Via Macro Risk Advisors (Tune into the Alpha Exchange podcast)
Celebrating 30 Years of the Fab Five
It was 1991. A shallow recession ended in the US, the DOW(!) broke 3,000 for the first time, and the US invaded Iraq. It was also the first year that the “Fab Five” hit the scene, a group of freshman at the U of Michigan that took the NCAA by storm. The team would be the first to compete in an NCAA championship game with all 5 freshman starters. The Fab Five “30 for 30” is the most watched of the series in ESPN history.
Today’s Fab Five of Market Risk
30 years after Webber, Rose and Company made their mark, the world is different, more complex. The DOW has recently broken 35,000, the SPX has 5,000 in its sights. Ten-year rates, 8% in 1991, are trudging along at 1.5% this year. Most curiously, y-o-y CPI spent most of 1991 lower than its 2021 level. Envious, today’s bond investor stares at negative real rates as far as the eye can see and wonders what will become of a market so manipulated by the deep pockets of modern-day Central Bankers.
While today’s pricing setup is befuddling to many, there remains a strong view that inflation is still the anti-P/E of bonds. And stocks are expensive by all counts except when weighed against the ridiculous proxy of bonds. The “Fab 5 of Market Risk” all ties back to inflation and how the 60/40 portfolio is far less diversified than it appears. Details here:
- Valuation. Factset reports that the trailing and forward 12m P/E of the SPX is 25.9 and 20.5, respectively. These levels were last seen during the madness of the original tech bubble. Shorting a market on valuation alone is never a good idea, but we should be reminded of the old Graham and Dodd inspired adage “there are no bad securities, only bad prices”. It is well established through metrics like the CAPE ratio that forward returns from a starting point as high as today’s are not likely to be promising.
- Correlation. The edifice of portfolio construction leans on the negative correlation between the risk-free and risky asset. While in place for 20+ years, this very favorable outcome is no sure thing. What happens when the stabilizing impact of duration as a risk class turns the other way? While “risk on/risk off” would suggest otherwise, the market is quite vulnerable to higher rates. A flip in stock/bond correlation would likely come about at the same time as both stock and bond volatility were both increasing. The portfolio vol greatly expands.
- Concentration. For the SPX, 25% of the market cap can be found in just 7 stocks. In the QQQ, the top-heaviness is even more pronounced. The top constitute just under half the market cap. This concentration leaves the indices over-exposed to factors such as growth and momentum and at a material valuation premium to the remainder of the market. There are shared risks among mega-cap tech companies including exposure to higher rates and the potential that regulatory change (anti-trust, content, privacy) is imposed upon them.
- Duration. Rates are very low and bond and stock market duration is very high. “Long duration” growth stocks are most vulnerable to a rise in interest rates. In this solid piece, Sanford Bernstein warned that the valuation of stocks tied to low rates was at its highest level ever (1.5x) relative to the overall market. These are the same big-cap tech stocks that comprise so much of the market cap of the SPX and QQQ. Exceptionally high exposure to rising rates across both the bond and stock markets at a time of rising inflation is a significant risk.
- Inflation. The case that the rate of price increases will indeed be transitory is losing ground. It is important as well to watch market implied measures. While these suffer from some contamination due the Fed’s feverish buying of nominals and TIPS, the movement higher in breakevens shouldn’t be ignored. Both five- and 10-year b/e’s have essentially matched the levels achieved on May 17th , a day that saw the VIX spike to 27. Even the Fed’s usage of “transitory” (and words of similar thrust) is in decline.