Risk Review: Equities

Introduction

The Noah Rule: Predicting rain doesn’t count; building arks do

Warren Buffet coined this phrase in his 2001 shareholder letter following one of Berkshire Hathaway’s worst-performing years (mainly due to insurance payouts as a result of the attacks of 9/11). The Oracle of Omaha’s metaphor strikes a chord for many asset managers who bearthe responsibility of allocating portfolios on behalf of their clients. It’s one thing to predict a disaster, it’s another to provide an actionable plan to protect yourself.

As we enter the new decade, the U.S. equity market is confronted by significant risks. Consumer credit, an alternative asset class, which provides low volatility alongside relatively high returns can be used to hedge that risk. 

Inflated Prices

One key indicator of stock valuations is private equity (PE) activity sincePE firms seek to acquire undervalued companies. Data from Preqin shows that the aggregate value of U.S. buyouts fell 25% year-to-date through October, compared with the same period a year earlier. Higher stock prices are a double-edged sword for PE firms. On one hand, potential targets are more expensive, and on the other hand, competing corporate acquirers can pay with their own stock (which is also inflated), giving them an advantage in a bidding war.

The decline of deal activity has been met with a surge of cash on hand.

Private equity firms aren’t alone. In his recent shareholder letter, Warren Buffet lamented that prices have inflated drastically over the course of thiss decade, such that it is increasingly difficult to find an attractive acquisition target. Berkshire Hathaway’s cash pile climbed to a record high after five consecutive quarters of growth.

Cause of Increase:

There are a myriad of causes for inflated stock prices. One of the most prominent  is record-low interest rates that have enabled companies to borrow money for a minimal cost. Companies then use that money to reinvest in their company or buy some of their own stock, thereby driving up prices. Another cause that cannot be ignored is the growth of ETFs and passive investing. While Jack Bogle conceived the concept of investing in index funds in the ’70s, this investing method exploded in popularity in the aftermath of the 2008 financial crisis.

Some are concerned that the shift to index funds has increased the demand for stocks across the full spectrum of the market, independent of each company’s performance. James Mackintosh of The Wall Street Journal explains this phenomenon, “If you imagine stock prices are set by investors who have read every annual report and checked prices against the value implied by their estimates of future growth and earnings prospects, then ETFs are a disappointment. ETFs accelerate the move to consider companies as a basket of exposures to countries, sectors, factors and themes”. As index investing expands, stock prices may be more determined by the index fund they are in, rather than solely by companies’ underlying fundamentals.

Dr. Michael Burry of Scion Asset Management takes Mackintosh’s idea one step further and warns that ETFs pose a greater risk to equity markets than most people realize, “This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue.”

A similar sentiment was echoed by Jeffrey Gundlach of DoubleLine Capital who expressed that ETFs were causing a “herd behavior” among investors.

This is not to say that a market crash is imminent. In fact, there is a strong sense of optimism on Wall Street as we enter into the new decade. Interest rates remain low and the two major headwinds for markets – the U.S. China trade war and Brexit uncertainty- have moved to the periphery.  That said, as discussed above, there are a number of factors that may be inflating stock prices. In this environment, reducing exposure to equities may be a good defensive strategy.

When there is increased uncertainty in the stock market investors typically rebalance their portfolios by increasing their allocation to government debt. However, bonds across the developed world have been underperforming. Iin Europe and Japan, central banks have taken the drastic step of issuing bonds that yield a negative interest rate in an effort to stimulate economic growth to pre-crisis levels. In the U.S., despite the economy’s strong performance, yields on bonds remain historically low. This is due, in part, to the fact that the U.S.’s share of the global economy is shrinking, thus increasing its dependence on trade and the performance of foreign economies. As such, investors need more options for asset allocation.

Consumer Credit

There are a variety of other asset classes to which investors can reallocate their money. Indeed, many institutional investors have already allocated more capital towards alternative asset classes such as real estate and venture capital in recent years.

One often-overlooked alternative asset class is consumer credit. Traditionally, consumer credit has been controlled by banks who preferred these types of loans due to their high yield and low volatility. Consumer credit took off as an investable asset class in the mid-2000s as independent lending marketplace lending platforms (MPLs) offered loans to consumers. Instead of holding the loans on their balance sheet, MPLs enabled investors to purchase them on an open market. Since MPLs did not have the overhead costs of brick-and-mortar banks, they were able to offer a more competitive interest rate than banks and still profit off selling loans to investors.

 As an asset class, consumer credit is notably resilient, remaining profitable even at the heights of the Great Recession.

The robustness of consumer credit was tested by Orchard Platform Advisors. After running the available data through various stress situations, their research concluded that, “marketplace lending should prove remarkably durable to various economic stressors”. In parallel, their study showed that consumer credit outperformed other fixed-income investments.

In fact, when the results of the study are broken down on a yearly basis, we see that consumer credit consistently outperformed bond portfolios and over some periods, even outperformed the S&P 500.

As an asset class, consumer credit strikes the balance between yield and volatility which position it as a safer option when compared to  equities and more profitable than bonds.

 Besides return and stability, consumer credit offers investors access to liquidity through their short duration and the ability to invest in individual loans offering a variety of risk profiles. Consumer loans tend to have a term of 36 to 60 months.  Additionally, unlike stocks or bonds, where shares of each company or bonds with similar maturities are identical, every individual loan is unique. By accessing a wide array of data available by credit bureaus, investors can analyze each loan’s individual risk profile and asses which are most appropriate to invest in.

 While there are no guarantees in investing, in the face of an increasingly risky equity market and low-yield bond environment, asset managers should consider consumer credit as their ark.

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Nothing contained in this communication constitutes tax, legal, or investment advice.  Investors must consult their tax advisor or legal counsel for advice and information concerning their particular situation. This article contains certain statements that may include “forward-looking statements.” All statements, other than statements of historical fact, included herein are “forward-looking statements.” Although Pagaya believes that the expectations reflected in these forward- looking statements are reasonable, they do involve assumptions, risks and uncertainties, and these expectations may prove to be incorrect. Actual events could differ materially from those anticipated in these forward-looking statements as a result of a variety of factors. You should not place undue reliance on these forward-looking statements. This article reflects our views and opinions as of the date herein, which are subject to change at any time based on market and other conditions. We disclaim any responsibility to update these views. These views should not be relied on as investment advice or an indication of investment intention. Discussion or analysis of any specific company-related news or investment sectors are meant primarily as a result of recent newsworthy events surrounding those companies or by way of providing updates on certain sectors of the market. Pagaya does stand to beneficially profit from the performance of consumer loans it owns or acquires.  Read the full disclaimer.