All Asset All Access

All Asset All Access, April 2018

In this issue, Research Affiliates assesses the longevity of tech-dominated corporate earnings growth and how shifts in the efficient frontier are influencing positioning.

Rob Arnott, founding chairman and head of Research Affiliates, reflects on why diversifying strategies are key when corporate profits are driven by a handful of large companies, while Brandon Kunz, asset allocation specialist for Research Affiliates, offers insight into the impact of changes in the efficient frontier on portfolio positioning. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.

Q: If elevated corporate profits and the rising monopoly-like power of big tech companies continue to lift stock prices, how useful are diversifying strategies today?

Arnott: This question presupposes that the current trends are here to stay, suggesting that “this time is different.” While that’s debatable, most of us would agree that today’s investing environment is remarkably interesting. This may be the first time in the history of capital markets that the most dominant companies – seven of the eight largest global companies by market capitalization1 – all come from just one slice of the market: the high-flying technology sector. Corporate profit margins are near record levels (as a share of GDP), mainstream equity and duration valuations are in the richest deciles ever and market volatility levels are still near historical lows (despite some recent flux). Will these market conditions persist? Not indefinitely. But abnormal markets can potentially endure for some time.

We believe the continued outperformance of today’s “top dog” companies and rising corporate profit levels are not sustainable in the long run (as recent volatility may attest). In 2012, we studied the largest companies by market capitalization in each sector for a given year in the eight largest stock markets globally (going back 59 years), and found that two-thirds underperformed their own sector over the ensuing 10 years – by an average 4.70% per year.2 And generally the closer we get to the top of the list, the stronger the underperformance. Each year, for the single largest market-cap stock in the world, the average shortfall was 10.5% per annum compounded over the next decade, relative to the MSCI ACWI Index. Over the last 40 years, eight of the 10 biggest companies in the world by market capitalization for a given year were no longer on the top 10 list a decade later.

There are likely a host of explanations for why companies don’t retain the top perch – whether in a sector, a country or the world – indefinitely. Excessive scrutiny from regulators or the punditry, competitors looking for an edge, the natural human tendency to resent success and punish winners, and reduced agility as a company grows may all contribute to disappointing subsequent outcomes. Most of these top dogs also tend to be priced at lofty valuations, reflecting a consensus view that they will remain on top and continue to grow handily. Any disappointments can be severely punished.

Are we really in a new era in which the trending, high-flying tech market leaders can collectively outperform over the long term without some of them devouring the others’ market share? Hardly, in our view. Let’s not forget that disruptors are never the main beneficiaries of their innovations (their customers are) and that disruptors are often disrupted by newcomers with their own innovations. Of the 10 largest U.S. tech names by market cap at the peak of the tech bubble in 2000, two failed outright. How many are still in the top 10? Four. How many have outperformed the S&P 500? Zero. What’s the average underperformance of that Y2K top 10 list? An average 530 basis points per year, for 18 years! How many high-profile pundits think the outcome for today’s crop of tech fliers will be similar? I’m not aware of a single one.

Turning to corporate profits more broadly, we also believe the recent trend of rising U.S. corporate profits has run its course, for a few reasons. First, some of the strongest mean reversion in the capital markets occurs between past and future earnings growth rates. As we discussed in a recent paper,3 over a full span from 1881 to 2017, we observe a reliable negative relationship between past 10-year and subsequent 10-year real earnings growth.

Second, should we rely on the possibility that real wages continue to stagnate, as they have for decades, making way for further growth in profits as a share of GDP? Recall that for profits to continue rising faster than GDP, another component of GDP needs to decline. As we pointed out in the same piece referenced above,3 the shrinking element over the past 60 years has been wages and salaries. If we want profit growth, but at the expense of the labor force, we should be careful what we wish for! If growth in profits continues to crowd out wage growth, we can expect rising populist pressures to promote redistribution, reversing past profit growth. Can profit growth stall for a long while? Yes. For instance, real earnings per share for the broad U.S. stock market reached a peak in 1915 that it did not exceed again until 1953. That’s 38 years of zero real growth, let alone growth that might rival GDP growth.

