The time may be ripe for relative-value strategies

Taking a look at current market conditions, this article explores the merits of implementing alternative investment strategies to capitalize on the eventual convergence of valuations towards intrinsic values, historical averages and...reality.

When Up is Down and Down is Up

It would come as no secret to those of you who are both attuned to the current market conditions and familiar with some financial history and theory that we are traversing a somewhat bizarre period.

Economic dissonance

On the one hand, we have persistently low interest rates and monetary stimulus from central banks - a worldwide phenomenon, on a scale and scope never done before in the history of capitalism. The foundations of this novel approach to salvaging an ailing economy were laid during the Great Financial crisis in 2008-2009, and upon them rested the entire recovery initiative which never seemed to have ceased. The COVID pandemic only added fuel to the fire, catapulting these efforts into the stratosphere. The only conditions that would warrant such measures would be a severe and prolonged depression.

On the other hand, as a result of monetary intervention we have peak-level financial markets, real estate markets and if we are to believe the news, a highly prosperous economy with low levels of unemployment soaring job creation and labour shortages - hardly the type of environment that requires stimulus.

In short, according to the financial news we are experiencing one of the most prosperous periods in our lifetimes. Nevertheless, the central banks and governments are stimulating markets as though we are going through a greater depression than that of the 1920's

Financial Innovation without net benefits

In addition, the pandemic has given birth to many strange phenomena: meme stocks, NFTs, countless crypto currencies, and an array of fin-tech companies ready to take on, and disrupt the long established banking world and even our idea of money for years to come. All this is very exciting, but it is worth remembering that finance as an industry acts as a lubricant to the gears of the economy. It does not create anything. In the best of times, it just facilitates the allocation of capital and free flow of resources where they produce the highest value. It would be hard to imagine an economy predominated by participants trading financial instruments amongst them as a thriving one. Sure there is activity, there is drama, but not much value gets produced. Then again, value these days takes a much more liberal interpretation. To illustrate my point take this story: "Single pixel of digital-only art sold as an NFT for more than $1.7M at Sotheby's". One of the items in this story surely must be mispriced - is it the digital pixel NFT, or the USD 1.7M?

The Risk / Reward dynamics do not work nor matter anymore

What we have here then is a market that is hard to understand, at least by traditional measures. In yet another twist lets turn to the 10 year T-bill for instance, currently yielding 1.35%. This is in a context where the measured US inflation sits at 5.37%, the Fed prints money like there is no tomorrow and the government burns through it almost as fast, hitting again and again their self-imposed debt-ceiling level only to extend it after sessions of haggling in congress. Are investors accepting 1.35% because they perceive the current risks so high that they are willing to get a negative real yield for 10 years, or in a more traditional line of thought, they view the current environment as risk-less as it’s probably ever been, thus demanding a very low risk premium to part with their money? The jury is out on this one. There is also a lot of talk about sustainability these days. In one example, under the guise of sustainability, the company was able to obtain close to EUR 1B from investors at below 1% yield, in an oversubscribed offering, in spite of it’s credit rating being BBB-, a score considered by most to be of a lower grade and just a notch up from the Non-investment threshold. The examples abound, yet even a child would scratch their head trying to figure if the current dynamics are sustainable and whether the leading lights of our financial system should even try to sustain it in its current form.

Source: Macrotrends -Fed Balance Sheet vs Gold Price

Stock valuations are as polarized as the society they represent

Much can be said about the current stock valuations. Traditional metrics do not matter anymore. As long as a company has a beautiful story with a "happily ever after" ahead, no price seems too small. Fortunes have been exchanged for visions of a better world and individual wealth records have been broken again and again and again. This created a massive wealth gap, not only amongst us mere mortals but even in the constituents of the S&P with the top 10 stocks now accounting for over 30% of the index. The gap is even larger if one considers the Russell indexes.

So where does one go hunting for value in schizophrenic markets which simultaneously hold true, diametrically opposed views on everything from risk to valuations and even with respect to the very idea of what money is and isn’t?

Alternative Investment Strategies - A solution for an alternative investment world.

More specifically, I am referring to relative-value strategies, which seek to capture value while isolating the positions from stock-market volatility or certain factors such as interest rate increases or even unexpected inflation. There are several techniques an astute investor can use to make the most of such strategies, depending on the risks they want to isolate and those they are willing to undertake.

