Over the years we have spoken frequently about how we use the Four Pillars of the
market to determine our allocation decisions on a forward-looking basis for the next
6-12 months. For many of our clients this can be the difference between achieving
their return goal or missing it by a few percent. The Four Pillars that we focus on are
Growth, Valuation, Sentiment, and Capital Flows. Each pillar is discussed and assessed
by Clearbrook’s Investment Committee until we have a consensus view of whether it is
a tailwind or headwind for a particular geographic region, asset class, and investment
strategy. It is important to note that specificity is not the goal of the exercise. We try to
avoid getting bogged down in the weeds of uncovering, analyzing and predicting every
data point. Instead, we actually take a step back from this mass of information, and
concentrate on the most important factors to paint a clearer picture of the direction of a
particular asset class, industry/sector, and capital flows. After we have determined the
pluses and minuses behind each pillar, we aggregate them together to give us a view on
the global economy and investment landscape. The process enables us to have a “proactive” forward looking view to asset allocation. This is contrary to the reactive posture
many investors take, making alterations to their asset allocation after changes in growth,
valuation, sentiment or fund flows have already occurred.
Growth
We do not have one standard measure of growth, rather we apply what we
believe is the best measure of growth in a geographic region/country, industry/
sector, and asset class. Usually, this involves some measure of economic growth,
whether that is GDP, the unemployment rate, retail sales, etc. and a measure of
a particular industries growth rate (revenues and earnings). If we are discussing
large-cap US equities then we are concerned with the expected earnings growth
of the S&P 500, the expected growth rate of the US economy, and the strength
of the economy and stock market (is the growth expected to be relatively high
or low compared to recent history). This exercise is not exclusive to equities
either, if we want to determine the growth rate of the German economy we will
look to its expected GDP growth, expected rise/fall in unemployment, and the
expected change in the industrial production measures and service industry
measures, amongst others. If we determine that the German economy is likely to
expand over the next 12-18 months we may decide to overweight international
equities or underweight international bonds, depending on our valuations and
determinations of the other pillars.
Valuation
Similarly, to our measures of growth, we use broad based measures of absolute and
relative valuation to determine if an industry or asset class is over or undervalued.
Amongst equities we employ a discipline of comparing fundamental metrics such
as forward P/E or P/B across industries, and relative to their historical averages. We
do not rely solely on the market’s view of comparative valuation either. For example,
when we access the valuation of the S&P 500 and we determine the forward P/E of
the equity index is above its historical average, we need to understand the current
and forward macro environment to make a fair comparison. Specifically, during the
COVID-19 induced recession and market correction, corporate earnings dropped by
historical levels due to the economic “shut-down,” sending the S&P 500 P/E higher. As
the US re-opened and we expected the US economy and corporate earnings to grow at
a faster rate than their historical averages, we recalibrated our valuation view to accept
a higher current P/E which should decline as corporate earnings accelerate. This
environment would have us isolate sector/industry groups that would be the greatest
beneficiary of the revival in corporate earnings, such as US large cap equities.
Sentiment
Sentiment is more difficult to quantify than traditional measures such as economic
growth or equity valuation, as this branch of behavioral finance can be an overriding
factor in the movement of markets in the short-term and over the long-term as
well. Often times when fundamental data appears to be decoupled from market
movements, such as the past six months, investor sentiment is the cause. Global
markets are forward looking mechanisms and will typically move in price six to twelve
months in advance of actual changes in economic or earnings growth. At Clearbrook,
there are a number of factors we follow to track sentiment such as consumer
confidence, investor sentiment and business confidence which are leading indicators
that reflect prevailing conditions and likely developments for the months ahead. If
indicators are positive, they would provide a positive and expansionary forward view.
Similarly, investment flows into broad asset classes (i.e. equities, money market funds,
fixed income, etc.) can reveal positive or negative sentiment for a particular asset
class. Sentiment is an important factor that we use to determine our tactical as well as
long term strategic portfolio positioning. The foundation of our investment process is
based on fundamental data, but it is important to understand sentiment will typically
drive short-term asset price and direction. Outsized valuation moves in financial
markets have historically been prompted by a dramatic geo-political or economic
event, which causes a substantial shift in sentiment. Two recent events during Q4
2018 (shutdown of the US government and US/China trade tensions) and Q1 2020
(COVID-19 pandemic) caused market sentiment to turn decisively negative, and ignited
a severe market correction or bear market. These types of events offer an opportunity
to asses the market environment and take advantage of fundamental mispricing
because of overly positive or, in this case, negative sentiment.
Capital Flows
Capital flow is a specific measure we use, to track the inflows and outflows of capital
across regions, countries, asset classes, investment strategies and securities. The
increase or decrease of global liquidity by central banks and government policies can
have a profound effect on global markets, particularly those that are less efficient and
smaller in total capitalization. A few of the measures we use to track capital flows
are M1 and M2, trading volumes, investment flows, and central bank action within the
global bond currency markets. Each of these measures can have greater or lesser effect
depending on the size of a region, country and capitalization of a particular market/
asset class. For instance, in the emerging markets asset flows and currency valuations
(relative to the USD) tend to have a greater effect on asset prices than they would on
the larger US markets. As such, it is important to understand what the liquidity profile
and the direction of capital in the emerging markets before making portfolio allocation
decisions for this asset class. The best example which highlights the importance of
liquidity and understanding the direction of capital flows was observed in the credit
markets during the COVID-19 induced bear market. Massive price dislocations occurred
in securities ranging from investment grade corporates to high yield, sending bond
prices lower by several points and yield spreads to expand by hundreds of basis points.
The massive downside price reaction caused a number of fund closures, as liquidity
dried up, prompting securities prices to decline further in an endless spiral. If not for
the Fed’s swift actions to inject massive amounts of liquidity into the credit markets,
the situation could have likely mirrored what occurred during the GFC in 2008. Without
understanding the liquidity profile of an asset class and the outlook of flows within it,
investors can often miss a key driver of asset prices and risks. Investors can subject themselves to perhaps unknown or unrecognized risks, and conversely miss out on profit
opportunities when they present themselves.
Conclusion
While there are many factors that can influence the direction of each pillar, the
simplicity of our approach is its strength. As asset allocators, we must have the
ability to step back from the day to day gyrations in the markets and take a stance
for our clients. Remaining focused on our Four Pillars allows us to take a clear
view of the market outlook and enables us to act swiftly and decisively, especially
in moments of uncertainty and stress. With that focus in mind we continue to
enable our clients to strive for and achieve their goals.