Finally, even supposing profit margins remain at elevated levels for the foreseeable future, we believe future earnings per share growth cannot outpace real GDP growth in the long run, for a simple and underappreciated reason. Economic growth in the private sector consists of growth of existing companies and the creation of new companies – entrepreneurial capitalism. It follows that the growth of existing businesses must be slower than GDP growth, which itself has been disappointingly low.

If an investor believes that 1) these current market trends will fuel stock price gains for a protracted period, or 2) he or she can precisely predict when market trends will reverse, then there’s no point in holding diversifying assets. In our view, the first postulation is implausible, and success with the second has been extraordinarily rare. In this unusual market environment, do we really want to place all our eggs in one basket? We’ve regularly said diversification is most needed when it is least wanted. And the best time to embrace diversifiers is when no one wants them!

Q: What does your forecasted efficient frontier look like today relative to other points in time, and how does it influence positioning within the All Asset strategies?

Kunz: Before diving in, I’ll mention that the efficient frontier is a set of optimal portfolios that offer the highest expected return per unit of risk (modeled under a simplifying set of assumptions, including rational investor behavior, no transaction costs or taxes, and infinite market liquidity, among others). Introduced by Harry Markowitz in 1952, this concept is fundamental to modern portfolio theory and embraces the benefits of diversification.

Both the height and the steepness of efficient frontiers signal the degree to which markets are offering future reward for taking on risk. For instance, when asset prices are rising, yields are falling and future expected returns are declining, the efficient frontier may shift downward for assets across the board. In this context, it may also flatten as procyclical risky assets outperform their countercyclical defensive counterparts.

Efficient frontiers used by Research Affiliates also shift as we incorporate additional factors into our return forecasting process. These include changing macroeconomic fundamentals (which we capture through our business cycle modeling) or shorter-term momentum (captured through portfolio optimization and trading considerations), aspects that go beyond the scope of this discussion.

Because an efficient frontier representing a broad set of asset classes will vary over time, the overall risk tolerance and risk composition of the All Asset strategies are also time-varying and dynamic. Given All Asset’s value-oriented, contrarian nature, we adjust our risk tolerance depending on when we believe risk-taking is most likely to be rewarded. The risk composition of these strategies will also shift as we increase exposure to what we deem to be cheap asset classes while reducing exposure to those we believe are rich or priced to deliver lackluster future returns.

Let's take a look at the chart below, which sheds light on what our efficient frontier looks like today compared with two years ago, five years ago and at the bottom of the global financial crisis.

Figure 1 is a line graph showing percentage estimated returns of Research Affiliates’ efficient frontier portfolios versus their volatility for January of 2009, 2013, 2016 and 2018. The graph plots estimated return on the Y-axis and volatility on the X-axis. Each line, representing one of the time periods, has a positive slope, showing greater volatility on the X-axis with higher returns. A line representing 2009 is the highest. The line is above and to the left of lines representing the other time periods. The line for January 2013 is below the other lines for most levels of volatility, showing the lowest estimated returns for levels above 0.07 in volatility. The line for January 2018 is higher and slightly steeper beyond 0.07 in volatility. And January 2016 a bit higher than that, but well below the line representing January 2009.

The dark blue line reflects the efficient frontier at the depths of the global financial crisis, when assets across the board took a beating and the efficient frontier shifted dramatically up and to the left. At the time, Rob Arnott went on record with a piece in Barron’s, saying, “I view 2009 as an ‘ABT’ year – Anything but Treasuries.”4 Of course, as we became more constructive on asset prices and economic fundamentals, we transitioned our strategies from their powerfully risk-off postures to much more of a risk-seeking stance, all while maintaining emphasis on Third Pillar asset classes (diversifying markets – including real assets, emerging markets and high yield bonds). These changes tended to be beneficial over the next several years.

By January 2013 (see brown line), we entered the fifth year of a bull market for U.S. stocks and were several years into the post-crisis economic expansion. Assets broadly were trading higher, and therefore expected returns for most assets declined significantly. In tandem, the All Asset funds dialed back risk, as reflected by allocations to “dry powder” asset classes (i.e., short-term bonds, cash equivalents and alternative strategies) of 10.2% in All Asset and 13.9% in All Authority, levels meaningfully above the since-inception averages of 7.0% and 7.5%, respectively. This shift in risk tolerance proved to be prudent, as many of our “home base” Third Pillar markets entered into what turned out to be a three-year bear market.

