September 13, 2021 – With the continued economic recovery, a reduction in central banks’ monetary stimulus remains top of mind for investors.

Specifically, investors have a heightened sensitivity to the Federal Reserve’s tightening of monetary policy.

This tightening of monetary policy will consist of two parts. First, the reduction, or “tapering”, of its asset purchases. Second, the raising of its federal funds rate.

The implementation of these two existing policies has had the following effects on the equity markets:

  • The reduction of the federal funds rate to near-zero has driven investors to look for returns from outside of bonds. This interest rate decline has fueled the “TINA” (there is no alternative) outlook that forced investors out of safe bonds and into more speculative asset classes such as equities and real estate, amongst others. The current low level of interest rates justifies high equity valuations. Suppose, if the 10-year Treasury is yielding 1.3%, by adding a 300 basis point equity risk premium to the risk-free rate one can justify a 4.3% equity yield (which when inverted, represents an elevated 23.3x P/E ratio for the equity index).
  • The Fed’s $120 billion in monthly bond purchases, so-called quantitative easing, has flooded the capital markets with liquidity. This flood of liquidity has caused funds to flow from bonds to other asset classes, generally through index funds. Researchers from Michigan State University, the London School of Economics, and the University of California, Irvine, recently theorized that “flows into index funds raise the prices of large stocks in the index“, fueling a feedback loop of positive performance and additional fund flows.
The S&P 500 is currently trading at record or near-record valuations under a myriad of valuations measures. Specifically, the Q Ratio (shown in the magenta bar below), which measures the total price of the market divided by the replacement cost of all its companies, indicates that the S&P 500 is 100% overvalued. Under the Q ratio measurement, the S&P 500 would need to decline -50% to reach fair value. The cyclically adjusted price-to-earnings ratio (shown in the blue bar below) shows a similar level of overvaluation of the U.S. large cap index.

Note that valuation measures such as the Q Ratio and the CAPE ratio are notoriously poor for market timing. These valuation measures have been elevated for the past decade, and if an investor stayed out of the equity market during that timeframe, they would have missed out on substantial gains.

Nonetheless, some strategists posit that perhaps the large-cap indices have gotten ahead of themselves, the effect of a zero-interest rate policy and unprecedented quantitative easing. The above-average returns over the past decade may have pulled forward returns from the future.

Current valuations have caused Bank of America strategists to forecast, based on the S&P 500’s current trailing normalized PE ratio of 29x, a 10-year annual return for the equity index of -0.8%. This 10-year return would represent the first negative decade since the Tech Bubble.

A zero-interest rate policy combined with quantitative easing, which have contributed to the expansion of equity market valuations, would be acceptable in an environment of consistent monetary stimulus. However, the danger for equity investors is when this unprecedented level of monetary stimulus is removed.

Given the thesis that current equity market valuations are reliant on the current level of monetary stimulus from the Fed, investors should consider the attractiveness of the large-cap indices once this stimulus is removed. Specifically, the Fed has indicated that they may begin to taper their monthly asset purchases either in November or December of this year and may be in a position to begin an interest rate hiking cycle as early as 2022. Once monetary tightening commences, as liquidity is reduced and rates rise, what is likely to happen to the large-cap indices whose valuations have been so reliant on policy staying loose?

While the scenario of richly-valued equities combined with the withdrawal of monetary stimulus does not call for a 0% allocation to U.S large cap equities in one’s portfolio, although the much-emulated Yale endowment is dangerously close with their ~2% weighting, it does support the idea of diversifying into other asset classes that present a more attractive risk-reward dynamic.

Accelerate manages five alternative ETFs, each with a specific mandate:

  • Accelerate Arbitrage Fund (TSX: ARB): SPAC and merger arbitrage
  • Accelerate Absolute Return Hedge Fund (TSX: HDGE): Long-short equity
  • Accelerate OneChoice Alternative Portfolio ETF (TSX; ONEC): Alternatives portfolio solution
  • Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Buffered index
  • Accelerate Carbon-Negative Bitcoin ETF (TSX: ABTC): Eco-friendly bitcoin
Please see below for fund performance and manager commentary.

SPAC arbitrage yields continued their rise in August, starting the month off at 1.9% before peaking north of 2.3% on August 24th.

The average SPAC now trades at a -1.9% discount to NAV (-2.4% discount on a median basis). Currently, more than 95% of SPACs trade at a discount to NAV. Six months ago, an unprecedented 100% of SPACs traded at a premium to NAV.

Widespread apathy and a negative media bias toward the asset class has unearthed tremendous opportunities for investors. SPAC arbitrage spreads have reached their widest level since March of 2020. Approximately $3.8 billion of “free money” remains available, measured as the difference between price and redeemable NAV, for investors willing to buy SPACs at a discount. This “free money” does not include any potential return from upside optionality (SPACs trading above NAV) or additional warrant value.

Due to the widening of arbitrage spreads, ARB declined -1.2% for the month. ARB’s 7.0% weighted average unlevered expected yield currently sits at its highest since inception.

HDGE rallied by 5.0% in August, with all five long-short factors contributing to positive fund performance.

The long-short price momentum portfolio increased 4.6%, with positive momentum longs rising 2.8% and negative momentum shorts falling -1.8%.

The long-short trend portfolio rose by 4.4%, as positive trending longs went up 3.6% and negative trending shorts fell -0.8%.

Undervalued longs ticked up by 3.8% during the month, and overvalued shorts declined -0.5%, leading to a 4.3% rise in the long-short value portfolio.

Rounding out the multi-factor strategy’s positive monthly performance was operating momentum, with a 2.7% gain, and quality, with a 2.0% rise.

In August, ONEC gained 5.7%, with the primary contributor the 19.7% surge in bitcoin. Additional positive contributors include long-short equity’s 5.0% gain, real estate’s 3.0% increase and infrastructure’s 2.2% uptick.

Negative performance contributors include arbitrage’s -1.2% decline and gold’s -0.6% fall.

Although early days, since launching in January 2021 as the “Yale endowment in an ETF”, ONEC has outperformed both expectations and competitors. We continue to believe ONEC works best as a traditional portfolio diversifier, efficiently diversifying a 2-asset stock and bond portfolio to 8 asset classes with just one trade.

ATSX was up 2.7% in August, approximately doubling the benchmark’s performance due to the fund’s long-short buffer portfolio.

ATSX’s long-short Canadian equity overlay portfolio is driven by Accelerate’s predictive multi-factor algorithms.

The most significant factor contributor to the monthly outperformance was price momentum, as positive momentum longs gained 1.0% and negative momentum shorts fell -4.2%. The operating momentum, value and trend long-short portfolios also contributed to the overlay’s positive monthly performance, up 1.5%, 0.5% and 0.4%, respectively.

Have questions about Accelerate’s investment strategies? Book a call with me.

-Julian

Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.

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