult it is to predict short-term returns. When we think about building investment strategies, we design strategies that allocate to higher expected returns areas over the long term. Doing so serves our clients better than trying to predict short-term price movements.
**Travis Fairchild: **Our confidence in market premiums increases the longer you go out on the calendar. Anything a year or shorter, you can think of almost like a coin flip. Your chances of outperforming or underperforming using even the most well-researched market premiums are about 50/50. As you extend your time horizon from one to three years, your chances increase to about 60% to 70%. When you look at a 10-year period, you can have much more confidence that the premiums you use will outperform, especially in multi-factor models with value, profitability, and size. In short, your chances of outperformance depend on your time horizon and how you tilt your portfolios.
Dave Twardowski: Over a 30-year period, it was extremely unlikely that a tilted portfolio would have underperformed the market. With these portfolios, even though the average daily excess return is expected to be positive, investors should remember they won’t end up realizing premiums every day. The difference between realizing and expecting premiums comes from the higher volatility associated with higher expected returns. So even if you don't outperform over a quarter or a year, it doesn't mean you won't over a long time frame.
Christian: I took a look at the Fama French data, which dates back to 1963 or almost 60 years. If you missed the top 7% of trading days, you would end up with no value premium. The same holds for value, profitability, and size. Missing 7% of the best days causes your premiums to disappear.
Exhibit 2. Cumulative Gross US Equity Premium Performance, January 1963 to May 2021
So was value investing ever dead, as the popular narrative would have investors believe?
Dave: We don't think so. If the last year has said anything, it's said that the value premium can occur at any given time. We saw a strong pickup in value in the following months after the 2020 drawdown through the beginning of 2021.
The question now is not whether value is dead, but what is value? That's something we've tried to answer with Andrea Eisfelt, UCLA professor and member of the Vise academic committee. One way to increase your chances of capturing the value premium over time is to adjust for intangibles, knowing there are different accounting standards between growth companies and energy or utility companies. Those differences in accounting standards can make a measurable difference in the returns you can capture over the long term.
Over the past six months, there have been several investment manias: meme stocks, SPACs, Cryptocurrencies. How should investors evaluate these events?
Dave: We think about investing by sectioning things off into behavior and valuation-based metrics. As the name implies, valuation-based is associated with metrics that valuation theory suggests are related to long-term expected returns: profits, cash flows, prices. And then there is a behavioral component that we can't necessarily justify through a valuation model, but they do happen.
One of those interesting behavioral events is the meme stocks. The question there is can you do anything to capture profits in GameStop or the other meme stocks? And the answer is that they're so unpredictable that it's often difficult to figure out when these things are going to happen.
We're always trying to focus on building portfolios in a systematic way to capture higher returns, but at the same time, we know that events like GameStop do pose price risks. So when you look at purchasing a stock in your portfolio, you want to be cautious and aware of the short-term microstructure events in the market from a risk management perspective.
We think about how behavior translates into things we can do in the trading process to manage risks while adding incremental benefit to portfolios in a cost-effective way. One of those is this idea of signals intelligence, which basically allows you to capture behavioral components of prices in the trading process. You wouldn't construct a strategy on these signals in taxable accounts because they are too high turnover to be efficient, but they're aspects of the trading process you want to consider.
Being mindful of these trading filters is essential, but it's not something we think you can systematically profit on moving forward, which is why we consider it more of a filter rather than a portfolio building block.
Something like SPACs doesn't appear to pose a behavioral problem. Is there a valuation-based or another explanation for what's happening with SPACs?
Christian: It's an adverse selection problem. Normally, equities aren't on a timer to get a deal done or launch a new product. They may be on an implicit timer, but there's never an explicit one. With SPACs and how the deals are structured, if you don't have an acquisition target and some deal terms in 18 months, you generally have to return capital to investors. So if you think about the motivation for the managers running SPACs, as they reach the end of that timer, they're incentivized to get a deal done and not always the best one. It'd be interesting to see whether the companies that go public via SPAC become blue-chip companies or whether SPACs target distressed companies to avoid returning capital to investors.
Travis: It goes back to the valuation element that Dave spoke about earlier, where we're looking at stocks and comparing them to their peers on valuation metrics and fundamentals (e.g., profitability, cash flows, and expected growth). Comparing a SPAC to our investable universe on any of those data points is often impossible. Either the data doesn't exist yet or is difficult to acquire. Without the necessary information, we wouldn't be able to make an informed investment decision.
Dave: That's why you won't see SPACs or IPOs in our investment strategies. The limited amount of available information around the first year makes it difficult to understand patterns in returns. It's not just SPACs and IPOs, either.
Where do cryptocurrencies fall on the valuation and behavior spectrum?
Dave: The question for me is whether cryptocurrencies are a commodity or a security. If it's the latter, then what drives valuations? Part of what's happened in the space so far is a product of supply and demand. There's only a limited amount of Bitcoin by design so you often see wild price swings when demand increases. Over time, if there is still no way to value or model cryptocurrencies, it's hard to make a case for it being a worthwhile investment in the long term.
Christian: It comes back to what Dave said about valuations. Think about the two major evaluation theories; firm foundation theory and castle-in-the-air-theory.
Firm foundation theory says intrinsic value helps you understand the relationship between prices, expected future cash flows, and expected returns. A security’s price is a function of its expected future cash flows discount by some discount rate, or expected return.
Castle-in-the-air theory is rooted in supply and demand dynamics and psychology of the market. In other words, if I buy Bitcoin now, will somebody in the future be willing to pay me more for it?
I think about traditional equities and fixed income as investments and crypto and commodities as speculative assets. Maybe each asset has a role in a portfolio. Some people insist that Bitcoin can be a good hedge against inflation or an uncorrelated source of return. But I think we need some more data to understand where cryptos fit in a well-diversified portfolio.
In part 2, the investment strategy team shares their thoughts on the economy and policy. Is a new bubble forming in the housing market? Will rising coronavirus cases spook the market? How can investors combat potentially higher capital gains rates?
August 3, 2021