Fast-forward to January 2016 (see green line). While not as attractive as that of the financial crisis, this steeper efficient frontier reflected recent falling prices and rising probabilities of an economic slowdown in nearly every non-U.S. market. As emerging market (EM) equities, represented by the MSCI Emerging Markets Index, fell below a Shiller price/earnings (P/E) ratio of 10x for the first time since 31 October, 2002, our colleague Chris Brightman suggested they represented “… possibly the trade of a decade – for the long-term investor.” Concurrently, we increased the risk tolerance for both the All Asset and All Authority Funds, largely through a tactically elevated, near-high exposure to EM equities. These and other Third Pillar assets have since emerged from their prolonged bear markets. For instance, over the 24 months through 31 January 2018, EM assets delivered cumulative returns of 78.11% for equities, 31.88% for local bonds and 20.21% for currencies (as proxied by the MSCI EM index for equities, JPMorgan GBI-EM Global Diversified Composite (Unhedged) index for local debt and JPMorgan ELMI+ Composite for currencies). Our strategies captured these opportunities through higher allocations to these and other “riskier” diversifying assets.

Turning to January 2018 (see blue line), rising asset prices have again prompted us to reduce our overall volatility tolerance. These levels remain higher than each fund’s since-inception realized volatility, which suggests continued attractive return potential, most notably in international asset classes. That said, our volatility tolerance is lower today than at the end of January 2016, and it’s lower than it would be if the efficient frontier from 2009 were available today.

Let’s now consider the potential to deliver upon our secondary benchmarks of Consumer Price Index (CPI) +5% for All Asset and CPI +6.5% for All Authority. The passive return potential suggested by today’s efficient frontier falls short of these benchmarks and the funds’ returns in recent years. That said, various assets within our Third Pillar-centric opportunity set remain attractively priced, and our toolkit in seeking to achieve these benchmarks includes exposure to actively managed PIMCO funds and the potential to create additional value-added through tactical allocation shifts, dynamically changing our risk tolerance and risk composition. Moreover, the All Authority Fund is able to use leverage to further enhance its return potential (with some concomitant risk). Taking these additional return drivers into account, we believe that while our strategies’ long-term secondary return benchmarks may be more difficult to achieve today than they were a couple of years ago, they are by no means off the table.

Further reading

Recent editions of All Asset All Access offer in-depth insights from Research Affiliates on these key topics:

  • Positioning for volatile markets and the link between equity valuations and macro conditions (March 2018)
  • The likely effect of tax cuts on long-term corporate profits (February 2018)
  • The outlook for asset classes around the world in 2018 and beyond (January 2018)
  • A recap of what drove 2017’s strong performance (December 2017)
  • A revealing look at why a negative correlation with mainstream assets isn’t required to benefit from diversification (November 2017)
  • A deep dive into the All Asset strategies’ dynamic risk positioning (October 2017)

The All Asset strategies represent a joint effort between PIMCO and Research Affiliates. PIMCO provides the broad range of underlying strategies – spanning global stocks, global bonds, commodities, real estate and liquid alternative strategies – each actively managed to maximize potential alpha. Research Affiliates, an investment advisory firm founded in 2002 by Rob Arnott and a global leader in asset allocation, serves as the sub-advisor responsible for the asset allocation decisions. Research Affiliates uses their deep research focus to develop a series of value-oriented, contrarian models that determine the appropriate mix of underlying PIMCO strategies in seeking All Asset’s return and risk goals.

1 These included Apple, Alphabet, Microsoft, Amazon, Alibaba, Tencent and Facebook as of 31 December 2017.
2 For more, see my June 2012 paper “The Winner’s Curse: Too Big to Succeed?” coauthored with Lillian Wu, and June 2010 article “Discovery of ‘too big to succeed’ law,” published in the Financial Times.
3 See “CAPE Fear: Why CAPE Naysayers Are Wrong,” published January 2018 by Rob Arnott, Vitali Kalesnik and Jim Masturzo.
4 See “How to Play a 'Take-No-Prisoners' Market,” published in Barron’s on 22 December 2008.
The Author

Robert Arnott

Founder and Chairman, Research Affiliates

Brandon Kunz

Partner, Head of Multi-Asset Solution Distribution, Research Affiliates


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All Asset All Access October 2018
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