Josh Coval, a professor of finance at the Harvard Business School, spoke last week at a lunch seminar, discussing his thoughts on the market and the world economy. With his permission we summarize his remarks below.
Is the market currently overvalued?
The investor should ask a different question - what is the risk premium in the market? There is no clear indication that it is time to buy or sell. Historically, over the last 100 years, stocks have outperformed bonds by 7% annually. While academics cannot come up with a good story as to why this level of superior performance has persisted, theory suggests that a premium of 2-3% is expected. Investors appear to be more comfortable investing in the stock market, especially over the last 20 years, resulting in capital to shift from bonds to stocks. Coval does not expect the 7% performance superiority to last forever, but expects some level of superior performance to persist, resulting in higher risk for stock investments in exchange for historically higher rewards.
What is the state of the private equity and hedge fund markets?
Private equity and hedge fund markets do not outperform the market if the investor properly adjusts for risk. Returns from private equity have been very impressive over a 20-30 year period. The key question is how investors should adjust for risk. Private equity returns behave like a ‘levered’ equity return, essentially as if equities were bought on margin. An investor might actually outperform private equities by buying stocks on margin. With hedge funds there is a similar story, but it is not just a levered bet on the market. There is an important characteristic of hedge funds that consists of writing insurance against a dip in the market. Hedge funds are not necessarily doing this explicitly, but implicitly. So the question to ask is whether hedge funds outperform a strategy that includes writing insurance against market dips, and the answer appears to be no. Coval cautioned that this does not apply to all hedge funds, just to some of them. The returns are not that great once you properly adjust for risk.
What are the key predictors of market performance?
Predictors of market performance have value only if they can predict what others cannot predict. The question is not just whether someone can predict market movements, but whether they can predict these movements better than other investors. It is not as easy as it might seem. Looking at price-to-earnings multiples over the recent past, the market is now above average, but not tremendously so. The problem is that lots of people look at this data, so its value is greatly diminished (i.e., it is already built into the market). It is similarly difficult to find individual stocks that are improperly priced. Lots of people get compensated handsomely to find these stocks, and these people are doing an increasingly better job. Improper pricing is more likely to exist in smaller, less liquid companies. Coval has seen a stream of PhD candidates writing theses, based on regression analyses, showing how to generate alpha using behavioral biases. They get hired away by Wall Street and the investment opportunity goes away.
What sectors will perform the best in the next year or two?
Coval talked about the attraction of value stocks in recent years, and the fact that a lot of capital has been deployed in value stocks. It is not enough to know that value stocks will generate superior earnings. The question is whether they will generate better earnings that others think they will. The capital inflow to value stocks has eliminated this mis-pricing. The same thing has happened to emerging markets. Coval singled out Renaissance Capital as a firm that has been successful finding investment opportunities, but they are not worrying about whether now is the time to go into value stocks. Their analysis is more micro and much more sophisticated.
What happened in the last six weeks?
The probability of entering an inflationary period has shifted in the last six weeks. Inflation will depend on the US current account deficit. In the last few weeks, information from Congress is that there will be increased pressure on the Chinese to loosen pressure on their currency, the Yuan. Coval is not sure the
Chinese will allow this to happen, and believes that the Chinese will continue to intervene aggressively to keep their currency undervalued. People overlook that the Chinese economy is heavily dependent on exports to the US, and the Chinese cannot afford a revaluation of the Yuan that would slow these exports. Coval would not be surprised if the current account deficit persists and valuations remain as they are. Southeast Asia and China will play a central role in the world economy going forward and addressing this question is critical to making a macro bet on world economies.
Coval believes that one of the problems with US portfolios in general is that they are not sufficiently diversified globally. The US is about 40% of the world economy, but most investors have more than 90% of their assets in the US markets.
How does Josh Coval invest personally?
All of Coval’s retirement funds are passively invested in index funds. More than half are in foreign equity markets, because it is difficult to get index exposure in the foreign debt markets. He has some active exposure through a couple of small hedge funds, and does not do any active delegated management. Coval believes the evidence is pretty clear that it is difficult to beat the market as an investor, and just as difficult to find someone who will do that after fees.
What is happening with structured finance?
Coval’s research is centered on structured finance, and the last portion of the talk was devoted to this topic. Structured finance is the process whereby investment banks purchase a portfolio of securities and then divide the portfolio into tranches, with the tranches having prioritized claims on the cash flows. For example, a portfolio of BBB corporate bonds can be purchased. The risky tranche (called the equity tranche) will absorb the losses on the initial defaults of bonds in the portfolio, if defaults were to happen. Other tranches have correspondingly lower levels of default risk, and the least risky tranche can carry an AAA credit rating. Since there are very few companies with AAA credit ratings, and there is a market for buying AAA credit, structured finance has become the mechanism to satisfy this demand. Coval contends that these structured AAA products are actually being incorrectly priced. He argues that their risk of default can come only from a broad failure across the US economy. Academics call this systematic risk, because it cannot be diversified away, and pricing models have proven that investors should be compensated for systematic risk. But current pricing on structured products indicates that investors are not getting adequate yields from these investments. A great deal of debt issued from private equity transactions ends up in structured products, and this undervaluation has contributed to the growth of the private equity markets.
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