Given the market is continually in a state of flux it can be difficult get a handle on the market’s strength and weakness. One measure is to assess the market based on its risk adjusted return, or Sharpe Ratio.
The Sharpe Ratio is a measure of return per unit of risk, calculated as the excess return over the risk free rate, divided by volatility of the excess return. For example, if the excess return of the market was 6% and the volatility was 12%, then the Sharpe Ratio is 0.5.
The long term risk adjusted return for the S&P/ASX 200 Accumulation Index is 0.25 . However, for the twelve months to December 2019 the S&P/ASX 200 Accumulation Index risk adjusted return was 2.6 versus its forty year average of 0.25. To put this into perspective the one year risk adjusted return for the Index has only been higher on five occasions over the last forty years. Those five occasions were:
• Sept 1987 – prior to the ’87 Crash
• Oct 1993 – prior to the US Fed interest rate increases of early 1994
• July 1997 – prior to the Asian Crisis
• Jan 2005 – recovery after the tech crash and the beginning of the resources boom
• Oct 2007 – prior to the GFC and following a sustained elevated Sharpe Ratio over an extended period
The following chart compares future five year returns when historical risk adjusted returns have been at extremes.
Low Sharpe Ratios (where Sharpe has been as low at -2.0) typically provide future returns greater than the markets long term average. Note, the average total return for the market since 1980 has been 10.9% per annum (before inflation).
Conversely, high Sharpe Ratios (where Sharpe has been as high as +3.0) typically provide future returns that are below the market’s long term average and with greater variability.
Similar trends are exhibited over shorter time frames, with the following chart detailing the future one year returns from the market when Sharpe Ratios are at these same extremes.
Now we do not intend to be alarmist and nor are we proposing an imminent market crash. We don’t make forecasts. But we are mindful that risks are elevated and the returns of the last year are unlikely to be repeated in 2020. To use an old adage, history does not repeat, but it certainly rhymes.
With the market driven by a rebasing of valuations rather than earnings growth and risk adjusted returns well above historical norms, several possible outcomes may drive a normalization of the Sharpe Ratio:
1. Returns will moderate or fall;
2. Underlying stock volatility will rise; or
3. We will see a combination of lower returns and higher volatility – which often go hand in hand.
Monetary policy stimulus, both globally and locally, provided a tailwind that has supported the local market and produced a stellar 23.4% total return for equities over the year to December 2019.
This supportive environment tends to ‘raise all boats’, suppress underlying stock volatility and does not allow price discovery and dispersion to be fully expressed. And whilst we may still see interest rate reductions locally, the effectiveness of monetary policy when rates are excessively low will require earnings growth to justify market valuations. With analyst forecast earnings growth for the market in the low single digits, stretched valuations, the dissipation of prior tailwinds and a return to higher underlying stock volatility consistent with longer term trends, returns for the market are unlikely to repeat that of the last year.
And what does that mean for Equus Point Capital and how we seek to provide investors with meaningful risk adjusted returns?
As a market neutral strategy we are seeking to provide investors with a return stream independent of the direction of the broader market. Ideally we seek to provide returns in both positive and negative markets over a full investment cycle, uncorrelated to the market.
Stocks with positive / negative earnings growth tend to be reflected in share price appreciation / depreciation. An environment stimulated by central bank intervention tends to support stocks irrespective of their fundamental merits. However, while these sugar hits are short term in nature and assist in rebasing valuations, we are optimistic that the emerging environment will be more conducive to a systematic investment process that is seeking to derive meaningful returns from the momentum premium.
The momentum factor is based on inherent behavioural biases that are not easily arbitraged away. Momentum and trends in individual stocks, increased stock volatility and price discovery should assist in the re-emergence of the momentum premium going forward.
The material contained in this communication (and all its attachments) has been prepared by Equus Point Capital Pty Ltd. Equus Point Capital is a Corporate Authorised Representative of Prodigy Investment Partners Limited AFSL No. 466173 (“Prodigy”).
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