Standing At The Edge Of The Abyss

by: KCI Research Ltd.

The U.S. stock market, while experiencing a tremendous move higher over the past decade, has been delineated into the "Haves" and "Have Nots".

The funnel of money into the winning investment strategies and winning stocks has stretched relative (and absolute) valuations to extremes.

These valuation extremes are going to end badly for many, specifically those in the majority, and it will be a boom for those brave souls invested in the minority.

"A 60:40 allocation to passive long-only equities and bonds has been a great proposition for the last 35 years… We are profoundly worried that this could be a risky allocation over the next 10." - Sanford C. Bernstein & Company analysts, January 2017

"Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria." - Sir John Templeton

"Life and investing are long ballgames." - Julian Robertson


During my time writing on Seeking Alpha over the past six years, I have emphasized two points on a regular basis. First, the big opportunity, for a long time now from my perspective, has been in the out-of-favor equities that are not favored by the current structure of the market funnels of liquidity. Admittedly, this opportunity has been a long road, except for 2016, though I still think there is a historic reward at the end of this long, challenging journey. Second, the broader U.S. stock market is historically overvalued, and this has been the case dating all the way back to April of 2015, in my opinion, when the S&P 500 Index was trading over the 2,100 level (thus we remain overvalued today).

Starting valuation levels are ultimately the most important determining factor for long-term equity returns (and fixed income returns for that matter), which is a significant problem for both stock and bond investors today.

However, in the short term to intermediate term, almost anything can happen, and that has certainly been the case with the distorted financial markets for much of the past decade, certainly since 2016 in my opinion. Financial markets have been tipsy on the combination of central bank liquidity, passive/ETF price indiscriminate fund flows, and the dominance of popular investment and trading strategies, which have combined to almost eliminate price discovery, pushing traditional value investors to the brink of extinction, with worse relative performance than even the peak of the late 1990s technology euphoria.

Where do we go from here?

A return to price discovery could decimate the returns of in-favor markets, investment strategies, and equities, what I call the "Haves", which are collectively standing on the edge of the abyss, peering over the edge of a long relative and absolute drop down, while the scorned out-of-favor investment strategies and equities, what I call the "Have Nots", could finally be on the verge of a historic climb higher, fueled by a capital rotation from growth to value that could exceed the rotation witnessed from 1999-2007.

Investment Thesis

The next decade is going to look very different in performance terms than the past decade, with value stocks poised to dramatically outperform their growth counterparts.

Where We Stand Today

The S&P 500 Index, as measured by the SPDR S&P 500 ETF (SPY) has put together one of its best decades of performance, rising almost in a straight line from its March 2009 lows as illustrated in the chart below.

(Source: Author,

The strong performance of the S&P 500 Index has been driven by the largest equities, particularly disruptive growth equities, which have thrived in a global investment landscape that is starved for growth.

(Source: Author,

Looking at the chart above, the FAANG stocks have thrived, with Netflix (NFLX) gaining 6,291% the last decade, Amazon (AMZN) gaining 2,239% over the trailing 10 years, Apple (AAPL) shares higher by 955%, Alphabet (GOOGL) (GOOG) shares higher by 446%, and Facebook (FB), which has not been around for the full 10 years as a public company, up 382%. All of these equities have significantly outperformed SPY, which is up 275% over the past decade, and SPY itself has outperformed a majority of domestic and international equities and equity indices.

Microsoft (MSFT), not a nominal member of the FAANG club, has seen its shares rise 684% the past decade, and provides another example of how intoxicating the performance of in-favor large-cap growth stocks has been.

Growth Trounces Value

The outperformance of growth is more encompassing than just the FAANG names, though they have certainly led the charge, as the relative performance of the S&P Growth Index versus the S&P Value Index shows below.

(Source: Author, Stockcharts)

Growth stocks actually started outperforming before the full brunt of the 2007-2009 decline, and they really have not looked back ever since, reaching a new high in relative performance, topping even the early 2000 extremes.

Market Structure Imbalances Are Accelerating

Passive investment buyers, by definition, are price indiscriminate. Within the U.S. market, passive funds have overtaken their active counterparts already in the large-cap section of the market according to data from Morningstar (MORN).

This shift to passive is pervasive, with Moody's (MCO) predicting that passive funds will surpass active funds in terms of assets under management in the U.S. market by 2021.

A quote from the above linked article highlights the perceived advantage of passive investments, with many viewing them as being superior, partly due to performance over the past decade.

Greater investment in passive products is "akin to the adoption of an improved technology," according to the report.

Investing has almost been distilled to a formulaic science, without the needed skills of those who value investments.

Going further, as I wrote in the SA article titled, "It's 1999 All Over Again", the amount of passive money by itself understates the impact of passive investments, because many active managers are forced to become closet indexers.

A couple of decades ago there were essentially no 'closet index' funds, says Martijn Cremers, a professor of finance at the Yale School of Management who worked with Petajisto on a previous study of this issue. But as index investing has become more popular, individual investors have become 'more benchmark aware,' he says. 'Your performance relative to the benchmark has become more salient.' As a result, investors are now quicker to bail out of funds (or individual stocks) if they fall short of their benchmark indexes, creating an incentive for managers to at least match their benchmarks - and a disincentive to make big bets that could go wrong, Cremers says…

The end result is that the impact of price indiscriminate buying of passive investors has been actually understated by market observers and commentators. Speaking from the perspective of someone who started an active, boutique money management business in February of 2009, it has been very hard to be different than what is performing well, particularly since 2012.

