Now that stock market investing has become a subject for dinner table conversation, everyone seems to have an opinion on how to navigate it. To the uninitiated, the concept of short selling can be complicated enough—why would someone ever want to “own” a stock if he or she believes it might go down in value? But then the GameStop-Reddit battle took GameStop Corp. (NYSE: GME) to preposterous values utterly divorced from the stock’s fundamentals. Suddenly, the trajectory of the market became fodder for Saturday Night Live skits and Investment Advisors were fielding everyone’s opinion on the investment world.
It didn’t help matters that Wall Street veterans were adding more vague and ambiguous information to the conversation. In a recent viewpoint posted on GMO’s site, co-founder Jeremy Grantham opened with the assertion that, “The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble.” To put it bluntly, that’s an audacious prediction. In virtually no other industry does a leader simply throw up his or her hands and say, “it’s time to stop doing what we do.” Imagine a boat supplier declaring summer was over in June. Such an approach would be problematic for an average investor but, for an Advisor hoping to justify their fees, halting activity would be hard to explain with a straight face. To his credit, Grantham admits to this, saying, “don't wait for the Goldmans and Morgan Stanleys to become bearish: it can never happen. For them it is a horribly non-commercial bet. Perhaps it is for anyone.” Yet here he is, in the sincerest terms, warning clients that an investment bubble will soon pop. In fact, he’s been voicing his concerns since June of 2020—when the S&P 500 was approximately 800 points lower than it currently is.
The real irony? He might be on the right track. The market has been on a historic tear since the Global Financial Crisis in 2008 and many valuation metrics are at all-time highs. More ominously, the market has not only recovered from its pandemic-shocked lows in March 2020 but it continues to set new records. This, despite the fact that the pandemic is far from “over.” Yet, to be sure, Grantham isn’t the first or the last to predict the end is nigh. A select few have proven quite prescient with their calls about market bubbles and, in the process, bolstered their reputations enormously. Even a broken clock is correct twice a day, however. And many more investors, either by luck or skill, have called market tops correctly once, only to miss on further prognostications. John Paulson or Meredith Whitney come to mind.
A Fork in the Investment Road
The problem with all of this? Market Timing—which is essentially what Grantham is advocating—implies only two choices. Either a person is investing, or they are not. By stocking up on cash or moving equity investment into money market funds, investors are effectively giving up on the possibility of any significant investment performance. Worse yet, Grantham’s conclusion is built on metrics that have been gradually losing their reliability for quite some time.
For example, he uses the market’s P/E ratio (Price-to-Earnings ratio), relative to GDP (gross domestic product), as one of his chief proof points that stocks are overvalued. This, on its surface, is reasonable enough given the ratio currently resides near the top of its historical range. But P/E ratio is principally a measure for valuation, not risk. It’s akin to judging if a car is speeding by looking at the gas meter. You might be in trouble if the tank’s empty but, without checking the speedometer, you’ll have no idea if you’re about to get pulled over.
Instead, an investor often relies on a commonly accepted proxy for risk such as beta. On this matter, Grantham has referred to the market, as far back as 2014, as a “beta desert” in which investors won’t be compensated for the risks they’re taking. Beta is the volatility of a given security relative to the stock market as a whole. Within a CAPM (Capital Asset Pricing Model) framework, a higher beta value traditionally indicated greater volatility and, therefore, both greater risk and greater reward. Well…there are a lot of assumptions baked into those conclusions. While many of the implications of these statements have proven correct, generally and historically, there are increasingly frequent instances that create exceptions in the definition of ‘risk’. One needs only look at the recent impact of RobinHood and retail investors since the beginning of 2020 to see the changing face of market risk. And, if unconvinced, the GameStop debacle provided the exclamation mark that things are no longer ‘normal.’ Traditional thought held that beta described systematic risk—or the sensitivity of the security to the trajectory of the overall market. And, meanwhile, non-systematic risks—such as a warehouse fire or a CEO departure—could be alleviated with diversification.
Well, I’m here to tell you: I think that’s bullshit.
I believe there’s a portion of non-systematic risk, or idiosyncratic risk, that cannot be diversified away and it remains unexplained in a CAPM world. It comes down to the risks posed at the company level versus those posed at the stock level. You see, there is another type of idiosyncratic risk that is not firm specific. It is stock specific. And this is caused by humans who impound vague and idiosyncratic information into the stock’s price.
For example, a warehouse fire may be a negative event for both the company and the stock. But this doesn’t mean the information will be incorporated appropriately. Some investors might discount the warehouse’s importance leading to an inflated stock price; others might overstate its importance and underprice the stock. This is where the Human Factor comes in.
The Human Factor is the probability a company will fail to deliver the growth implied by the stock price. Through this, we seek to identify the losers, stocks we believe are overpriced. This occurs when humans price vague or ambiguous information into stock prices in a systematically incorrect way. Investors may be unaware of this risk, but it erodes performance and they are not compensated for taking it. There is no benefit, only cost. I believe the only way an investor can avoid a loser is by knowing its Human Factor.
Don’t Lose Yourself in the Stock Market
The key ingredient here is the continued ability to invest. One isn’t hamstrung by the limited options resulting from Grantham’s conjecture. Rather than divesting from the entire market to avoid a bubble, an investor or advisor might instead avoid the exact stocks that have become overheated. In fact, there are complements available specifically crafted to avoid the Human Factor. If one fears the market is due for a correction in the major names that’ve driven the S&P 500’s performance to date, this complement may offer similar performance but with little overlap in those stocks.
Wall Street veterans won’t stop making calls about market tops, now and in the future, based on increasingly outdated metrics such as P/E ratio or beta. In so doing, they may cost themselves considerable outperformance as the market—rationally or irrationally—continues to move higher. Unfortunately, this is akin to sailing the seas with a handheld compass while ignoring GPS positioning. It may’ve worked in the past but that doesn’t mean you need to keep using it forever.
New Age Alpha is a global leader in building actuarial based asset management solutions that aim to inure investor portfolios against an idiosyncratic risk caused by human behavior. Investors are unaware of this risk that leads to loss, cannot be diversified away, and don’t get rewarded for taking it. Unlike firm specific risk, that can often be diversified away, this risk affects stock prices specifically and we believe is caused by human behavior. Through our research we have identified a dramatically differentiated source of alpha that is uncorrelated with traditional risk factors and managers, and as the foundation to our investment approach, we have built a range of actuarial based asset management solutions that aim to mitigate and inure investors’ portfolios against this risk.
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