With US equities up 26% since the end of November, George Lagarias, Chief Economist at Mazars, not only shares his analysis into the current market valuations but also answers the question of whether it is better to run with the bulls (overweight risk), run away (underweight risk) or do-nothing (neutral risk) when reviewing investment strategy
In 2016, Ricardo Torres Martinez, a teacher, took his students to a farm in Apodaca, Mexico. He lined them up in rows in the Bull Ring and told them to sit absolutely still. Then he let the bull loose. Incredibly, the bull ran back and forth between the students, but no one was hurt. “The animal doesn’t attack. It just wants to be safe”.
Mr. Martinez will probably never stand for the “Teacher of the Year” award.
But he did illustrate a principle: doing nothing is a choice as strategic as any other.
Not to put too fine a point on it, but most of the market feels like Mr Martinez’s students. With equities up 26% since the end of November, the question is whether to run with the bulls (overweight risk), run away (underweight risk) or do-nothing (neutral risk).
The answer is not easy.
The overweight equities argument initially relied on a very thin narrative: “It’s all about AI and pending rate cuts”. That was easy to dismiss as an exaggeration. AI valuations reached exorbitant levels and rate cut expectations were clearly way above the Fed’s intentions. However, in the past few weeks, European equities, (the Eurostoxx 50) has been catching up to the Magnificent 7 (until 14 March when tech picked up again). Value has been also performing well. So, instead of thinking about mean reversion, we are seeing other markets catching up to the hottest American stocks. As months pass, rate cuts are brought closer. Given that Quantitative Tightening doesn’t appear to have the adverse effect we thought it would if anything it seems that stocks which have underperformed are now catching up, fleshing out a more robust long argument.
The underweight argument makes more fundamental sense. At the time of writing, equities have already given investors nearly 8%, a standard year’s average. The Nikkei and the Dow are both near or at 40,000. Equity risk premiums in the US (the differential between the earnings yield and the bond yield) have been negative for over a year – which means that investors aren’t compensated properly for the amount of risk they are taking if we think of that risk in terms of earnings. Also important is the bond/equity trend from 2009, which has now broken above the third standard deviation. This means that equities are abnormally outperforming versus bonds – and rate cuts are coming. But the momentum of the equity bull market gives pause. Who wants to stand firm against such bullishness, especially when none of the usual metrics warn of “irrational exuberance” are flashing red?
The Do-Nothing approach is not always a favourable one. A manager is as likely to be criticized for underperforming, as they are for flying too close to the benchmark. After all, an investor would argue that they pay active managers to be… well… active. And they would, rightly, point out that there’s never a clear case for a market to go in one direction. However, from an investment management standpoint, being neutral is also a choice.
The key is, that this depends on the benchmark. When the benchmark is an established index, then criticism may arise as to whether a “neutral” manager is rightly commanding their fees.
In some cases, however, the benchmark may not be an index, but the Strategic Asset Allocation. This is an Asset Allocation plan based on long-term assumptions about the risk and return of various assets. So the “do-nothing” option, in that case, is not about being inactive. By adopting a Strategic Asset Allocation (SAA), a manager has sought to remain permanently active over the long term.
Being neutral the SAA is the admission that there’s not a clear case for a tactical asset decision, at least in the short term and it’s prudent to stick with the longer-term direction of the portfolio. Putting it differently, making an asset allocation decision just to satisfy the demand for one, is probably riskier than sticking to long-term strategic planning.
An asset manager with a Strategic Asset Allocation is never inactive. They have already made decisions at a strategic level. Over the shorter term, they just have to decide when they can rely on their long-term assumptions, or whether they have a clear view of a certain asset class and invest more in it to generate “alpha”.
Mr Martinez’s students were not cowards for not reacting. They went in and strategically placed themselves to achieve the primary goal of being in a bull ring: Getting out unharmed.
