The Ballad of Bulls & Bears

Believe it or not, bull and bear fights were a once popular blood sport introduced by the Spanish conquistadors that ultimately became quite popular across California throughout much of the 1800s. At the time, California’s grizzly bears were commonly viewed as a menace that posed serious risks to those inhabiting the area – but settlers did see some value in the mighty beasts as gladiatorial combatants. In fact, an 1888 account from the historian Hubert Howe Bancroft described the pastime as follows:

In a typical battle, the grizzly bear – standing up to eight feet tall and weighing as much as 800 pounds – would be chained to a post with the bull roped to the bear to keep the two in orbit. The burst of an officiator’s pistol would initiate the contest, and more often than not, the bear would emerge victorious despite being chained to a post. Over time the cruelty of this blood sport faded along with the grizzly bear itself, but the proverbial influences of this once popular pastime serve as the origin for what we now refer to as bull and bear markets. The terms are thought to derive from the way in which each animal attacks its opponent; that is, a bull will thrust its horns up into the air while a bear will swipe down with its claws. These actions were then related metaphorically to the movement of a market, wherein uptrends were referred to as bull markets with downtrends referred to as bear markets – the latter of which seems to hold the winning record (at least in a historical context). Why might this be the case?

Renowned economist and investor, Benjamin Graham, once said “the longer a bull market lasts the more severely investors will be affected with amnesia, because after five years or so, many people no longer believe that bear markets are possible.” Perhaps this is why Benjamin Graham is widely recognized as the father of value investing, but he’s right – and this is why many investors find themselves overconfident, yet underprepared when the inevitable does happen. But what is it that causes these environments in the first place?

Traditional financial literature teaches that markets are designed to be efficient (i.e., accurately reflect new information), and though markets have become impressively efficient over the years, they are not perfectly efficient – even with today’s technological advances. Nothing lasts forever, and as Benjamin Graham put it so delicately, all bull markets will eventually come to an end whether we want to believe it or not. John C. Bogle, founder of The Vanguard Group, once said that “reversion to the mean is the iron rule of financial markets” – meaning that most assets do in fact have a fair value, and when valuations drift too far in one direction, asset prices tend to revert back to their normal or average levels over time. Interestingly enough, the average duration of a bull market is seven times longer than that of a typical bear market, so what might begin as a healthy uptrend often leads to extreme valuations that ultimately overcorrect to the downside – resulting in a wave-like pattern that is commonly referred to as the economic cycle. Asset prices rarely sit at their mean or fair value, and the longer a bull market persists the more violent its corresponding bear market is likely to be. The true investment challenge is performing well in difficult times, hence why the bear often emerges victorious despite being chained to a post.

This is exactly what happened in 2022 and what many speculate may continue in 2023. As you might remember, most assets – particularly those of a mega-cap tech orientation – embarked on a historical tear following the Great Financial Crisis that left many amazed and others confused. What was once infamously acronymized as FAANG (Facebook, Apple, Amazon, Netflix, and Google) ultimately became an unloved darling of Wall Street, impacting investors far and wide as market-cap-weighted indices such as the S&P 500 and Nasdaq-100 became increasingly concentrated in these industry-specific growth holdings. Worse yet, the same mechanics that led to last year’s equity selloff also teed up what would become the worst year in recorded history for fixed income – something that may seem obvious in hindsight after years of easy monetary policy, but a reality that once again caught many off guard.

Equities and fixed income had almost always served as a yin and yang, but last year was different. This methodical, yet painful churn was the product of overdue mean reversion that asymmetrically impacted the most vulnerable investors, and while it’s difficult to predict the market with any degree of accuracy, we can rely on the economic cycle for some indication of what might be on the horizon. We wrote last summer how this incredibly rare, 1st percentile event would be especially problematic for those relying solely on equities and fixed income to generate a stable source of total return, and though we were unsure when this lethal one-two punch might unfold, we warned in our 2021 year-end commentary that mounting inflationary pressures and the subsequent need for tighter monetary policy (i.e., higher interest rates) would ultimately serve as a dual-headwind to equities and fixed income. This façade of diversification may have come to a head in 2022, but given the mean reversive tendency of financial markets, we’d like to offer a token of collective optimism as we turn the page on a new year.

The old adage on Wall Street has always been “dance so long as the music is playing”, but at Silicon Hills, we prefer to find a chair before the music comes to a screeching halt. Last year we accomplished this via risk-managing alternatives and a factor-based approach to equity investing – isolating highly profitable companies trading at attractive relative multiples and allocating to non-traditional assets such as commodities and currencies in lieu of fixed income. Herein lies the raisons d’être of our entire methodology, but rather than focusing solely on the past, perhaps the better question is what might lie in store for 2023. Have we experienced the mean reversion that Benjamin Graham and John C. Bogle warned us about, or are we only mid-way through a 9-inning ballgame? Understanding our own inability to predict the future, we can summarize our 2023 capital market expectations as follows:

• Equity valuations have compressed and expected returns have increased, but “the value spread” is very much alive and well.
• Fixed income effectively navigated its “awkward phase” and appears to be this year’s comeback kid.
• Risk-managing alternatives illustrated their dominance last year and should continue to be a bellwether if we find ourselves in a recession.

