Views From the Floor

In this week's edition: smarter markets, shrinking markets, CAPE fear and helicopter money. It’s all action in this week’s View’s From the Floor.


In this week’s edition (23 Apr 2019) - China’s Economy: Low Point?
 

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Is the Market Getting Smarter?

How many stocks are in the Wilshire 5000 Index? Trick question. Although the index started life in 1974 as a list of approximately 5000 US stocks, it now only contains 3486 names.

The universe of US stocks has been shrinking steadily since 1997, with a notable decline in listings (Figure 1). The reason for this is three-fold: more private equity buyouts, industry consolidation, and companies deciding to stay private longer. With regards to the latter, this may be because public markets are getting smarter. Investors could be eschewing the youngest names, which are typically growth oriented and therefore less profitable, sensibly targeting older ones. In fact, the percentage of IPOs with negative earnings has increased from around 25% in 1990 to around 70% in 2019 (Figure 2). The beta-adjusted alpha for stocks listed in the last year is -2.9%, compared to 0.5% for companies who have been listed for ten years or longer (Figure 3).

This move away from young, R&D intensive companies could be reinforcing the trend towards a shrinking stock market. Investors avoid young, negative earning stocks, discouraging these companies from listing. Without the new listings, natural attrition, buyouts and M&A inevitably reduces the investable universe. Markets may possibly be smarter, but at the price of being smaller.

Figure 1: Distribution of US Stocks by Age, 1990-2018

Distribution of US Stocks by Age, 1990-2018

Source: CRSP, Bloomberg, Man Numeric; As of December 31, 2018.

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As of March 2019.

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Source: CRSP, Bloomberg, Man Numeric; As of December 31, 2018. Risk free rate is proxied by the BoA Merrill lynch 3-month Treasury Bill Index.

CAPE Fear

Figure 4 shows a version of Jeremy Grantham and Ben Inker’s model for assessing the level of the Shiller cyclically adjusted price-earnings ratio (CAPE) according to psychological inputs. The model has three inputs: the volatility of GDP, the volatility of inflation and the real return on equity (ROE). The logic is this: as inflation and GDP become more volatile, and returns more compressed, investors get scared, and pay less for equities.

The model has been useful in the past as, when it registers a significant negative deviation from the CAPE, the market is usually positive over the subsequent 12 months.

As of December 31, 2018 this spread (Figure 5) had fallen to -3 points but the key level we are watching for is -4. We have reached this deviation 17 times since 1927. Of these occasions there has only been one (in December 1931) where the real return of the S&P 500 was not positive over the next 12 months. The average real return across these 17 instances was 19%.

Figure 4: Grantham-Inker Behavioural Model

Grantham-Inker Behavioural Model

Source: Man Solutions, Bloomberg; As of December 31, 2018.

Figure 5: Spread Between Actual and Model-Implied CAPE

Spread Between Actual and Model-Implied CAPE

Source: Man Solutions, Bloomberg; As of December 31, 2018.

Chinese Helicopter Money

Chinese banks have created USD25 trillion of new M3 (‘broad’) money since January 2009, according to BCA Research (Figure 6). This is roughly three times the size of total broad money creation in the Eurozone, Japan and the US combined over the same period, which BCA estimated at USD8.3 trillion. Given that China’s nominal GDP is only 38% of the combined GDP of the US and Eurozone, the relative size of this figure is staggering.

We feel this presents a worrying picture for long-term Chinese growth, even though we have acknowledged that the short-term outlook is strong after the latest round of stimulus. Without regulators halting the expansion of credit and the money supply, Chinese leverage has never been higher. Logically, higher leverage means larger interest payments, both at corporate and consumer level, diverting future cash away from consumption or investment. If payments become excessive, they act as a drag on growth.

In our view, this is also a source of opportunities for stock pickers. With so much credit creation we believe it is likely capital has been misallocated on a grand scale and that in time, equity value maybe destroyed by the misallocators.

Figure 6: Money Supply Levels

Money Supply Levels

Source: BCA Research; As of April 22, 2019. *Includes certificates of deposit.

With contribution from: Rob Furdak (Man Numeric, co-CIO), Shicong Wang (Man Numeric, Senior Portfolio Analyst), Henry Neville (Man Solutions, Analyst) and Pierre-Henri Flamand (Man GLG, CIO).