At GMO, we look at all investment opportunities through the lens of valuation and today, looking at traditional stocks, bonds, and credit, it isn’t pretty. With bond yields near historic lows and equity valuation multiples high, well-priced assets are few and far between. With little to love, we have been looking beyond traditional stock and bond allocations to liquid alternatives. Liquid alternatives, however, typically use stocks and bonds in their investment strategy. If everything looks ugly, how can these liquid alternatives be attractive?
Liquid alternatives have advantages today:
- Less exposure to mean reversion
- Potential to generate return in an otherwise bleak environment
- Wide relative valuation spreads across equities improves the opportunity set for some alternative strategies
- Positive correlation of valuation and sentiment improves the opportunity set for strategies which consider both factors
Alternatives have less exposure to mean reversion
Mean reversion, the tendency for asset classes to return to historic valuation levels, is the major downside risk for investors today: for example, as discount rates and interest rates return to normal levels, stocks and bonds will reprice and suffer poor returns. How poor? The further into the future cash flows are, the bigger the impact from mean reversion.
The chart above shows an estimate of this valuation risk by asking the question “what is the return if all assets revert to fair value instantaneously?” U.S. large cap stocks would fall by 40%, U.S. 10 year Treasury bonds would fall by 20%. Of course, asset classes have never experienced instantaneous mean reversion, though there have been periods of rapid mean reversion in history. The total loss from reversion to fair value estimates the magnitude of this risk.
Most alternatives are relatively insulated from the ravages of mean reversion. Alternative strategies typically have less dependence on cash flows far out in the future, and therefore lower duration. These strategies have limited exposure to a systematic repricing.
- The price of a stock reflects the present value of dividends decades into the future; if the discount rate rises, the price of the stock drops dramatically. U.S. stocks have duration greater than 20 years.
- In a merger arbitrage strategy, for example, you have a position in two companies completing a transaction1. The deal will typically close within 12 months, giving this investment strategy a duration of less than 1 year.
- We estimate that the HFRI index has a duration of roughly 2 years.2
Liquid alternative strategies may continue to deliver positive returns through a mean reversion scenario.
Equity relative valuation spreads are wide
Equities are expensive, but they are not all equally expensive. U.S. stocks have risen significantly more than those in Europe, Japan, U.K. as measured by the MSCI Europe, Australasia, and Far East (EAFE) Index since 1990, or emerging markets stocks as measured by the MSCI Emerging Markets Index since 2004.
The chart above focuses on one valuation metric, the Cyclically Adjusted Price to Earnings Ratio or CAPE (a.k.a Shiller PE). Taking a simple spread between the valuation of U.S. and non-U.S. stocks (for example: U.S. CAPE – EAFE CAPE) and comparing that to history, we see that the spreads between valuations are at historic extremes. Today the U.S. CAPE is at 28.5 and EAFE CAPE is at 19.8; the difference between the two is 8.7, a 96th percentile observation. The U.S. CAPE is 14.2 higher than the Emerging Markets CAPE, a 99th percentile observation.
Wide relative valuation spreads provide an excellent opportunity set for strategies that take long and short relative valuation positions across equities. Global macro strategies, equity long-short strategies and equity relative value strategies all may benefit from wide spreads as they can take long positions in more attractively priced markets and short positions in the more expensive markets capturing the spread.
The correlation between valuation and sentiment is rising
Some long-short investment strategies, for example certain global macro strategies, may use both valuation and sentiment factors in determining their positons. When valuation and sentiment signals align, this may result in a high confidence view (e.g., a cheap asset with positive momentum). However, when valuation and sentiment signals are contradictory (e.g., a cheap asset with negative momentum), the signals may cancel each other out and result in no position at all.
As shown in the chart below, valuation and sentiment had been quite negatively correlated in late 2015; since then, we have seen a dramatic rise in the correlation between the two factors: more assets with relatively attractive valuations are supported by positive sentiment. This may provide an improving opportunity set for strategies that rely on both factors.
As investors, we are prudently skeptical of any strategy that seems too good to be true. In today’s dismal environment, liquid alternatives are worth a careful look. Of course, none of these strategies is risk-free. In a true downside scenario or liquidity crunch, these strategies could suffer negative returns. However, they are often less exposed to general market expensiveness and take more “skill-based” or alpha risks, as opposed to beta or duration risks. In a world where the traditional beta risks are looking not-too- sweet, liquid alternatives may be a way to pretty it up.
1In a typical stock for stock transaction, the investor is long the target, short the acquirer.
2See: Inker, Ben. The Duration Connection. GMO White Paper, Q2 2016.
Alternative investment strategies such as liquid alternatives are speculative and entail a high degree of risk.
You cannot invest directly in an index. Past performance is no guarantee of future results.
The cyclically adjusted price-to-earnings ratio, commonly known as CAPE, Shiller P/E, or P/E 10 ratio, is a valuation measure usually applied to the US S&P 500 equity market. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation.