November 24, 2024 – Overheated stock markets can be exhilarating for investors while they are happening. Success stories dominate the media, and “fear of missing out” (FOMO) drives more participation.
Rising prices attract more buyers, pushing prices even higher in a self-reinforcing cycle. Confirmation bias makes investors focus on success stories and ignore warning signs, as herd behaviour amplifies the collective exuberance. If one’s neighbour is getting rich in the stock market, it is human nature to want to participate. Investors have certainly been participating heavily in the recent stock market rally, with this year’s U.S. equity fund inflows hitting a new all-time record, approaching $500 billion.
With equity indexes steadily marching higher and brokerage account values continuing to swell, caution gets thrown to the wind, and bullish behaviour takes over. Speculative buying, often fueled by leverage, accelerates gains. One can look to the proliferation and growth of leveraged U.S. single-stock ETFs, which take 2x leveraged bets on the current market darlings (think Tesla and NVIDIA) and are trading record volumes, to highlighted this phenomenon.
Overheated markets often accompany narratives of groundbreaking technologies or major structural changes. In the late 1990’s, it was the dawn of the internet. Today, it is the growth of artificial intelligence. Perceived new economic regime changes often bring with them exuberant moods from equity investors. One way to measure investor exuberance is via the equity risk premium.
The equity risk premium refers to the excess return that investors expect to earn in the stock market above and beyond Treasury bonds. This premium compensates investors for the higher risk associated with equity investments compared to risk-free securities.
Currently, we find ourselves in one of the most jubilant equity markets in history, with the U.S. equity risk premium reaching zero, a level not seen since the tail end of the dot-com bubble.
A zero equity risk premium implies that investors no longer require a premium expected return above the risk-free rate. It short-circuits the traditional trade off between risk and reward, and indicates that investors are willing to take more risk without a commensurate increase in reward.
A zero equity risk premium market, or a stock market that is expected to provide no additional return above the risk-free rate, can be dangerous for investors. Unfortunately, it does not imply that equity risk has been eliminated, although it sometimes feels that way during raging bull markets. However, it does indicate that while additional risk taking in stocks is not expected to generate a premium return, this increased risk taking can provide much more substantial downside risk compared to the risk-free asset. This dynamic provides an asymmetric return profile, with low expected upside and high downside potential.
Broad stock market valuations can provide insight into potential forward equity returns and potential risks. Generally, the higher the starting valuation, the lower the future return, and the higher the downside risk. Currently, U.S. equity market valuations are their 97th percentile most expensive compared to historical values, ranked across several metrics.
In a 2001 Fortune article, Warren Buffett discussed a market valuation metric that has become known as the “Buffett Indicator”. Named after the Oracle of Omaha, who referred to the calculation as “probably the best single measure of where valuations stand at any given moment,” the indicator compares the total market capitalization of all publicly traded stocks in a country to its Gross Domestic Product (GDP). This ratio provides insight into whether stock market values are outpacing economic growth, which might indicate a market bubble or overvaluation.
Buffett stated, “the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%… you are playing with fire.” A high ratio indicates overvaluation, suggesting that stock prices might be too high relative to economic output, possibly hinting at a market correction risk.
Currently, the Buffett Indicator hit a new record high of nearly 200%, reaching the level at which Buffett warned that investors were playing with fire in 2001.
That said, it is always more relevant to observe what Buffett does, rather than what he says. One dynamic worth noting is that the Chairman of Berkshire Hathaway, America’s largest conglomerate, has been selling equities hand-over-fist, and in the meantime building up a record pile of cash.
Either Warren is really attracted to the current 4.4% pre-tax yield provided by 3-month Treasury bills, or he is concerned about stock market valuations.
When bull markets inevitably reverse course, investors can face painful asset price declines, which rapidly erase trillions of stock market wealth. Investors who entered late or leveraged heavily can face devastating losses. The previous euphoria and extreme bullish sentiment are replaced by panic and fear as equity markets spiral downward. Trust erodes rapidly in financial markets, institutions, and even government policies, particularly from retail investors.
While the previous market exuberance plummets along with the markets, despondency becomes ubiquitous. A sour mood from investors proliferates as equities fall post-bull market peak.
