BofA: The Market Is No Longer Efficient
Almost exactly 8 years ago, in April of 2009 we wrote for the first time that as a result of the confluence of unprecedented central bank intervention meant to prop up risk prices which distort markets in the long run, and the rising dominance of HFT and algo trading strategies, which distort price formation in the ultra-short term, the market is no longer a (somewhat) efficient, discounting mechanism, but has in fact been “broken.”
Now, in a note released overnight by BofA’s Savita Subramanian, the equity analyst comes to the same conclusion: the market is no longer efficient, primarily as a result of a wholesale scramble for short-term, data-driven trading gains, which have made a mockery of fundamental analysis and a focus on long-term investing profits.
Here are some of her observations:
Stocks for the long-term is an all but forgotten concept today. The rise of short-term investment strategies, which tend to rely on access to better, faster and larger stores of data and information, has attracted trillions of dollars of capital, compressing equity holding periods and likely exacerbating spikes in short-term volatility.
Managed futures funds (also known as CTAs), which tend to trade based on quantitative algorithms, have grown rapidly over the past several decades. According to BarclayHedge, their assets have grown to over 250bn, making up close to 10% of the total hedge fund universe.
Similarly, low volatility computer-driven strategies have also seen significant growth in recent years.
Quantitatively oriented clients have 3x the number of factors today than they did twenty years ago (Chart 5). Quant/factor investing popularity has increased sharply, at the expense of interest in fundamental investing (Chart 6). One of today’s greatest market inefficiencies may stem from the scarcity of capital devoted toward long-term, fundamental investing.
And yet, long-term market inefficiencies have increased: Given the abundance and improvement in data, analysis and tools, oddly enough, what should be an increasingly efficient market shows some signs of becoming less efficient. In tandem with asset growth in “fast money”, the opportunity set, as measured by the range of market prices, has shrunk on a short-term basis, but has risen on a long term basis.
The number of analysts covering stocks has structurally
decreased – suggesting that the human element of fundamental analysis
(assessing body language of management, physical channel checks, etc)
have been supplanted by processes.
* * *
So are human traders destined for extinction as robots take over all jobs with only ETF trading soon remaining? Well, since BofA’s paying clients tend to be human, Savita had to put an optimistic spin on her findings. This is what she said:
Fundamentals win over long time horizons. The declining interest, assets and resources devoted to fundamental analysis suggests a significant opportunity in our view. Fundamental investing is not dead, far from it, but seems to require patience. Our analysis shows that fundamental signals see amplified performance as time periods are extended, but technical and positioning-based signals do reasonably well in the short term, but see marked alpha decay over the long term.
Over the long term, valuation is almost all that matters. Valuations have historically explained 60-90% of subsequent returns over a 10-year time horizon, with the price to normalized earnings ratio (our preferred valuation metric) explaining 80-90% of returns over the subsequent 10 years (Chart 13). Most other valuation measures have a reasonably strong level of efficacy over long time horizons (Table 1). We have yet to find any factor with such strong predictive power over the short term.
Time really is money…At least for stocks. As investment time horizons lengthen, the probability of losing money in stocks generally decreases. While trading stocks over a one-day period can be
considered to be only marginally better than a coin-flip, the probability of losing money plummets to 0% over a 20-year time horizon. Moreover, time horizon arbitrage is unique to equities: other asset classes (for example, commodities, as shown below) do not exhibit such characteristics (Chart 14).
Over the past 80 years, only two decades have produced negative total returns: the 1930s (only -1% despite the Great Depression) and the 2000s (-9%, the worst decade for investors which started with high valuations and the “tech bubble” bursting and ended just after the financial crisis). Other decades also had numerous crises: 1940s (WWII); 1950s (Korean War); 1960s (social unrest, Vietnam war, JFK assassination); 1970s (hyperinflation, oil embargo); 1980s (mortgage rates near 20%, LatAm debt crisis, crash of 1987, S&L crisis); 1990s (Asia/Mexico/Russia crises, LTCM) yet produced solid returns for those who remained invested.
While we applaud the finding that “valuations matter” – as otherwise thousands of universities around the world would have to give their econ and finance professors the pink slip – there’s just one problem with the above: LPs and other asset allocators no longer have “patience.”As another BofA analysis also released overnight showed, according to which a great rotation from active to passive management is taking place. And while fundamental investing may “not be dead”, those who practice it will soon have no cash left to manage, which is essentially the same thing.