(Dec 27): Hedge your holdings. Stay defensive. Figure out a risk tolerance and do not buy anything that keeps you up at night. All the investment advice at the tail end of the financial crisis came with a huge dollop of caution.
So, at the start of the century’s troubled teens, who would have predicted US stocks would not only lock themselves into the longest bull market ever, they would also do better than they ever had before? But that is exactly what happened. Adjusted for risk — or, more precisely, the volatility stock investors had to bear — gains in the Standard & Poor’s 500 index since Dec 31, 2009 are poised to be the highest of any decade since at least the 1950s.
Theoreticians always say that reaping great rewards in investing requires assuming great risk. And while it took gumption to own stocks in 2009, the path since then has been unprecedentedly easy. Price swings dwindled as interest rates fell, proving again that rewards in the stock market often come when they are least expected. “You should be aggressive when things look the darkest — that’s clearly a lesson that works,” says Bill Stone, chief investment officer at Avalon Investment & Advisory. “Of course, it’s impossible to know that when you’re running in real time.”
Stocks in the S&P 500 have returned 249% in the past 10 years, about 1.2 times the historical average. But at the same time, the 2010s were the first decade without a bear market, defined as a 20% drop from any peak. Sure, there were six separate 10% corrections, all hair-raising, though never enough to kill the bull.
A widely followed measure on Wall Street known as the Sharpe ratio shows the extent of the serenity. The ratio tracks stock performance relative to Treasuries and the volatility stock investors experience. At around 1, the current reading is the best among any decade since at least Dwight Eisenhower’s presidency, according to data compiled by Bloomberg. It shows that the returns, as good as they were in absolute terms, were even better considering how little they cost, so to speak, in volatility.
That does not mean it felt like smooth sailing in the moment. There was the May 2010 flash crash, Europe’s sovereign debt crisis in 2011 and 2012, and China’s currency devaluation in 2015. Now a global trade war is renting psychic space in investors’ heads. A lot of things that could have turned the world upside down kept flaring up. Magically, the bull market has endured.
For a visual sense of how it all felt, look at two gauges of anxiety. One is an index of the frequency of newspaper stories around the world mentioning uncertainty about economic policy. Unsurprisingly, the measure has shot sky high over the past decade. And yet it has had surprisingly little effect on investors. Consider the CBOE Volatility Index, or VIX, a measure of S&P 500 options costs that shows how much volatility investors expect. While it has spiked from time to time, it has generally dropped back to low levels.
It all makes a kind of sense when considered alongside what central bankers have been doing. Almost every time something scary has hit the headlines, they have stepped in with a salve. The latest example: The US Federal Reserve took a U-turn on monetary policy, embarking on a rate-lowering cycle after trade angst last year sent stocks to the worst December since the Great Depression. With the Fed’s support, growth scares so far have been just that: scares.
Partly because it has seemed like everything was about to fall apart, nobody has been able to get that excited about anything. The euphoria that often helps kill an expansion has not materialised. This is true for investors as well as corporate managers. While awash with near-record cash, CEOs never got aggressive in their investment plans. During the latest earnings season, a Bank of America Corp index tracking guidance on capital spending among S&P 500 companies hit a 10-month low. “There are scant signs of investment or valuation bubbles,” says Jeremy Zirin, head of Americas equities at UBS Global Wealth Management. “This stands in sharp contrast to the situation on the eve of the last two recessions.”
Some attribute the eerie calm to the rise in passively managed index funds or even social media, which has made people so sceptical of news that perhaps prices do not react as much anymore. Others say stock volatility was low because economic volatility was, too.
Indeed, while perceptions of risk were high, fundamentals were stable. US GDP expanded 1.6% to 2.9% in each of the previous nine years and is expected to chug along again in 2019. Based on standard deviation, that is the smallest fluctuation over any 10-year stretch in data going back to 1930.
Huge gain, little risk. Sounds like paradise. It is — if you are riding with the market owning something like the SPDR S&P 500 ETF Trust or another index fund. For anyone competing against an instrument like that, it has been more like hell.
The uninterrupted advance has complicated the market plans of hedge funds, which place both bullish and bearish bets on stocks. Since the end of 2009, they have returned 4.3% a year, trailing the S&P 500 by almost nine percentage points, according to data compiled by Hedge Fund Research and Bloomberg. While the stock market may be a poor benchmark for hedge fund performance, it is obvious that a soaring one is tough to compete with.
Mutual funds cannot keep up with the market either. Take large-cap blend funds, which invest in the same kinds of stocks you would get in the S&P 500 index fund. Over the 10 years through June, just 8% of them managed to both stay in business and beat the benchmark, data compiled by Morningstar shows. That is an “awfully low” success rate, says Jeffrey Ptak, the firm’s global director of manager research.
Ptak has theories to explain the subpar performance. For one, returns in various styles and sizes have become increasingly clustered, making it hard to profit from differentiation. Usually, managers seek to gain an edge over a benchmark by tilting away from its dominant style — say, large-cap funds branching out to small-caps.
In a world where the rising tide lifts all boats, such a strategy does not work, at least not to differentiate returns. Indeed, 10-year returns among size categories are not far from one another: 13.4% a year for large-caps, 12.5% for mid-caps and 13.2% for small-caps.
Another factor, Ptak says, is that as passive products lure more money, the money that is left in the hands of active stockpickers gets more savvy. Ironically, this makes it harder for these managers to stand out. When weaker hands leave the stockpicking game and just buy the index, managers face a tougher battle betting against one another. “Inferential evidence suggests that the playing field has become more level,” says Ptak. In other words, the 2010s were the decade when the game got harder to win — even as high returns meant almost everyone took home a participation trophy. — Bloomberg