The Value Spread

There are a number of ways to bifurcate the investable equity universe, but perhaps the most common is growth vs. value. Simply put, growth-oriented equities tend to trade at higher prices relative to current revenue/earnings due to their future growth potential – technology companies being the most common example. Conversely, value-oriented equities often trade at lower relative multiples and offer greater profitability/cash flow in lieu of future growth potential. Growth equities tend to perform best during periods of economic expansion, whereas value equities exhibit the most relative outperformance during periods of economic contraction. Predicting the economic cycle with any degree of certainty is of course a difficult undertaking, but an effective means of assessing the relative attractiveness of growth vs. value equities is the value spread – which is essentially a statistical means of comparing the valuations of growth and value equities. The higher the spread, the more expensive and thus less attractive growth is relative to value. Provided below is a time-series representation of the value spread published by our partners over at AQR Capital Management:

As you can see, the greatest value spreads tend to precipitate the most difficult market environments – the Dot-Com Bubble and Great Financial Crisis being the most recent examples. Perhaps this time is different, but even if you look at a simple chart of the S&P 500 price-to-earnings ratio, the market has yet to revert to its long-term average of approx. 15 despite the volatility that we experienced last year.

This reaffirms our belief that the value spread is still very much alive and why we continue to believe that our factor-based approach to equity investing – isolating highly profitable companies trading at attractive relative multiples – is the best way to navigate this year’s market uncertainty. Equity valuations have declined and future expected returns have increased, but it would appear that the bubble has yet to pop. Growth outperformed value for over a decade, and though it’s difficult to predict what the future may hold, history would suggest that this resurgence in value is still in its early innings.

The Comeback Kid

Remember the days when fixed income yielded next to nothing with interest rates near zero? It may seem like forever ago, but the game has changed. With the Fed’s most recent interest rate hike on February 1st of 25 basis points, the target range for the Fed Funds Rate now sits at 4.5%-4.75% – the highest since October 2007.

The pace of rate hikes over the past 12 months has not only put significant pressure on both equities and fixed income, but has also resulted in a historically inverted yield curve – a tell-tale macroeconomic signal that a recession is likely on the way. In fact, an inverted yield curve has emerged roughly one year before nearly all recessions since 1960.

This of course reaffirms our findings as noted above, but with short-dated fixed income offering yields in excess of 4%, investors can now earn a great source of income (and thus inflation protection) all the while insulating their portfolios from mounting economic risks. 2022 may have been the worst year in recorded history for fixed income with long-dated Treasury Bonds losing nearly 33%, but in our view, fixed income has escaped its awkward phase and now has much better days ahead – just like Bubba Newman (John Ritter) in the 1980 classic The Comeback Kid.

The Bellwether

We’ve written at length about the value of risk-managing alternatives, and simply put, our thesis remains unchanged. We began introducing these instruments in late 2021 because we recognized the limitations of traditional fixed income as an equity risk mitigant (for reasons previously discussed), and despite our reembrace of fixed income, we believe that risk-managing alternatives will remain critically important to portfolio construction in 2023. Not only have these strategies offered a positive long-run return and good performance amid equity market drawdowns, but they also tend to perform best during times of trouble for the core portfolio – including Fed tightening, high volatility, and large moves in inflation up or down. We run a number of alternative strategies that provide tactical, uncorrelated exposure to most major asset classes across the global market, but my personal favorite is trend-following managed futures, which leverages a series of quantitative models to take long and short positions in various futures markets – including commodities, currencies, and other derivative instruments. Provided below is an illustration of just how valuable managed futures can be to a diversified portfolio – not only reducing portfolio risk and maximum drawdown (while keeping annualized return intact), but also carrying a dynamic correlation to equities in both up and down markets.

It’s difficult to assess where exactly we might be in the economic cycle or if we ultimately find ourselves in a recession, but regardless of the outcome, we still believe that risk-managing alternatives, a reembrace of fixed income, and a value-oriented, factor-based approach to equity investing will be key to navigating 2023. Easing recession fears, a resilient labor market, and friendly inflation prints have sent the market higher this year with the S&P 500 and Nasdaq-100 up 6.3% and 10.7% (respectively) in January alone, but despite the recent uptrend – we believe that this bull-bear cage fight is far from over. Markets will continue to mean revert and the economic cycle will persist as it always has, but if there’s one thing we can learn from our west coast predecessors: don’t underestimate the bear, no matter how strong the bull.

About the Author

Dean Rogers, CFA

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