Absolutely everyone is buying stocks, for now
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Hello. Neither the S&P nor the Nasdaq hit an all-time high on Wednesday. Something is wrong? Send me an email: robert.armstrong
Retail feed (part 2)
Last Tuesday, I wrote about the dramatic increase in investor flows, especially retail investor flows, heading into equities. Here is yet another chart, the one from Strategas, which shows how extraordinary the trend is. It compares the flows in exchange traded funds for each of the past 15 years.
One of those years is unlike any other, and we are in 2021. And this is happening at a time when equity mutual funds are not losing assets to ETFs as quickly as most years, which makes it all the more remarkable. Here’s how Todd Sohn from Strategas described the phenomenon to me:
It is the persistence of the rally in equities, up 100% since last March with barely a decline. It’s everyone in the pool, that’s it, every region, every sector.
It’s not quite all industries, admits Sohn. Cyclical sector ETFs that started the rally as rates rose fear on the edges of this rally. But the size and direction of the trend remains remarkable.
Indeed, investor positioning and sentiment are sufficiently optimistic that many Wall Street strategists scared. I asked Sohn if he was worried about the pool party. He said what he is watching is the extent of the market. When the indices keep going up but are backed by only a few names (the Faangs, say), he gets nervous, citing 2015 as an example of a collapse in magnitude and a sharp correction that follows. A measure of breath is the portion of stocks reaching three-month highs. On this metric, this market looks average at best (see the bit at the bottom right):
I also asked Nikolaos Panigirtzoglou, the JPMorgan strategist behind Tuesday’s charts, about the stability of a market amplified by huge flows. His view is that the rebalancing of the portfolio by large institutional investors could ultimately constrain the market.
As the retail frenzy drives up stock prices, institutions inadvertently find themselves overweighted in stocks, so they are more likely than usual to sell stocks, take profits, hold cash or buy bonds. Here is Panigirtzoglou’s estimate of the composition of the overall portfolio, i.e. all equities, compared to all bonds and cash:
Panigirtzoglou told me:
If you look at this chart, there have been some decreasing peaks. Yes, there is a lot of liquidity in the system, but relative to the size of the equity market, it is actually quite low, and that is a warning sign. [The share of wealth in equities] may continue to rise, but we are reaching a territory where if sentiment changes for retail investors, the vulnerability is very high.
Attentive readers will note that the share of equities has fallen sharply from its peak in 2018, even before Covid arrived, and markets have remained stable. But that was because bonds also rallied, sparing investors the work of rebalancing. Things may be different this time around.
I’m not sure exactly how much these observations on the market spread and rebalancing add to the simpler points that the bull market is old, valuations are very high, and massive inflows cannot last forever. But I will be watching both indicators.
Latest comments (really) on private equity
Two final thoughts on PE before leaving the subject alone for a while.
The EP as regulatory arbitration. I described PEs as ‘leveraged stocks’, and I had heard that the reason why many institutional investors don’t just increase their equity portfolio and pay 2 and 20 to a PE manager is prohibited by law. . But I didn’t know the details. Edward Finley, professor of finance at the University of Virginia, alumnus of JPMorgan and former lawyer specializing in trusts and estates, gave me 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 very complicated to monitor and report. Hire PE and you skip it all.
A law called the Uniform Prudent Management of Institutional Funds Act contains vague language about limits on the amount of leverage that charities can use in their investments. If a charity wants to use leverage, it needs to hire a lawyer to determine if it is within limits, and it may not be. Hire PE and you avoid all that too.
IRS rules state that if a non-profit organization has a substantial amount of UBTI, that entity loses its tax-exempt status (this is to prevent charities from simply buying operating businesses. and compete unfairly with those who pay taxes). Of course, “substantial” is not defined, so it’s the back to the lawyers. Why not ignore it and get PE leverage instead?
So if you want returns from leveraged stocks in your endowment, it’s much easier to get them through PE. But I don’t imagine that would be the biggest hurdle for an endowment manager who borrows to buy stocks. The biggest hurdle would be having, uh, the courage to walk into the boardroom and offer to leverage the University’s stock portfolio by 60%. Even if this hurdle was cleared, the manager would have to live with massive daily volatility that would have been hidden if he 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 have, on average, resembled public market returns, readers took issue, saying you need to invest with top managers to outperform. This means that you can know in advance which managers are top-notch; that is, it must be that a manager whose last fund outperformed has an above-average chance of outperforming in his next fund. This is called “persistence”.
Is it true? The most recent study I could find on the subject was this one (of Harris, Jenkinson, Kaplan & Stucco). It looks at the cash flow data for 2,200 funds up to the end of June 2019. The interesting thing about the study is that it looks for persistence on the database. that would be available to investors when they invest in a particular fund, not all the information available after the fact about all fund performance. In other words, the PE X manager markets his most recent fund when his previous fund is only halfway through its life; the study examines whether the partial results of the previous fund (s) provide an indication of the performance of the next one.
They don’t. While persistence is visible in the data after the fact, it is invisible from the real-time perspective of investors:
For buyout funds with post-2000 vintages, the persistence of performance based on fund quartiles disappears. When funds are sorted by performance quartile of the previous general partner’s fund at the time of fundraising, the performance of the current buyout fund is statistically indistinguishable regardless of the quartile.
Be careful there.
A good read
Brendan Greeley September 11th.