- The ongoing long‐term bear market has driven investors to avoid risk, causing safe assets such as U.S. Treasury bonds and high dividend stocks to become increasingly expensive.
- The flight towards safe assets has caused the yields of high quality global government bonds to reach unprecedented lows, in many cases offering negative real yields.
- In equity markets, capital has concentrated in traditionally defensive (safe) sectors such as utilities and high dividend payers.
- Fear of sudden market shocks has created a “risk on / risk off” dynamic where managing risk levels has superseded investing based on fundamental factors.
- Near constant investor fear and nervousness has had a decidedly negative  effect on actively managed mutual funds.
- Recently, there have been positive signs that investor fear is beginning to subside.
- A return to a more normal investment environment could lead to significant losses in is supposedly “safe” assets. In addition, it should reward investments in what are now considered risky assets whose current valuations are more compelling in the long‐term.

A Long, Hard Slog

Investors are scared, and who can blame them? For the past twelve years, the market has provided many bumps and bruises, with little in return. Investor woes began with the bursting of the tech bubble in 2000, followed soon after by 9/11 and recession. After a brief respite, investors then suffered the collapse of the housing bubble, leading to the most severe banking crisis since the great depression. Given the difficulty investors have recently faced, it’s no wonder sentiment has become extremely fragile and pessimistic.

Aside from a few brief periods of calm, there has been an unrelenting parade of negative news to stir up concern among investors. However, as the graph below makes clear, the reward for equity investors who have ridden out the market volatility is that they can look back on the last twelve years to see that the S&P 500 remains lower than it was in 2000 when the bear market began.

More recently, we’ve experienced a series of aftershocks or mini panics that have been just severe enough to scare anyone who was beginning to feel comfortable again. Most of these fears and panics have emanated from the fiscally troubled European Union, but our own politicians and policy makers have done a great job of shaking investor confidence here at home as well.

An Exodus From Risk

As our current bear market has lengthened, investors have become increasingly reluctant to invest in equities due to their perceived risk and volatility. This reluctance has resulted in a massive shift by investors towards bond funds. As the graph below shows, in the past five years investors have moved roughly one trillion dollars more into bond oriented mutual funds than into stock oriented mutual funds.

But it isn’t just fear that has pushed investors towards bonds. Before the long‐term bear market in equities began, bonds were enjoying a very long‐term bull market that began in the early 1980’s. As the graph below shows, over the past 30‐ years, yields for 10‐year US Treasury bonds have fallen from a high of  nearly 16% to the recently recorded all‐time low of 1.4%. Since bond prices go up when yields go down, bond investors have enjoyed a strong tailwind for more than three decades. This long and successful performance history in bonds coupled with the recent volatility and poor performance in the equity market has attracted more and more investor capital towards bond oriented investments.

For bond investors, the combination of fear and unrealistic return expectations has driven the prices of the safest government bonds to irrational heights. Under normal circumstances, investors are willing lend money to safe governments, such as the United States, at some yield above expected inflation. The yield above inflation is known as the real yield.

Historically, 10‐year U.S. Treasury yields have provided a real yield of about 2.5% above inflation. In contrast, according to JP Morgan¹, as of June 30, the after inflation real yield of the 10‐year treasury was a negative 0.44%.

This means investors are willing to lend money to the U.S. government and accept less purchasing power as repayment when the bond matures. This flight to the safety of government bonds hasn’t just been in the United States; this has been a worldwide phenomenon. A recent article² in the Wall Street Journal highlighted the extraordinarily low yields in highly rated government bonds around the globe. As you can see in the nearby graph, many of the stable countries in Europe are offering little, and in some cases negative yields, on shorter‐term, 2‐ year bonds.

The Clamor for Equity Yield

While evidence of the clamor for safety has been clear in the bond market, the undercurrents of fear in the equity markets have been less obvious. Although largely unrecognized, most major market indices have more than doubled since bottoming in 2009. While early gains were widespread, investors have recently seen a bifurcation among equity values.

Sectors traditionally considered as defensive (or safe) have greatly outperformed the rest of the market, while sectors that typically benefit from a growing economy (cyclical stocks) have underperformed the broader market. The graphs below come from a recent pair of Wall Street Journal articles^3,4 that highlighted the divergence of both prices and values of defensive stocks and cyclical stocks.

Historically, “defensive” stocks are slow growing but stable businesses, such as utilities and consumer staples companies. These stocks typically have lower earnings growth, and often offer higher dividend yields. As a result, these stocks ordinarily trade at a discount to the broader market. Presently, because of the flight to safety they are trading at a premium.

Given the recent sharp divergence in the performance of these sectors, many of these defensive sectors appear overvalued when compared to cyclical sectors. The table below represents the degree to which each of the sectors of the S&P 500 are either overvalued or undervalued as compared to their average valuation over the past 20 years. Red shading indicates they are relatively expensive, blue shades indicate they are relatively inexpensive.

As you can see, the defensive, or safe, sectors have become increasingly expensive, while the cyclical sectors have become increasingly inexpensive. Stocks offering high dividend yields have performed particularly well, and as a recent Barron’s article⁵ noted, they have become particularly expensive as well. According to the article, high yielding utility, telecommunication, and consumer staple stocks are priced higher than they have been in 80% of historic periods.

A Bipolar Market

Following the 2008 financial crisis, investors’ psyches seem to have suffered a form of financial shell shock. The devastating events of the early 2000’s and the financial crisis of 2008 have caused investors to become nervous and hypersensitive to negative news. This hyper‐sensitivity has created a new and unfamiliar dynamic in the market known as “risk on / risk off” where risky assets move in lock‐step, either up or down, depending on the good or bad mood of the market.