Nonetheless, an equity bear market can bring with it reduced valuations, which in turn provide greater future returns with lower risk for those enterprising investors looking for a deal.
While we patiently await any cracks in the current bull market rally, there are methodologies that allocators can utilize to mitigate the effects of a popped bubble bear market, or at least a bull market correction.
One method is to hedge one’s equity exposure, either partially or fully, with short positions. A balanced long short approach can isolate a portfolio from the downside risks presented by record high valuations and a zero equity risk premium. If one is not getting compensated for the risk, why take it?
Long short equity allows one to maintain bullish exposure, while hedging to ideally sidestep future drawdowns in the equity markets.
Below, we highlight one top-decile stock expected to outperform and one bottom-decile stock expected to underperform in this month’s AlphaRank Top Stocks.
OUTPERFORM: Fairfax Financial Holdings (TSX: FFH) is a diversified financial services company engaged in property and casualty insurance, reinsurance, and investment management. Under the leadership of founder and CEO Prem Watsa, often referred to as “Canada’s Warren Buffett,” Fairfax has built a reputation for strategic investments and prudent financial management. Fairfax demonstrates a solid financial foundation, strategic investment decisions, and prudent capital management. Its consistent earnings, reasonable valuation metrics, and positive analyst outlook suggest that the stock may be a compelling option for investors seeking exposure to a diversified financial services company with a track record of stability and growth. Fairfax is steadily executing share repurchases, reducing the share count by -5.1% over the past year, as its stock remains at an attractive valuation. In addition, it significantly beat expectations last quarter, and the stock continues to display positive momentum, which we expect to continue. Disclosure: Long FFH in the Accelerate Canadian Long Short Equity Fund (TSX: ATSX).
UNDERPERFORM: Agilon Health Inc (NYSE: AGL) is a healthcare company that partners with primary care physicians to transition to value-based care models. Despite its innovative approach, the company’s stock has faced significant challenges. Over the past year, Agilon Health’s stock has experienced a substantial decline, with an -84% plunge, indicating ongoing financial struggles and investor concerns. The company’s short interest stands at 36.22 million shares, representing 11.95% of the float. This short interest level marks a 0.95% increase from the previous month, suggesting growing bearish sentiment among investors. Historically, heavily shorted stocks have underperformed. Consistent operating losses, combined with business performance that has underwhelmed expectations, make a challenging environment for AGL stock. Despite its low-priced shares that have fallen below $2.00, its market valuation is still approximately $800 million, leaving room for equity market capitalization decline. Disclosure: Short AGL in the Accelerate Absolute Return Fund (TSX: HDGE, HDGE.U).
The AlphaRank Top and Bottom stock portfolios exhibited mixed performance last month:
- In Canada, the top-ranked AlphaRank portfolio of stocks gained 3.7% compared to the benchmark’s 0.7% gain, while the bottom-ranked portfolio of Canadian stocks rallied by 6.2%. The long-short portfolio (top – bottom ranked stocks) lost -2.5% in a challenging month. Over the past five years, the top decile AlphaRank portfolio has risen by more than 150%, while the bottom ranked portfolio has gained roughly 25%.
- In the U.S., the top-decile ranked equities declined by -0.3%, outperforming the S&P 500’s -0.9% loss. Meanwhile, the bottom-ranked stocks gained 1.9%, leading to a 2.2% loss for the top decile minus the bottom decile long-short portfolio. Over the past five years, the top-ranked U.S. equities have gained approximately 120%, while the bottom-ranked portfolio has fallen by about -20%.
AlphaRank Top Stocks represents Accelerate’s predictive equity ranking powered by proven drivers of return. Stocks with the highest AlphaRank are expected to outperform, while stocks with the lowest AlphaRank are anticipated to underperform. AlphaRank assigns a numeric value to each security from zero (bottom-ranked) to 100 (top-ranked) based on selected predictive factors. All Canadian and U.S. stocks priced above $1.50 per share and $100 million in market capitalization are evaluated. In both the Accelerate Absolute Return Fund (TSX: HDGE) and the Accelerate Canadian Long Short Equity Fund (TSX: ATSX), Accelerate funds may be long many top-ranked stocks and short many bottom-ranked stocks. See AccelerateShares.com for more information.
