2017 was easily the strangest of my investment career, making even the 2000 euphoria seem less bizarre. Investors have embraced risk to a degree that is unprecedented.
Household holdings of stocks now rival prior peaks and the overall equity market cap to GDP is in bubble territory. The crowds piling into ETF continue to leave us wondering what happens when the masses head for the exits. Stocks with perceived momentum, especially in the tech sector, appreciated at astounding rates this year, leaving value stocks behind. The gap in performance between growth and value stocks was historic and that certainly did not favor us.
Tech stocks dominated returns in the S&P 500 and several large cap, old line industrial mega caps were treated like high-growth companies with only moderate improvements in their earnings. We benefitted a bit from the mania in industrials. Countless equities trade at prices that far exceed reasonable targets, but those that fell out of favor were mercilessly sold. That has created opportunities for us on the long side in the retail, energy, healthcare, and media industries.
The low levels of volatility this year have been smashing records going back decades. In fact, if one compares the returns of the S&P 500 to its volatility, this year stands out as a significant historic outlier. Stock prices also remain stretched relative to key moving averages.
The more we read about the scale of VIX selling that is taking place and the astounding size of short positions in volatility-related instruments, the more convinced we become that it will likely be the center of the next storm. We wonder how long it will be before the practice becomes questioned by investment committees and plan sponsors no matter how desperate they are to generate income. We are also convinced that even some supposedly sophisticated investors have no idea how much risk they are taking. We wish we had a nickel for every instance over our careers when the risk in derivatives was woefully underappreciated.
The corporate bond market, in which credit measures have been pushed to the limit in recent years with gargantuan issuance, did mostly hold up this year. We still expect the credit cycle to turn negative in coming quarters and pressure overall sentiment in other asset classes. Covenant protection is absurdly low and the manic quest for yield of any kind has led to excessive risk-taking. We simply don’t think enough bids near the market will be there when the seas become less calm.
We think China calls the global shots. If the leadership there is willing to impose a curtailed lending pace for a while, economies across the planet will feel the effect next year. The frenzied pace of infrastructure spending is expected to be reduced by half as the government deals with lending abuses and bad debts.
Regardless, it is becoming obvious that each additional yuan of debt is producing much less GDP growth than it did in prior years. The day of reckoning cannot be avoided forever when even the currently extreme levels of marginal borrowing prove unable to move the needle enough to keep up the overall pace of economic activity.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.