A largely unanticipated effect of this new dynamic has been a severe polarization of various asset classes. In a normal investment environment, investments are evaluated based on their unique characteristics. For example, large company stocks are viewed differently than small company stocks. In today’s market, there are two types of investments; risky and safe. When the market is “risk on,” nearly all risky assets do well. But when the market is “risk off,” risky assets get pummeled.

Modern portfolio theory was designed on the principle that a diversified portfolio, containing different types of investments, would provide better performance and safety than a portfolio containing only a few types of investments. The central concept was that different assets classes move independently of one another, therefore offsetting each other and lowering overall portfolio volatility.

Modern portfolio theory worked well until recently. The current 12‐year bear market, which has been frustrating and often vicious, has conditioned investors to fear that even a minor negative headline or market turn has the potential to become a full blown market crash. The chart1 provided by JP Morgan below shows clearly how correlated and polarized risky and safe asset classes have become.

As you can see, in 2005 (top chart), there was a lot of diversity in the levels of correlation among various asset classes. By contrast, in 2011 (bottom chart), these correlations became very strong with risky assets moving very closely together, and safe assets moving contrary to risky assets. This indicates the heightened fear in the market and a general disregard for the underlying fundamentals of each of these individual asset classes. In today’s market environment, there is very little gray area; an asset is either risky, or it isn’t.

The Punishing Impact on Alpha

Active investment managers select stocks in an effort to outperform the overall market, or in technical terms, create “Alpha.” The recent convergence of the extreme fear and nervousness coupled with the high levels of correlation and polarization has created a difficult environment for these active managers. A recent study⁶ by JPMorgan’s Chief Equity Strategist, Thomas Lee, found that the average year‐to‐date relative performance of actively managed large cap mutual funds versus the Russell 1000 through July is the worst it has been in at least 15 years.

The common sense discipline of active management is to buy what is cheap, and sell what is expensive. In the current market, however, fear has driven valuations higher on already expensive defensive assets, and driven valuations lower for already cheap cyclical stocks. Buying investments that are expensive, and selling investments that are cheap could be reasonably viewed as somewhat irrational.

But this is not the first time in recent memory that the market has been irrational. As the chart below shows, actively managed mutual funds suffered through a very difficult period in the late‐90’s when at the pinnacle of the dot‐com boom, fund managers shied away from pricey technology stocks in favor of more attractively priced stocks.

As the underperformance persisted, investors like Warren Buffet were dismissed as out of touch with the “new paradigm.” When the tech bubble peaked and burst in 2000, it became evident that greed had motivated the markets irrational rush into tech stocks.

This time, the desire to allocate to and from risk in portfolios has crowded out fundamental investing, with the overriding theme of “safety at any cost.”

Signs of Calm

Since the market bottomed in 2009, we’ve had three major market corrections; all three surrounding negative developments in Europe. The first resulted in the now infamous “flash crash” that saw the Dow Jones Industrial Average decline 1,000 points in a matter of minutes. All told, the 2010 market correction brought the S&P 500 down 16% before things settled and the rally continued.

In the summer of 2011, the double whammy of the debt ceiling debate and ongoing Euro‐zone crises caused the S&P 500 to decline 17% in just 11 trading days, with a total decline of 18% before the market calmed and rallied again to new highs. This year, the catalysts for a correction were the same; Euro‐crisis and domestic policy uncertainties, but this year, the market reaction was much milder. In May and June, the S&P 500 declined a relatively modest 10% before the rally once again resumed.

The CBOE VIX Index which is a widely recognized benchmark for expected market volatility has recently settled to levels last seen five years ago, or before the financial crisis began. This suggests that investor sensitivity is finally beginning to abate.

Final Thought

At current prices, there remains a lot of danger in so called “safe” assets. Fear has caused capital to stampede into the safest areas of the market and to flee risky assets. U.S. Treasury bonds will provide a negative real return if inflation rises, and the safe areas of the equity market are far more expensive than the risky areas.

As has been proven many times in the past, when the investors operate in emotional extremes, and markets behave in illogical ways, irrational trends will eventually reverse and correct. Often the correction happens in dramatic fashion, such as a bursting bubble. The timing of the change is also very difficult to predict. Recall that former Federal Reserve Chairman Alan Greenspan gave his famous “Irrational Exuberance” speech in 1996, or some four years before tech bubble actually burst.

With so many uncertainties on the horizon, such as the ongoing European crisis, geopolitical concerns in the Middle East, our own domestic economic concerns, as well as our upcoming elections and surrounding policy uncertainties, it is difficult to foresee a meaningful change in dynamics of the market in the near‐term. But the market often changes when it is least expected, and recent weeks have shown signs of a reversal in these trends.

As investors become reconditioned to expect uncertainty, and to avoid overreacting to every tidbit of negative news, fundamentals will start to matter again, and thoughtful investing based on fundamental factors will again be fruitful. It is important to recognize that the ultimate measure of the safety of an investment is the price you pay. At the wrong price, safety can be extremely dangerous.

Questions or comments, please contact:
Owen Murray, CFA
omurray@horizon‐advisors.com

References:
1. “Guide to the Markets— 3Q 2012”, J.P. Morgan Asset Management
2. “When Interest Rates Turn Upside Down”, by Davis Wessel, WSJ.com, 8/8/2012, Link
3. “Investors Testing Limits of Defense”, by Jonathan Cheng, WSJ.com, 7/22/2012, Link
4. “Stocks: The ‘Safety’ Dance”, by Ben Levisohn, WSJ.com, 8/10/2012, Link
5. “The Danger in Dividend Stocks”, by Jacqueline Doherty, Barrons.com, 8/25/2012, Link
6. “U.S. Equity Strategy Flash”, by Thomas Lee and Katherine Khor, J.P. Morgan, 7/27/2012

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