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A Blatantly Biased Defense of Active Investing

A Blatantly Biased Defense of Active Investing
(Dollar Photo Club)

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Tuesday, 07 March 2017 11:40 AM Current | Bio | Archive

Those who manage money, and those of us who advise money managers, believe that active investing isn’t dead.

Of course, we are biased.

Maybe it’s wishful thinking, but the recent deluge of attacks on this style by its critics, who tout the advantages of the passive investment style, might be a signal for contrarians. As money pours out of active into passive funds, there is a danger of a stock market bubble (a.k.a. a melt-up) forming as a result. If it bursts, active funds are likely to outperform passive ones. In addition, Election Day seems to have marked the end of the Age of Central Banks, which followed the financial crisis of 2008, and the beginning of Trump World. Arguably, there might be less correlation in terms of performance among various types of stocks in the latter environment than in the former.

Warren Buffett has joined the debate on the side of passive investing. Apparently, he views himself as a rare successful active investor. According to his annual shareholder letter: “Both large and small investors should stick with low-cost index funds.” He added, “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.”

His main beef seems to be with hedge funds rather than all active mutual funds. According to a 3/1 Chicago Tribune article, “Three years ago, he provided similar advice to the trustees of his estate: ‘Put 10 percent of the cash in short-term government bonds and 90 percent in a very low-cost S&P 500 index fund. ... I believe the trust’s long-term results from this policy will be superior to those attained by most investors ... who employ high-fee managers.’”

A 3/3 CNBC article noted that last Wednesday’s huge rally in stocks, the day after Trump’s first speech before Congress, might have been fueled by passive investors: “A big factor was buying in a single exchange-traded fund. According to data from Bank of American Merrill Lynch, the benchmark SPDR S&P 500 ETF (SPY) saw a huge inflow of $8.2 billion on Wednesday, its largest for a single day since Dec. 19, 2014.” Apparently, these passive investors liked that Trump acted more presidential than he has in the past.

Now consider the following:

(1) Betting passively on valuation. For many years, Joe and I have shown that the current bull market has been driven by corporations buying back their shares and paying dividends to investors, who probably reinvested lots of the cash in stocks. The buybacks made sense, especially if they were financed with funds raised in the bond market, as long as the after-tax cost of those funds was below the forward earnings yield of the S&P 500. That’s been the case since the beginning of the bull market, evidenced by the $3.2 trillion in buybacks by the S&P 500 corporations from Q1-2009 through Q3-2016 (Fig. 1).

Joe and I have been using the average of BoA Merrill Lynch data for AA-AAA and BBB-A yields as a proxy for the cost of money raised in the bond market (Fig. 2). The after-tax cost is actually lower since interest costs are deductible as a business expense. (That might change under the Republicans’ tax reform plan.) The bond yield has been below the forward earnings yield since 2009. The valuation model based on the so-called Fed’s Stock Valuation Model (which I so named back in 1997) shows that in February stocks were 57.5% and 23.1% undervalued using the 10-year Treasury and corporate bond yields (Fig. 3).

The reciprocal of these two yields can be used as “fair value” measures of the S&P 500 P/E. Used as an asset allocation model based on the Treasury yield, the P/E should be 41.3 based on February data. Used as a corporate finance buyback model, the P/E should be 22.8. Both are well above the current P/E of 17.6 (Fig. 4).

Both fair-value P/Es seem excessively high since they nearly match (22.8) or well exceed (41.3) the record-high S&P 500 forward P/E (25.2). That’s especially true if bond yields move higher. If they don’t, then that would imply weak economic growth, which would mean anemic growth in earnings. In this scenario, higher P/Es would only be justified if investors believe that there won’t be a recession in the foreseeable future.

Then again, if the recent melt-up simply reflects individual investors pouring money into passive stock funds, then it could continue. In this case, valuation multiples would lead the melt-up, until something happens to scare investors out of those passive funds, which could trigger either a correction or a nasty meltdown. It is obviously a bit late in the game to start only now to be a long-term investor given that stocks aren’t cheap no matter how valuation is sliced and diced.

(2) Betting actively on sectors. In defense of active investing, let’s recall that many active managers overweighted the S&P 500 Information Technology sector during the second half of the 1990s. I turned bullish on the sector on March 20, 1995, in a Topical Study titled “The High-Tech Revolution in the US of @.” During the bull market of the 1990s, the Tech sector rose 1,697%, well outpacing the S&P 500’s passive gain of 417.0% (Fig. 5). Many active managers also overweighted the S&P 500 Financials sector during the 1990s as the banks were benefitting from deregulation. This sector rose 608% during the bull market of the 1990s.

During the previous bull market, from 2003 to 2007, active investors tended to overweight Materials, Energy, and Industrials, which I dubbed the “MEI” sectors and recommended overweighting. The MEIs were beneficiaries of the global economic boom led by emerging economies, particularly China. During that bull market, Energy, Materials, and Industrials rose 223/154/125% respectively, outpacing the S&P 500’s passive return of 95.5% (Fig. 6).

(3) Betting actively on countries. Investing has become increasingly global since the end of the Cold War in the late 1980s and since China joined the World Trade Organization in 2001. On a global basis, the All-Country World MSCI stock price index would be an obvious choice for a passive investor (Fig. 7). For active ones, it would have been best to overweight the US during the 1990s, underweight the US during the 2000s, and overweight the US since 2010. That’s clear from the ratio of the US MSCI stock price index to the All-Country World MSCI ex-US stock prices index (Fig. 8). This conclusion is irrespective of the currency, though it was more pronounced in dollars than in the rest of the world’s currencies in aggregate.

The same conclusion obviously follows by examining the actual performance derbies of the major country/region MSCI stock price indexes. Here is the one for the previous bull market (in dollars): Emerging Markets (367.4%), EMU (215.4), UK (142.3), Japan (123.4), and US (96.7) (Fig. 9). Here is the one for the current bull market (also in dollars): US (250.5), Emerging Markets (92.5), Japan (85.7), UK (82.0), and EMU (79.0) (Fig. 10).

Joe and I are still recommending a Stay Home over a Go Global investment strategy, as we have been since early in this bull market. However, it has had a great run, and we are looking for opportunities overseas. We see some in Emerging Market Economies, where valuations are certainly more reasonable than in the US. However, Trump’s potential protectionism may be weighing on some of them. Europe is also cheap, but populist politicians may be a much more serious threat to the region’s economy, while US populists may be more supportive of US economic growth. Populists aren’t threatening to disintegrate the US the way they are doing in the Eurozone. (We are betting, of course, that California won’t secede from our union.)

(4) Betting actively on industries. Since Election Day, the so-called Trump trade has generated some obvious industry winners and losers from his proposed policies. Here are some of the winners through Friday’s close: Investment Banking & Brokerage (35.9%), Diversified Banks (32.8), Regional Banks (32.5), Technology Hardware Storage & Peripherals (24.3), Semiconductor Equipment (22.5), Construction & Engineering (22.1), and Steel (21.9) (Fig. 11). Here are some of the losers: Apparel Accessories & Luxury Goods (-13.6), Department Stores (-11.7), General Merchandise Stores (-5.8), Agricultural Products (-5.3), and Retail REITs (-2.5) (Fig. 12).

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
 

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A Blatantly Biased Defense of Active Investing
Defense, Active, Investing
1426
2017-40-07
Tuesday, 07 March 2017 11:40 AM
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