8 minA portfolio manager's dilemma
Guy Wagner Over the first nine months of the year, the global equity index (MSCI World) has risen by some 12% in euro terms, erasing a large part of its 2022 decline. This good stock market performance may seem surprising. Many managers admit that if they had been told at the beginning of 2022 that the Federal Reserve would raise its key interest rate by more than 5%, they would have replied that stock prices would plunge. All the more so as equity valuations were high at the end of 2021. However, after correcting in 2022, markets quickly recovered and are now close to their all-time highs. How can this be explained?
A first element of the answer lies in the resilience shown so far by the global economy. While a slowdown is clearly evident in some regions and sectors, the US economy - by far the most important for financial markets (in economic terms, but also in terms of investor sentiment) - has so far escaped recession. Similarly, the service sector has continued to record positive growth in most regions, benefiting from what some are calling a YOLO (You Only Live Once) effect, born of the pandemic and prompting people to travel or eat out. However, it's not certain that this resilience will last. History shows that there is normally a lag of some 18 months between the start of monetary tightening and the moment when this tightening is really felt in economic activity, sometimes more, sometimes less. We live in a world where everything is supposed to move fast. It is therefore logical that many market participants have come to the conclusion that, since the recession has not yet arrived, it never will. The reality, however, is that most economic indicators show a fairly classic pattern: weakness in sectors directly affected by rising interest rates first, followed by weakness in the manufacturing sector, and only afterwards an impact on the service sector. The labor market is a lagging indicator, reflecting the economy's past performance. The unemployment rate is generally at its lowest when a recession begins.
Less important fundamentals?
A second factor behind the good performance of stock markets could be that the factors that have historically determined stock market trends - corporate earnings and valuation levels - have lost their importance, at least temporarily. As far as corporate earnings are concerned, investors seem to want to focus whatever the cost on a positive interpretation of things, using the comparisons and figures that suit them best - quarterly, annual, analysts' estimates, etc. The fact is, however, that in the second quarter, S&P 500 company earnings for example were down by some 5% on the second quarter of last year. A clear slowdown in earnings growth can also be observed in the technology sector. Yet the market continues to value the sector's major companies as if they were still experiencing the same earnings growth as in the past. The emergence of artificial intelligence plays an important role in this. Generally speaking, investors love themes that stimulate their imagination and in which they can project infinite possibilities and high growth rates.
As for valuation levels, they have risen again, despite continued monetary tightening by central banks. In fact, this increase in multiples accounts for the vast majority of the rise in stock prices since October 2022. In many cases, multiples are now well above the historical average. While high multiples may have been justified 18 months ago by what some called TINA (There Is No Alternative), given the low or non-existent yield on fixed-income investments, investors now clearly have alternatives. The fact remains, however, that high valuations have never been enough to drive markets down. They only accentuate the decline once the movement has begun. They therefore play a crucial role in long-term market performance, but not in short-term returns.
Why have fundamentals apparently lost their importance? First of all, there's the craze for indexing. In an environment increasingly dominated by a passive approach, company valuation is becoming secondary. On the contrary, the greater a company’s valuation, the greater its weighting in certain indices. As a result, they reap an increasing share of every dollar or euro invested in these indices, while the opposite is obviously true for companies whose prices and valuations are falling. Whereas an active manager tries to take advantage of low valuations to acquire a company's shares, passive management does the opposite: rise leads to rise, fall leads to fall. Then there is the fact that investors like to stay in their comfort zone and hold assets they feel comfortable with. And the assets they feel comfortable with are usually those that have performed well in the recent past. And the assets that have performed best since the 2008 financial crisis are undeniably US equities, starting with technology stocks. The latter are thus benefiting from both their strong performance of recent years and their ability to stimulate investors' imagination. Notwithstanding the rise in US interest rates and the returns now being offered by money market and bond investments, many investors are finding it hard to part with them. A final acronym explains their behavior: FOMO (Fear Of Missing Out), the fear of not participating in any further rise in these stocks. What's more, many of these investors have never experienced a recession or a long-term bear market. Conversely, a market such as Japan, which peaked in the early 1990s, is finding it hard to attract long-term capital, despite its attractive fundamentals and valuation. While investors are prepared to give the US market the benefit of the doubt, they will sell the Japanese market at the first sign of trouble.
Evolution of the S&P500 index between 1966 and 1982
Source: Bloomberg
Each generation of investors grows up in a specific market regime, which it ends up internalizing and using as a reference. An investor who began his career in the mid-1960s will have experienced a US market that essentially stood still for almost 20 years, but with significant fluctuations (in 1982, the S&P 500 index was at almost the same level as in 1965). Over time, he will therefore have been conditioned to adopt a strategy of selling the market after a bull phase, and eventually buying it after a bear phase. The idea that equities could be the best long-term investment would have been foreign to him. In 1979, BusinessWeek magazine published an article entitled 'The death of equities', at a time when the valuation of the US market was near an all-time low. The fact that the market was trading well below its historical average didn't interest many people. 40 years on, a generation of investors who have experienced a spectacular rise in indices, interrupted only by short-lived declines, swear by equities despite valuation levels well above the historical average. Old habits die hard.
Back to a low-rate environment?
A third factor explaining the resilience of the markets is that many investors continue to implicitly assume that interest rates will not remain at current levels, and that the Federal Reserve in particular will soon be easing its monetary policy. The idea here is that debt levels and financing requirements are so high that persistently high interest rates in real terms would be a major problem. While this argument makes a lot of sense, recent statements by the Federal Reserve show that it clearly intends to keep rates at current levels for an extended period, and even to raise them further. It would take a major slowdown in economic activity and/or a major financial accident to change its mind. Neither would be good for stock markets.
Finally, it's worth pointing out that in many cases, the rise in the index is not representative of market behavior as a whole. In the United States, for example, the S&P 500 index is driven upwards by a limited number of stocks, starting with the major technology stocks, which have been given a new lease of life by the artificial intelligence theme. We have therefore reached a stage where 1.5% of S&P 500 companies (7 out of 500) account for almost 30% of the index. Over the first nine months of the year, the S&P 500 was thus up by almost 12%, while the S&P 500 Equal Weighted Index (which gives equal weight to each of the 500 stocks) remained unchanged.
S&P 500 and S&P 500 Equal Weight over the first 9 months of the year
Source: Bloomberg
In some respects, the current situation is reminiscent of 1999. Stock markets are rising despite higher interest rates, rising oil prices and a stronger dollar. Indexes are being driven up by a limited number of stocks, largely from the technology sector. In 1999, the major theme was the Internet and the emblematic company Cisco Systems. In 2023, the theme is artificial intelligence and the iconic company NVIDIA. In 1999, Cisco's share price was up by over 100%, while Nestlé's was down. In 2023, NVIDIA's share price is up by almost 200%, while Nestlé's is down. Cisco's share price has still not risen above its March 2000 level (even though the company's profits have risen sharply). Nestlé's price meanwhile has risen from CHF 30 to CHF 103.
What strategy should a professional portfolio manager adopt in such an environment? Play the relative-performance game by buying expensive stocks favored by investors, with the risk of not getting out in time? Respect fundamentals and try to find neglected assets that are attractively valued, but with the risk that they will continue to underperform? A manager opting for the first strategy risks losing his clients a lot of money. A manager opting for the latter risks losing his clients before the markets finally prove him right. This is the eternal dilemma of the professional manager.
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