Before we delve in, let's get a better understanding of what a relative value strategy is. In a nutshell, it is an approach of allocating capital in a way that seeks to exploit temporary differences in the prices of typically related securities and it has been a popular technique employed by hedge funds to extract value while reducing or isolating risk. There are several methods an investor can employ, the most common names ascribed to them being long-short market neutral, pairs trading and arbitrage. While the distinctions between the methods enumerated above could easily fade into one another, the foundations of these strategies are based upon a simple concept: simultaneously buying an asset or a pool of assets expected to rise in value while selling short an asset that is expected to depreciate in value. The main differentiators between the methods relate primarily to the velocity of the volatility, the correlation of the pairs and the types of assets involved. Let's take a closer look:

Market Neutral

A market neutral strategy involves creating long and short positions aimed to profit from both increasing and decreasing markets, while attempting to completely isolate some specific market risks. This can be achieved by employing both fundamental research as well as statistical methods. A simple example would entail choosing an industry such as banking and creating a portfolio of “winners” and “losers” amongst publicly traded bank securities and buying the first and short selling the latter. This would mostly isolate the portfolio from external market influences and correlations while seeking to extract the value of the net position. The success is highly dependent on the quality of the analysis.

Arbitrage

Arbitrage is a technique that employs the simultaneous buying and selling of securities or groups of securities, often in different markets seeking to exploit pricing gaps that create “riskless” profit opportunities. This method was famously employed by the hedge fund Long-Term Capital Management which sought to derive absolute profits by engaging in the buying and selling of treasury bonds, exploiting pricing gaps. Typically the returns of such methods are small relative to the amount of capital needed, thus occasionally leverage is employed to amplify returns. Long-Term’s story finished in disaster primarily due to the uncontrolled use of leverage amongst other factors. To learn more follow the link.

Long-Short

Using the same idea of buying and selling securities with the aim to generate outsized returns while reducing risk, this method typically complements a long-only portfolio adding a source of return as well as risk reduction. There are numerous ways to go about it. From a value investing standpoint, one would seek to “hedge” a portfolio of value stocks which are trading at prices lower than their intrinsic value by shorting a portfolio of over-valued stocks. An investor can gain extra-points if the short portfolio includes companies who are outright frauds or subject to impending events which prove detrimental to their long-term viability (product recalls, federal investigations, accounting fraud etc.)

The Verdict

The list above is by no means exhaustive and there are numerous other methods that can seek to take off-setting positions that can effectively lock in value. At the core, the idea is to realize the potential profits offered by extreme mispricing of securities or asymmetric risk-reward opportunities and seek to capitalize on them, while isolating certain macro risks which currently loom large: inflation, interest rate increases and stock market volatility amongst others. In addition to crafting and implementing one's own relative strategy, there are companies that can act as natural hedges against such macro factors: Insurance companies, for instance, could help offset inflation and interest rate risk through their balance sheets. In some instances, banks, depending on their portfolios and credit risks could do the same. Valuation and a thorough analysis are quintessential to make such plays work in this environment. For those who want a more passive approach, a long-short strategy can also be implemented at relatively low costs through ETFs. This reduces the need to constantly monitor positions, adjusting hedges and managing risk while providing a more diversified position. Here is a link to a list of such ETFs to serve as a starting point in your research.

I will conclude by reminding the reader that there is a rhythm in markets as there is in the natural order of the universe. Everything flows, rises and falls like the tides. The pendulum is on the precipice of changing course and swinging yet again and positioning an investment portfolio accordingly can make the difference between success and failure.

Disclaimer

This article by Cozar Investments is general in nature. We provide commentary and content that is educational in nature which is based on historical data, analyst forecasts using an unbiased methodology and multiple other sources. Our articles are not intended to be financial advice but rather to provide market commentary. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. To assess the suitability and merits of any investment opportunity we encourage to consult your financial advisors as the situation warrants it. We aim to bring you long-term focused analysis driven by fundamental data. While we make every effort to ensure the accuracy of the information presented using only sources we believe to be reliable, please take note that this analysis may not incorporate the latest price-sensitive company announcements, quantitative or qualitative material and we provide no representation or warranty, expressed or implied with respect to the accuracy of the material.

You should assume that Cozar Investments or the Author of the article holds positions in any of the securities discussed herein. Cozar Investments is not receiving compensation for the article other than from ad services displayed on the page. Neither Cozar Investments nor the Author have any business relationship with any companies whose securities are mentioned in this article.