Equities outlook for the next 15 years. Can managed futures help?
Systematic managed-futures traders do not typically try to make predictions. They do not study, in an opinionated manner, the fundamentals of businesses such as Microsoft, markets such as oil, economies such as the US or Europe or macro statistics such as unemployment rates. Instead they usually focus on two variables, namely historic price action and volume. Historic could range from a couple of months to a couple of nanoseconds, disregarding completely the fundamentals mentioned above. In other words trying to predict is the last thing on their agenda if it is on their agenda at all.
So for us, in trying to make an educated guess for the outlook of the equity markets for the next 15 years, we focused once again on historic information but with a slight twist. We analyzed current conditions vs. history to see if there is room for significant change in the next 15 years, to the point that would make attractive equity returns a highly probable outcome.
The two main determinants of value (and therefore stock prices over the long term) are profit expectations and discounting factors, determined principally by the level of interest rates. High profit expectations coupled with low or declining discounting factors, resulting from low or declining interest rates, create an environment of high perceived values and drive stock prices higher. Conversely low profit expectations coupled with high or rising discounting factors depress perceived valuations and stock prices.
So the question simply becomes, where are we on discounting factors and profit expectations at the moment and what is the likelyhood these will create momentum for higher stock market prices.
Exhibit 1 below shows the path of US three-month interest rates going back to 1934. Back in those days, interest rates were depressed for many years as part of dealing with the great depression that started in 1929 with the stock market crash. Three-month rates reached their lowest point in January 1941 at 0.02% and entered an uptrend afterwards that continued for the next 40 years until May 1981 when they reached 16.3%. Since then, interest rates entered a declining path to reach near zero in November 2008 and stayed as low due to the zero interest rate policy adopted ever since.
So it is broadly obvious what the next long-term trend for interest rates is. In all probability upwards, taking with them all discounting factors and as a consequence creating a major drag on perceived valuation of all asset classes (stocks, bonds and tangible property).
However, valuations are determined principally by two variables. Interest rates and profit expectations. So we next turned to profit expectations to see if there is a chance to create a positive momentum over the medium term. A gradual increase of interest rates may act as a drag on valuations however if profitability of US corporations enters an extensive period of positive momentum, its positive effects could potentially out-weight any negative effects of an increase in interest rates.
Exhibit 2 shows the profits after tax of all US corporations as a % of GDP since 1947. What stands out in Exhibit 2 is the mean-reverting nature of US corporate profitability as a % of GDP with the mean averaging between 6.00% – 6.50%. Any occasional breakouts above that, are usually followed by periods of severe reduction of corporate profitability. This is not by chance but rather a mathematical certainty. A variable (corporate profitability) that is a subset of another variable (GDP) cannot expand indefinitely as a percentage of the latter.
So where are we then on profit expectations. Again it is more or less obvious how this could unfold in the following years. As hard as it is to believe it, the percentage of corporate profitability is at its highest point in the last 70 years! Could this go any higher? Possibly but as systematic traders our focus is on probabilities. What is more likely than not, up or down?
So with interest rates most probably going up and profit expectations most probably going down, we can make an educated guess where valuations and stock markets are heading over the next couple of years. It would take a serious positive disruption to break away this negative momentum.
There is one more factor that could disrupt this momentum in a positive way. A growing positive market sentiment that reflects on market multiples i.e. p/e ratios. If this goes significantly higher (much much higher!) over the next few years, despite rising interest rates, it could offset any negative effects of such rates rising and profitability falling.
So let’s see where this is standing at the moment. Exhibit 3 shows the cyclically adjusted price-earnings ratio going back to 1881. What stands out is that currently investors, when buying stocks, are prepared to pay approx $24 for every dollar of annual earnings. This was significantly exceeded only twice in the last 130 years, during the market excesses of the internet bubble that eventually burst, in early 2000, and the market excesses of the late 1920s which preceded the stock market crash of 1929 and the great depression.
So, should we expect market multiples to significantly rise in the next few years. Again, probably not.
So, where does that leave us. As systematic traders we try to make an informed assessment of probabilities. Here we see a high probability of rates going up and a high probability for earnings to go down or at least stay sub-par. Higher rates result in higher discounting factors thereby depressing market multiples on earnings through which valuations are determined. If these lower multiples are applied to depressed earnings, we have a dim outlook for equities in the next 10-15 years if not more.
Can managed-futures help?
Suppose we are right, what is an investor going to do. How is the investor going to shield himself against this outlook to generate attractive returns or at least maintain his purchasing power in the medium term.
Well, although we can make an educated guess where we see equities 10-15 years from now, we cannot make any kind of reliable guess what path they will take. Equities may double in the next five years and then drop where they started in the following five, or vice versa. They could triple or quadruple during the period only to collapse in a stock market crash thereafter. Who knows. Fear and greed, the two most primitive of all human natures, will most certainly ensure that if our guess above is right the path towards it will not be linear.
A long-only investor stands little chance to benefit from a market that goes up 100% and then falls back where it started or lower. A trend-following investor though has significantly more chances in such an environment!
Trend-following is the most common strategy in the managed-futures space. As the name suggests, trend following aims to capture trends in the market, both on the upside as well as the downside. Furthermore it is not restricted to equities. Besides equities, trend following tries to capture trends in the currencies market, in commodities, in long term interest rates as well as short term by taking long or short positions in the futures markets representing those asset classes.
So even if our predictions on equities above prove entirely correct, a trend following strategy can still make money out of it by riding the advancing or declining equity trends that emerge during the interim. Even if there are no trends in the equities market, the strategy can still make money by diverting its focus to trends in other markets e.g. currencies, commodities, long or short term interest rates. A properly-designed trend following strategy ensures that the focus is constantly on the sectors presenting the highest opportunities for trends. For this reason managed futures and trend following in particular have a proven track record as an excellent diversifier to equities. The strategy works especially well during periods of market stress. In a period of severe market turbulence, when all other asset classes are collapsing (stocks, property, private equity), trend-following managed futures demonstrate extreme resilience as during such periods opportunities to capture mega trends are in abundance. This is another reason why managed futures present excellent diversifying opportunities in a traditional equities portfolio.
Exhibit 4 shows the performance between March 1999 and February 2016 of the S&P500 index (in red) vs. the SG Trend Index – 2x leveraged (in green), an index representing the largest trend-following managers in the managed-futures space. We can see that even during the period when the S&P was range-bound delivering no positive returns, the SG Trend Index was significantly outperforming. Due to the nature of the strategy that aims to capture rising and falling trends not just in equities but also in currencies, commodities, long and short term interest rates, the strategy is able to deliver positive returns irrespective of the range-bound behavior of equities.
We then added a blue line which represents the performance of a portfolio made up of 60% equities (S&P500) and 40% trend following managed-futures (SG Trend Index – 2x leveraged). What comes out as striking is not only the outperformance against a portfolio consisting of equities only but also the blue line equity curve is smoother. In other words, an allocation to trend following enhances returns AND reduces risk i.e. volatility. We can see for example during the 2008 stock market crash, trend following performed extremely well, mitigating equity losses to a large extend. Also, in the aftermath of the internet bubble and 9/11 when the stock market was suffering, trend following added resilience to the portfolio.
So, as regards the question “Can managed-futures help during a dim equities outlook?” the answer is an obvious yes they can. Any investment strategy that has a durable positive expectancy whilst demonstrating little or no dependence to traditional equities is a must for every serious investor that wishes to mitigate the risk of a, potentially, non-performing equities market in the upcoming years.