A Return to Stock Picking

Fifteen years ago, our re-evaluation of subprime-mortgage risk precipitated the Global Financial Crisis (GFC) with lasting consequences. Last year altered our assumptions about the price of time as the post-GFC duration bubble burst. This watershed moment in our financial history will also have lasting effects.

The monetary policy response to the GFC, Quantitative Easing (QE), inflated a duration bubble that Edward Chancellor contextualised in “The Price of Time”. Chancellor explained how the era of easy money led to asset bubbles, discouraged saving and exacerbated inequality. Critically it also forced yield-starved investors to undertake excessive risk, often of longer duration.

But QE also reduced asset price volatility and increased asset price covariance. Investment returns converged into the “everything bubble” as all asset prices rose together. In the decade of the 2010s, the five most significant constituents of the MSCI World Index increased their share of the total from less than 5% to more than 15%. In 2010 the list included two oil majors, a technology company, a bank and a consumer products company from three different countries. By 2020 all five were US West Coast technology companies.

Unsurprisingly, as equity markets converged, the best investment strategies involved repeating the successes of the recent past, such as index tracking and trend following. Low-cost trackers and momentum strategies were unassailable. After years of falling interest rates, investors added debt to boost returns. Private equity and venture capital funds boomed. It didn’t pay to be different, and FOMO fuelled leverage.

Meanwhile, stock picking (buying shares on individual merit), value investing (buying cheap shares), and mean reversion (the mechanism by which cheap shares become more valuable) became outmoded concepts, pushed to the margins of acceptable investment practice. Why bother investing in today’s cash flows or discounted assets when you can cheaply and effortlessly buy tomorrow’s growth? Time was free.

The duration bubble has now burst, and the free money era has ended. Over the last twelve months, the US Fed Funds Rate has exploded from 25 bps to 500 bps, a 20-fold increase in the price of time. The value of the foundational layer of the global financial system, US Treasury bonds, collapsed as their yields soared. The normalisation of rates happened at an abnormal speed, and we know the impact comes with long and variable lags. However, it didn’t take long to hit the UK.

Last September, a new government attempted to kick-start the UK economy with an unfunded, tax-cutting budget, unaware of a major fault in some of the UK’s most significant pension funds. Using a popular derivative strategy, these funds had boosted returns by loading up on bets that bond market volatility would remain within historical norms. Unfortunately, the reaction to the budget fell outside these norms, catalysing a liquidity crisis threatening payments to millions of pensioners.

A similar fault emerged at Silicon Valley Bank (SVB) six months later. By taking losses in previously held-to-maturity (HTM) long-dated Treasuries, SVB exposed significant unrealised bond losses. While SVB was not alone in this regard, it also had liabilities heavily weighted to larger uninsured deposits covering the payroll of the region’s cash-rich but often unprofitable start-ups. In “risk management” of improbable incompetence, SVB managed to be long duration on both sides of its balance sheet at the wrong time.

SVB and the UK pension funds had failed to spot the bursting duration bubble. In both cases, monetary authorities performed policy contortions to ease the resulting stress, providing liquidity to restore financial stability. Their new policy tools reduced specific financial pressure but cast doubt over the broader war on inflation.

Companies must now adapt to elevated inflation and higher debt costs. New capital formation requires re-equitisation as balance sheets de-lever. Equity returns will disperse as company-specifics reassert themselves. Covariance among sectors and asset types will decrease. The investment environment will again reward value, and mean reversion will re-energise sector rotation. Forward-looking active investors will outperform passive strategies pre-programmed to invest using the yardstick of the previous era’s winners. The post-duration-bubble period will be volatile, but its prize will go to the stock pickers.

Jeremy

Ealing

07/04/2023

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