Market commentators so often quote or reference the legendary investor and fund manager Warren Buffet, not only because of all that he has achieved, but also because of his achingly simple perspective on financial markets.
He has a typically straight-forward view on equity valuation, with his favourite metric being the total market capitalisation of all US stocks relative to the economy’s GDP output. He once described this as “the best single measure of where valuations stand at any given moment”. He also observed that when the metric exceeds certain levels, it is a bit like playing with fire.
In the same way that a country’s debt to GDP ratio is said to have become unsustainable once it reaches 100 per cent, this is the level at which the ‘Buffett metric’ indicates that some caution is warranted.
With the indicator now rapidly approaching its 2000 peak of 145 per cent, investors may be asking themselves if it is time to run for cover.
In the prevailing environment, investors are being forced to juggle with a fairly unique set of circumstances. If equity valuations are stretched, the same can certainly be said of bond markets, with the longest bull market in living memory driving yields to unprecedented lows. This raises the spectre of duration – which expresses the vulnerability of an individual security or bond portfolio to a rise in interest rates – especially with scant rewards on offer for locking-in to a fixed rate for a longer period.
Absorbing duration risk
The spread between two- and 10-year US Treasury yields has recently narrowed to just 60 basis points, meaning an investor would have to be very confident that we are near the peak of the Federal Reserve’s current rate-hiking cycle before absorbing the duration risk associated with a 10-year security.
As such, since the global financial crisis (GFC), the so-called quest for yield has typically involved the absorption of greater credit risk by descending down the quality spectrum. This, in turn, increases the possibility of being exposed to defaults.
The potential rewards for absorbing such risks are again scant, with credit spreads markedly tighter than in early 2016 when the energy industry was experiencing its weakest moment.
Similarly, while many ‘safe’ government bonds are offering negative real yields, investors holding cash are being penalised to an even greater extent. In fact, one of the reasons cited for the extended rally in risk assets is the lack of a cash-related opportunity cost.
- The Buffett Metric says if a country’s debt hits 100 per cent of GDP, it’s time to run for cover.
- Active managers outperform during downturns.
- ‘Buy and hold’ investors should consider having an active leaning in their equity portfolios.
Ironically, one place where equity investors could potentially hide from excessive valuations is in an actively managed equity fund.
Since the turn of the millennium, and especially post the GFC, we have seen unprecedented flows into passive or index-tracker funds.
The issue with the proliferation of such strategies, and a corresponding reduction in the proportion of capital that is actively managed, is that all other things being equal, overvalued stocks become increasingly expensive, while undervalued stocks get progressively cheaper – driven as passive strategies are by money flows.