Is now really the time to throw in the towel on active management?
When Trump addresses Congress this evening, global investors will be looking for more than promises. US equity investors are now waiting to price in the delivery of markedly higher US corporate profits. Market indices look expensive and thus the fortunes of passive investors seem unusually reliant on political outcomes; is it really the time to throw in the towel on active management?
It now appears from recent press briefings that the proposal to boost US defence spending to be announced later today will also defer any economic stimulus, perhaps as concerns over the US national debt grow. Tax reform is now said to be behind the complex repeal and replace of Obamacare in the legislative agenda, and may only be considered by Congress over the summer. The bond market is taking note as US 10y rates have declined modestly over the past month, as the steam comes out of the Trump reflation trade.
Political developments would be of much less consequence were US equities not at exceptionally high multiples of book value and earnings. This is not an overvaluation restricted to the large-cap segment of the US market either. When we calculate the median price/book valuation for non-financial US equities, we find that current trading levels are well above historical norms, Exhibit 1.
Valuation analysis is in our view the oldest form of behavioural finance and as such cannot prescribe a specific future trajectory for stock prices, but can inform medium-term return expectations. The association between higher valuations and lower expected returns even over a 3-year period is clear over the last 25 years. On average, regression to the mean would suggest that US equity markets may give up all of the benefits of earnings growth to multiple compression over the next three years. Such a significant reduction in the risk premium offers in our view little compensation for the risks of a Fed tightening cycle, which in the past has often created a slowdown or recession in US economic activity.
With valuations at current levels, it is also may be time to challenge the current consensus which strongly favours passive investments over active management, if judged by the very large share of equity inflows passive investments now enjoy. We would frame the question in the following way:
“If the economy is a disaster, the stock market has crashed and there is currently a high degree of fear and scepticism in terms of the outlook - but you believe monetary policy will prove the worst fears unfounded, would you:
a) Buy a bank to benefit from lower than expected loan losses
b) Buy a mining company to benefit from a rebound in commodity prices
c) Buy a large-cap pharmaceutical company which has sold off as investors used it as source of portfolio liquidity
d) Buy a less known company currently in a poorly understood restructuring process”
We believe the correct answer would in essence be (a), (b) and (c) - but perhaps not (d). A very company specific investment such as (d) might not perform at all even as the macroeconomic environment improved. The cheapest way to implement such a macro strategy would be an index fund. In fact, passive index funds have proved very hard for active managers to beat over the last 7 years.
However the situation is now very different from that outlined in our stylised question. As we have discussed above, there are rational reasons to believe the US index performance may disappoint over the next three years due to the combination of very high valuations and the headwinds of tighter US monetary policy.
If we believe index underperformance is likely, then the answer is to either to reduce exposure to the equity market in favour of lower-risk investments or to become a much more active investor focused on less well understood situations and securities, assuming that can be done at a reasonable cost. We feel the active versus passive debate – as helpful as it is for focusing on the impact of cost on investment performance – is at risk of relying too heavily on recent past performance. Past performance may of course not be an accurate guide to the future. In our view, the correct balance between active and passive management is dynamic and contingent on market conditions.
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