The CBOE Vix index of implied equity volatility — the so-called fear gauge — last week hit the lowest point since its inception. To many, this will seem altogether perverse in the light of a welter of uncertainties hanging over the market. These range from worries over the central banks’ ability to conduct a smooth exit from quantitative easing to Kim Jong Un’s threats to nuke the United States. So the question has to be asked: are investors increasingly blind to risk?
If they are, it will not be for the first time. Complacency is one of the preconditions for the switch from bull to bear markets. The current market is mature and has many classic warning signs attached. Take, first, the ever-rising percentage of the gains in the S&P 500 that are generated by a very narrow group of companies, Facebook, Amazon, Apple, Netflix and Google (now Alphabet), or the Faangs.
I was around in the great bull market of the 1960s when investors were similarly preoccupied with a narrow (though larger) bunch of companies known as the “Nifty Fifty”. These were companies with high and consistent earnings which you could allegedly buy on sky-high price-earnings multiples and hold profitably for ever. Unfortunately the 50 included such future dogs as Polaroid and Xerox alongside General Electric and Coca-Cola. It was a great story while it lasted.
Other such stories included the 1970s scare about the world running out of oil, which propelled oil company multiples skyward. Given the Opec-inspired oil price hikes of the mid- and late-1970s there was a great deal of impetus behind the bull run. The snag was that investors overlooked the ever-reliable elasticities of supply and substitution, which is another way of saying that the price mechanism worked, albeit with a lag, to ensure a glut in the 1980s.
Then, of course, there was the technology, media and telecoms bubble of the late 1990s. While there was something in the story, as there so often is in a bubble, it was hopelessly overblown. Fortunes were spent on shares in companies that were devoid of profits or viable technologies. Here, then, are some salutary lessons for devotees of the Faangs.
While equities are dramatically overvalued today on measures such as the cyclically adjusted price earnings ratio, the loopiness of the boom is not of dot.com proportions. But there ought to be more concern about the quality of earnings. Too much is coming from cost cutting rather than revenue generation; also from share buybacks that bump up earnings per share without improving corporate performance. According to the Federal Reserve’s flow of funds data, buybacks peaked in the first quarter of last year and have fallen ever since. This is ominous because the corporate sector has been the biggest buyer of equities since the market turned in 2009.
That highlights another disturbing feature of this long bull market, namely the proportion of the market now driven by price-insensitive investors. Buybacks are pro-cyclical and their timing reflects chief executives’ desire to inflate bonuses that are related to earnings per share performance. At the same time passive investing has been boosted by the arrival of exchange traded funds, which have been the second biggest buyer of equities over the bull market. Among other things, this approach condemns ETF investors to buy overvalued stocks and sell undervalued ones. And nobody knows how ETFs will perform in a downturn.
Just to round off the picture, standards of corporate governance are eroding. The case of Snap, which runs the mobile messaging app Snapchat, says it all. It came to the market earlier this year offering investors shares with no voting rights at all.
Yet it is in the debt markets that risk appetite seems sharpest. Debt covenants everywhere are weakening and emerging market debt is being valued on a basis that appears to ignore that emerging markets are places where stuff happens. The stuff has a nasty way of leading to defaults. Yet Argentina, a serial defaulter, was able in June to issue a 100-year bond despite having defaulted as recently as 2014.
The moral is that this is a time when investors should be reducing risk, not taking more on. The Vix index and the Argentinian century bond demonstrate that this is the very opposite of what is happening.