The Mercedes Next Door | Cyclical Markets and the Absolute return Investor
By: Matt Mckellar, Alex Kaumeyer, and Max Wang
It has now been slightly more than five years since the September 15, 2008 bankruptcy of Lehman Brothers—the largest bankruptcy in U.S. history, and one of the most defining moments of the 2008 global financial crisis. A highly respected, blue-chip financial services firm with $619 billion in assets had collapsed; a previously unthinkable scenario. Public equity markets experienced turbulence through the financial crisis that was unfathomable to many investors, prompting an exodus from the asset class (often referred to as a form of flight to safety) by a significant portion of retail investors.
Five years from the depths of the trough of market lows in March 2009, public equity indices are hitting new all-time highs. Unfortunately, there is no way to tell how high markets may go, or whether we have already begun to crest the peak. However, a patient investor investing his or her capital in an index perfectly tracking the S&P 500 on October 1, 2008 would have experienced a total return of 113% in the subsequent five-year period. The Dow and S&P 500 indices have surpassed the previous highs set in 2007, and continue to reach new records on an almost weekly basis. A sense of euphoria, or at least satisfaction, is permeating through the various forms of financial media. Investors are feeling a bit giddy: the week of September 18, 2013 saw the highest weekly inflow into equity market mutual funds and ETFs ever, surpassing yet another record set during the final stages of the American housing bubble.
With public market equities indices hitting new highs, it is the point in a market cycle when confidence begets excessive and conspicuous consumption: art and collectibles appreciate at a dizzying pace, high-end restaurants are fully booked-up weeks in advance, and a Mercedes Benz appears in your neighbour’s driveway. Economists call this the wealth effect; as a population’s perception of the value of their assets (in this case, equities) goes up, their consumption also rises. On November 12th, it was announced that a 1969 Francis Bacon painting, Three Studies in Lucian Freud, had been sold by Christie’s in a contemporary and postwar art sale for a record $142 million dollars.
This is the point in the cycle where investors favouring alternative investment, particularly absolute return investments, which have return strategies designed to perform without correlation to public markets, including investments focused on the apartment rental and receivable factoring businesses, as well as select hedge-fund style strategies, begin to become envious of their peers with heavier equities exposure in their portfolios. Despite doing well over the past several years, receiving what have often been strong and consistent returns, it is hard to ignore that from market trough to peak, that your neighbours may have done slightly better.
This is also the point in the cycle where it would be unwise to begin decreasing allocation to absolute return-styled investment strategies in favour of public equities. Even if we ignore the lost diversification benefits that uncorrelated, absolute return strategies add to a portfolio, we should be acutely aware that the capture of any marginal continued multiple expansion and earnings growth in public equities over the near term will almost certainly be less attractive on a risk-adjusted basis when compared to the steady, all-weather characteristics of the absolute return strategies available in the exempt market. Current public equity valuations, which now sit at a stretched Shiller P/E multiple of 25 despite weak sales and earnings growth, hardly seem compelling.
It should be noted that having a bullish view on equities is not necessarily inconsistent with the decision to begin increasing allocations to absolute return investment products at present, especially for disciplined investors. An investment strategy that calls for static relative investment sizes among asset classes in the portfolio (for example: 40% domestic and U.S. equities, 35% absolute return, 25% fixed income) should naturally dictate a portfolio rebalancing at this point in the cycle, as equities have undoubtedly appreciated beyond the relative size the investment strategy calls for. The wealth created by appreciation of public equities over the last five years should be put to work in assets with better forward-looking risk-return profiles.
Despite the outperformance by public equities over the past five years, investors should remain disciplined in their approach. When the next market correction presents itself, absolute-return investors will preserve capital and continue to prosper, and you will likely be able to pick up your neighbour’s Mercedes second-hand on the cheap