Feature – Equities


In contrast, another outlook remains more upbeat. Tilmann Galler, a capital market strategist, predicts that the sudden short-term fall in share prices could have a beneficial effect on long-term returns. “While the current recession is likely to lead to a drop in profits, continued reliance in government aid and dividend cuts, we believe that the underlying trends and margin forecasts will remain stable,” he says. But this view should be taken with a pinch of salt for several reasons. One is that the strong performance of stocks over the past 10 years was heavily driven by the US market. In 2007/ 2008, the market capitalisation of the US stock mar- ket was 60% of the country’s GDP, compared to 150% today. This suggests that stock market growth has become increas- ingly detached from the real economy.


There is also a positive correlation between share prices and sovereign debt, with US sovereign debt increasing dramatically over the past 10 years. While Trump’s corporation tax cuts have indeed provided a boost to share prices, it has not resulted in increased fiscal income as a result of economic growth, as promised. The growing dependence of equity mar- kets on political support might turn into a risk factor, given that Trump’s opponent Joe Biden has already announced a planned increase in corporation tax. This in turn could reduce profits on S&P500 investments by $20 per share in 2021, one report predicts. But taxes are not the only factor to overshadow future equity returns. Tim Hodgson, head of the Thinking Ahead Institute, argues that past returns were inflated because they did not factor in the costs of externalities of production, such as CO2 emissions and plastic pollution. He predicts that it will no longer be possible to discount those externalities from the production process and that returns will therefore be lower. Given those increased challenges to provide accurate valua- tions, it is no wonder that quantitative and passive strategies now account for the vast majority of all trading activities. A US financial giant estimated in 2017 that only 10% of all trad- ing activities were due to fundamental investors while quant and passive strategies accounted for the remainder.


Musical chairs What then, drives the persistence to remain invested in equity markets, despite uncertain valuations? Research of trading patterns in private markets suggests that persistence to remain invested is by no means due to blindness or stupidity. In a 2014 study, MIT scientists Catherine J. Turco und Ezra W. Zuckerman assessed the behaviour of market participants throughout the private equity boom of the 2000s. The scientists describe the behaviour of market participants as an “optimal dancing model”. Given the lack of opportunity to express dissenting opinions, many decided to participate in


48 | portfolio institutional September 2020 | issue 96


the upswing, with the expectation of exciting the market on time as soon as it crashes, akin to a game of musical chairs. A game that is heavily reliant on market liquidity. The authors discount the behaviouralist explanation of “ani- mal spirits” as driver for investor behaviour and argues instead that private equity investors in the mid-2000s knew what they were doing.


There are some indications that this could also apply to today’s equity markets. Based on a BoFA survey of fund managers in June, almost 80% argue that equity markets are currently overpriced, the highest level of pessimism since the survey started in 1998. Nevertheless, this growing pessimism has not necessarily coincided with a reduction of risk in portfolios. The average cash level in investment funds has been reduced to 4.7% from 5.7%.


The conclusion, based on Turco and Zuckerman’s approach, is that even investors who consider asset prices to be inflated pursue an “optimal dancing” rather than a “rational sitting” strategy. In other words, they invest with the hope of being able to exit the market when liquidity dries up. There are multiple explanations for this pattern, from the cur- rent lack of rational feedback mechanisms due to central bank distortions, which have left short-sellers in trouble due to the TINA (there is no alternative for stocks) narrative. The key driver to the recent surge is likely to have been the fear of missing out on future gains. Not being invested at the end of March while other asset managers were soon to book signifi- cant profits due to relatively attractive PE ratios is a stance that few equity investors would have been able to justify. Even vet- eran value investor Warren Buffet currently faces strong criti- cism because his investment firm, Berkshire Hathaway, has amassed a $137bn (£102bn) cash mountain. The pressure to be invested is likely to be even more pressing for lesser known fund managers.


In 2007, former Citigroup chief executive Chuck Prince famously told the Financial Times: “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.” But the current market tango involves another dancing part- ner: The gradual uptake of Covid-19 infection rates above the R1 value. In mid-March, it appeared as if the music had suddenly stopped. Central banks stepped in swiftly by providing new stimulants and turning up the bass and the party appears to continue. Unlike in 2008, when the increasingly absurd pre- sumption of efficient markets resulted in marginal regulatory tightening, optimal dancing to the central bank’s tune appears to have become the modus vivendi of today’s stock markets.


This story originally appeared in portfolio institutional’s German pub- lication portfolio institutionell.


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