Abnormal Can Still Be Rational

November 22, 2017

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Benjamin Lavine, chief investment officer for 3D Asset Management.

On Nov. 15, 2017, we had the pleasure of participating in an Inside ETFs webinar panel (“What Happens When Volatility Returns: New Approaches to Profiting from the Inevitable”) moderated by Inside ETFs’ CEO Matt Hougan, which discussed the current low-volatility environment, whether current market risk pricing offers little if any compensation to investors, and whether/how investors can protect themselves in the event of a “risk blow-off.”

As part of our introduction, we reiterated our view—a view mostly anchored to efficient capital asset pricing—that factor (smart-beta) investing reflects a rational view of market-risk pricing.

In other words, there is a strong economic rationale for why investors are compensated for taking on certain types of market risk, whether single-market equity risk (beta) or risk factors such as size (small-cap), value, momentum, quality, etc. Fixed-income investing also offers risk premium versus risk-free cash such as term structure (interest-rate sensitivity) and credit (default) risk premiums.

If such premiums did not exist, then capital asset pricing would collapse into absurdity whereby a speculative biotech stock would offer the same expected return as a global pharmaceutical stock that would offer the same expected return as cash.

In addition, risk premiums can be time-varying, meaning they can expand and contract depending on stages of the economic cycle. Investors will generally demand higher premiums for taking on value and size risks during periods of economic uncertainty, because the earnings of companies that comprise these risk categories are viewed as more cyclical versus the general market and/or dependent on financial leverage.

Narrow Risk Premiums

And now, risk premiums are narrow, whether they are measured by equity market valuations, risky fixed-income credit spreads or the volatility priced in equity options. However, compressed risk premiums reflect a positive, stable outlook for the global economy. Investors do not require as high of a rate of return to be compensated for investing in risky assets.

Figure 1 displays the forward price/earnings multiples based on Bloomberg consensus analyst earnings estimates over the next 12 months. As the markets have advanced since the 2008 financial crisis, so have the earnings multiples, such that investors now only require an earnings yield of 5.25-5.50% (18x-19x P/E multiples inverted) to invest in the S&P 500 Index versus the 2.30-2.40% that can be earned with U.S. Treasuries and 1.90% with 12-month Libor.

This assumes that: 1) analysts are correctly predicting next year’s earnings growth (estimate at ~10% based on the 11/17/2017 edition of Factset Earnings Insight); and 2) the investor has a long-enough time horizon to improve the probabilities that such risk premiums will be captured. 

 

Figure 1: High Global Equity Valuations Imply Lower Rates of Return (through 11/16/17)

Falling Risk Premiums Can Be Rational

For a larger view, please click on the image above.

 

Does Today’s Low Risk Environment Make Sense?

At one point during the panel discussion, Matt Hougan asked us whether today’s compressed risk premium environment can be considered “normal.” Another way of posing that question is to ask whether investors are being “fairly” compensated for taking on equity and fixed-income risk. Our response is that today’s risk environment may not seem normal or fair, but it can be considered rational given what is publicly observed in today’s economic environment.

At the micro level, one can always point to pockets of the market experiencing irrational pricing (Grant’s Interest Rate Observer makes a living out of identifying these pockets, as do many short investors).

 

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