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).


However, macro-level irrational pricing is extremely rare, and one would be hard-pressed to identify today’s low-risk environment as irrational. In this period of record-low volatility, the recovery in global economic growth from the 2015 commodity price collapse scare has produced a more stable backdrop in which lower volatility can be priced into historically risky assets.

Is this notion of fair versus rational just a matter of semantics? Not necessarily. Investors need to be mindful of the difference.

My own judgment could be that today’s credit markets are expensive and do not adequately compensate fixed-income investors for default risk. But my personal judgment of what constitutes normal or fair pricing is just one opinion that feeds into aggregate market pricing.

The majority of other fixed-income investors likely feel comfortable with the thin margins priced into credit risk. Does this euphoric sentiment rise to the level of irrationality given the context of the global economic environment? Market pricing may be unfair or abnormal, but not necessarily irrational.

One could argue that credit markets are irrationally pricing in default risk if the spread for compensating default risk is extremely low versus the expected default outlook. For instance, prior to last week’s sell-off, high-yield credit spreads (above risk-free fixed income) dropped below 3% in late October (Figure 2), even though Moody’s is projecting 2.3% default rate over the next year.


Figure 2: Fixed-Income Credit Spreads: Expensive But Irrational?

Falling Risk Premiums Can Be Rational

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


Investors don’t seem to be “fairly” compensated for sub-3% credit spreads in the face of 2.5% expected default risk, but would such narrow spreads be considered to be ‘irrationally-priced’? What if, instead, the spread was 1% and the expected default rate was 5%?

One could more easily argue that a negative, default-adjusted spread reflects irrational pricing, although it would also depend on whether fixed-income investors were pricing in a much more benign credit environment following the spike in defaults. Yet such a scenario is unlikely, as high-yield spreads have historically priced in expected default rates.

2008 Financial Crisis Part Of Systemwide Irrational Pricing?

However, such systemwide, irrational pricing events rarely, if ever, occur in well-functioning capital markets characterized by diverse, knowledgeable, and independent participants.

University of Chicago professor Eugene Fama received quite a bit of flack for refusing to acknowledge whether or not the credit events that led to the 2008 financial crisis reflected a credit bubble in housing.

Underlying his response is this notion that it’s unlikely we can identify a credit bubble ahead of time, even if such a bubble is staring at us in the face. Recall that it took several years for the “Big Short” investor thesis to play out, and several of those “professionals” almost went out of business before their shorts finally paid off as the global financial crisis unfolded.

For those who’ve studied this historical episode, many observers assign ground zero blame to the credit rating agencies for modeling housing price appreciation into near perpetuity, assumptions that made their way through the mortgage creation pipeline exposing great swaths of the global financial system to a housing downturn that did finally arrive in 2008.

Irrational pricing of risk assets before 2008? Perhaps, but one could argue there was still a reasonable basis for the assumptions used in those models. U.S. housing could have appreciated at a single-digit rate for the foreseeable future (admittedly, 30 years would be stretching it), but unless some forensic investigator had uncovered willful deception and fraud at the rating agencies, these were models of mortgage risk built on presumably historically based inputs.


What To Do In Today’s Low-Risk Environment

Hedging against downside risk amounts to taking out insurance on your portfolio, and as we are aware, insurance has a cost: premiums. Those betting on a spike in VIX via VIX futures or ETFs are, in essence, paying insurance premiums in the form of a steep term structure with negative roll-down costs.

For equity investors, some would argue for investing in lower-volatility or higher-quality stocks or ETFs, but these come with their own risks, such as introducing unintended interest-rate volatility or lower long-term expected returns, because higher-quality stocks tend to trade at a premium to the overall market.

The simplest way to reduce downside risk is to reduce your equity ratio, as pedestrian as that might sound. But reassessing one’s equity exposure also helps better frame one’s time horizon with one’s tolerance for taking on market volatility. Otherwise, narrower risk premiums imply lower expected returns for equity and fixed-income investors going forward. Again, this assumes you have the requisite time horizon to ride out the volatility.

Alternatively, one can expand the risk premiums in a portfolio to include liquid alternative risk premiums such as managed futures and long/short baskets, many of which are available in ETFs. However, this requires a more sophisticated skillset, and such strategies aren’t necessarily immune to market volatility. That said, they can potentially diversify the general equity and fixed-income risks in a traditional equity/bond portfolio.

A low-risk environment producing low expected returns for the risk involved is the reality we all face as investors. You can be like Warren Buffett and take your ball and go home, but that would leave you underinvested for the long run. A market correction will eventually come, and it could be at that moment that the strong hands earn the risk premiums from the weak hands.

The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of Nov. 20, 2017, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailing [email protected] or visiting 3D’s website at www.3dadvisor.com.


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