What Is Wrong With Passive Investing

I have written about this extensively, because it is so important, and this importance has grown as the market imbalances have grown.

In a September 21st, 2017 article I authored for members of The Contrarian, titled, "Investment Philosophy - A Golden Age For Active Investors Awaits", I pontificated on how there was very little price discovery in the market.

To illustrate this point, I referenced several quotes from Steven Bregman, president and co-founder of Horizon Kinectics, who presented at James Grant's October 4th, 2016 Investment Conference.

Here is the first quote I referenced:

A golden age of active investment management awaits only one signal event, Steven Bregman, president and co-founder of Horizon Kinetics, told the Grant’s conference-comers on Oct. 4. A collapse of the index/ETF bubble is that intervening disaster. To hear Bregman tell it, no crash would be so well-deserved

He called the exchange-traded fund excrescence the world’s biggest bubble. “It has distorted clearing prices in every sort of financial asset in every corner of the globe…,” asserted Bregman. “[I]t has created a massive systemic risk to which everyone who believes they are well diversified in the conventional sense are now exposed.”

While pondering whether we are in the middle of this signal event right now (could today's collapse in volatility be the signal?), consider Bregman's next quote that I referenced regarding price discovery:

"There is no factor in the algorithm for valuation,” our speaker noted. “No analyst at the ETF organizer — or at the Pension Fund that might be investing — who is concerned about it; it’s not in the job description. There is, really, no price discovery. And if there’s no price discovery, is there really a market?

Building on this narrative, Bregman then attempted to solve the riddle that he termed the "ETF Divide", and which I like to call the "Haves" and the "Have Nots". To illustrate his point, he used Exxon Mobil (XOM) as an example equity:

“Bregman lingered for a while on Exxon, a kind of ETF Swiss Army knife: “Aside from being 25% of the iShares U.S. Energy ETF, 22% of the Vanguard Energy ETF, and so forth, Exxon is simultaneously a Dividend Growth stock and a Deep Value stock. It is in the USA Quality Factor ETF and in the Weak Dollar U.S. Equity ETF. Get this: It’s both a Momentum Tilt stock and a Low Volatility stock. It sounds like a vaudeville act.”

Bregman proposed a mind experiment: “Say in 2013, on a bench in a train station, you came upon a page torn from an Exxon Mobil financial statement that a time traveler from 2016 had inadvertently left behind. There it is before you: detailed, factual knowledge of Exxon’s results three years into the future. You’d know everything except, like a morality fable, the stock price: oil prices down 50%, revenue down 46%, earnings down 75%, the dividend-payout ratio almost 3x earnings. If you shorted, you would have lost money” — because the financial statement didn’t mention the coming bifurcation of the stock market that Bregman called the “ETF divide.”

On one side of the line are the anointed ETF constituent securities; on the other side is everything else.”

We are still waiting this signal event, and the wait has been very painful. From a fund flow perspective, think about how this applies to the popular investing strategies of today, particularly passive investing, and dividend growth investing, where dividends are emphasized above all else.

REITs Are A Bubble That Will Be Popped

Building on this narrative of price indiscriminate buying, REITs have performed very strongly in 2019 and for the past decade, with both the Vanguard Real Estate ETF (VNQ) and the iShares U.S. Real Estate ETF (IYR) ahead of the performance of the S&P 500 Index.

(Source: Author, Stockcharts)

As someone who bought First Industrial Realty Trust (FR) and Vornado Realty Trust (VNO) near their lows in 2009, I certainly understand the appeal of real estate securities.

(Source: Author, Stockcharts)

However, the current infatuation with REITs, and really dividend oriented equities, is at the same extreme levels as the wholesale move into passive investments.

By October of 2018, REITs were actually the most expensive sector in the market (shown below), and this has only worsened this year.

(Source: Antero Resources October 2018 Presentation)

Ultimately, investors in REITs, and in the in-favor investment strategies today, which are going on a decade of being in-favor, are just chasing past performance, and in the investment markets, these manias usually end badly.

Closing Thoughts

The markets have continued in their current trends virtually unabated for the past decade, and they are at further relative and absolute extremes today than they have almost ever been, including at the early 2000 historic peaks.

This is going to lead to very divergent performance returns going forward, as ultimately starting valuations are the most important determinant of future returns.

The "Have" equities and investment strategies are going to suffer immensely, while the "Have Not" equities and investment strategies have the potential to benefit to a greater degree than most can imagine right now.

What will be the catalyst to spark this rotation?

Honestly, I am not sure, and the current trends and in-favor investment strategies have gone on for longer than I ever imagined.

However, with passive investments now the majority of investment assets under management, and a significant majority of assets under management if closet indexers are included, it will not take much to tip the scales, and once this happens, the current structure of the market and performance chasing will take over.

Bigger picture, fundamentals still do matter, fundamentals were always the wrong scapegoat, and I still believe 2019 is going to be a banner year for value equities, similar to 2000, as price discovery, after a decade of growth outperforming value, is poised to return with a vengeance.

To close, even though it has been a very difficult almost decade-long stretch for value-oriented investors, with pockets of significant outperformance, including 2016, I think we are about to enter a golden age for active value investors who do the fundamental work, who can find the future free cash flow-leading companies, and the most out-of-favor sectors and the most out-of-favor equities, including this public write-up, will be at the forefront of this opportunity.

Disclosure: I am/we are short SPY AS A MARKET HEDGE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Every investor's situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.