Executive summary
- AQM is flat, down 0.24 percent in Dec, and ended 2021 up 10.4 percent;
- In the past 18 months, AQM achieved 25.8 percent returns and a Sharpe Ratio of 1.24; and
- The fund now has 2 years 3 months of track record and has achieved 23.6 percent CAGR.
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Beware the bull market: Investors who no longer fear their bets on the S&P 500’s never-ending record are seeking excessive risk
Bull markets come, and bull markets go.
In 2021, the numbers seem stranger than fiction: Since the pandemic began, central banks have released USD32 trillion into global markets, equivalent to buying USD800 million of financial assets every hour of the past 20 months, according to Bank of America.
As a result, global equity market capitalisation has soared by USD60 trillion.
The S&P 500, which closed at records 70 times in 2021, gained 26.9 percent. This marks 12 consecutive months of notching a new record high, matching a streak only seen in 2014.
The panic of 2020? What panic? 21 months since the V-shaped recovery (Mar 2020), it seems like almost everyone is either a Warren Buffett “My holdings are up more than 47 percent since buying the dip” or an Elon Musk “My crypto portfolio is up 58 percent!”
The epic recovery from the 2020 Covid market crash has reinforced the erroneous sense that markets are safer now. After a 34 percent collapse in early 2020, stocks hit a new high in only 126 trading days — and continues to rally.¹
This creates a false sense of security: The past is viewed with rose-colored glasses and the future feels less turbulent than before. This is further compounded by hindsight bias to see past investment decisions in a positive light — “It was obvious to me that stocks will rally” — which causes an overestimate of tolerance for risk.
In markets, it is tempting to take excessive credit for one’s wins and any failures be conveniently assigned to external forces.
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High valuations, gloomy bond markets
A rule-of-thumb for markets is that when current valuations are high, future returns will be low. Equity valuations in America are very high, as measured by the cyclically adjusted price-earnings (Cape) ratio which compares share prices with the average corporate earnings of the past 10 years. The current Cape ratio, as of end 2021, is 38 — a level that was only higher during the peak of the dotcom bubble of 2000.²
Global bond markets face their worst year since 1999 after a global surge in inflation. The Barclays global aggregate bond index — a broad benchmark of USD68 trillion of sovereign and corporate debt — has delivered a negative return of 3.98 percent in 2021.
The decline has been largely driven by two periods of heavy selling in government debt. At the start of the year, investors dumped longer-term government bonds in the so-called “reflation trade” as they bet that the recovery from the pandemic would usher in a period of sustained growth and inflation. Then, in the autumn, shorter-dated debt took a hammering as central banks signalled they were preparing to respond to high levels of inflation with interest rate rises.³
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AQM in 2021
In this macro environment, because AQM is not an all-equities fund, its bond holdings, including long and short-term U.S. Treasuries, were the primary drag on performance. This does not necessarily mean that the fund is overweight in bonds. As a quantitative fund, our investment thesis is that the anti-correlation effect of bonds to equities, though ineffective due to unprecedented money printing by the Feds, will eventually (based on statistics) be in our favor when the equity rally cools.
Relative to an all-equities S&P 500 index, when equities are on a record rally — as is the case for the past 21 months — most diversified instruments will pale in comparison. Which is to say, after AQM’s outperformance during the market correction in 2020, beating equities during a V-shaped rally requires an investment of 150 percent or taking on leveraged positions.
A prudent investor should not be doing so because it amounts to timing the market which countless studies and funds have shown is simply not realistic.
If an investor expects a strategy to beat the market during both a market correction and a rally, an implicit expectation is for the strategy to perfectly time the market. (Like Buffett, we counsel time in the market, not timing the market.)
Hence, AQM’s quantitative approach to long-run outperformance: Focus on defense (less drawdown than the market during a correction) and — because the market spends most of its time in moderate growth — seek outperformance during the long periods of modest growth.
In practice, this means that AQM is not as sexy as funds placing headline-grabbing, outsized trades on Tesla, AMC, or the next unicorn.
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Summary
In 2022, the Federal Reserve is expected to raise interest rates to fight inflation and government programs meant to stimulate the economy, including the Fed’s record setting USD120 billion monthly bond buyback program, will gradually end. For the first time in almost two years, these policy changes are expected to take some air out of the market and will likely cause investors, businesses, and consumers to become a little more wary.
According to Bloomberg’s survey of more than 500 Wall Street firms, the overriding message is that “conditions still look good but the rip-roaring rallies powered by the reopening are history.”
AQM’s investment approach remains unchanged: Seek excellent defense and a statistical edge by being right most (not all) of the time to beat the market in the long run.
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