BLOG - How to measure a bubble in the market

Rob Davies, Fund Manager VT Maven Smart Dividend UK Fund

Stock market investors are always worried that they are committing fresh money to the market during a bubble when valuations are high, after all the market has doubled since 2009. The subsequent falls in value can be very discouraging even though history shows us that the longer investments are held the less important capital is to returns than dividends. Although there are lots of ways of measuring the market, such as yield, price to earnings (PE) ratios, price to book ratios and CAPE (cyclically adjusted price earnings ratio) they all take time to work out and may require access to data that is not commonly available. 

However, there is an easier way to determine if a bubble exists and how it can be measured. 

When investors look at publicly available data to assess fund returns the commonly used reference point is not an index but the average return of the sector. This is the actual performance of all the funds that are listed in the sector, and the largest and most relevant for UK investors is the UK All Companies Sector. 

And that difference between index and sector has two important features. 

One is that sector returns are net of all costs so they should be lower than the index. The second difference is that the majority of these retail funds, about 210 out of the 240 in the UK All Company sector, are actively managed. Although active managers usually state that their objective is to beat the index in fact their real goal is to beat other fund managers and secure a place at the top of the sector league table. They can do this in two ways. They can either invest outside their asset class or take more risk. The simplest way to take more risk is to buy smaller capitalisation stocks or those with high beta (volatility), i.e. those that move more than the index either because of the nature of their business, their debt levels or both. 

An active manager finds it difficult to dramatically outperform by having a bigger holding in a blue chip than others funds, or than the index. However, they can do well if they go overweight in small or medium cap stocks that subsequently rise. Most active managers play this game so the tendency is that, collectively, they hold more of these riskier stocks than the index. That worked well in the bull market from March 2009, driven by the quantitative easing (QE) that started then, until February 2014 when both ran out of steam.
There are good reasons for buying smaller and riskier stocks. Investment theory tells us that the higher risk associated with these stocks is normally rewarded by higher returns. That logic is fine when valuations between large and small companies are similar but right now the FTSE 250 is valued at an 11% premium to the FTSE 100 based on prospective PEs. 
It seems that this tilt to small and medium cap shares by active funds has allowed the average return of the UK All Companies Sector to beat the FT All-Share index by 7% over three years and 3% over five years, even after costs. Since the FTSE 100 makes up 90% of the FT All-Share while the FTSE 250 is less than 10% of it the degree of overweighting to mid-caps by active funds must be large. 

Clearly the return of each part of the market must, in aggregate, match the total market return. So if small caps have done well large caps must lag. Indeed, that is the case. Mid cap, and other active funds, have been good performers but passive funds, that don’t have the small cap tilt, have not kept up. They are all, bar a 250 tracker, in the third and fourth quartiles over three and five years. 

That is bizarre. It does not make sense for funds that purport to represent the index fail to match the sector, especially since passive funds tend to be cheaper than active ones. The explanation does appear to be that active funds do indeed hold a lot more smaller companies than the index weight suggests they should. That discrepancy is a measure of the excitement in the mid and small cap sectors which can be taken as an approximation of the froth in the market. It puts a number on how big the bubble is.

Looked at over a timescale of one year the position has started to change and half the passive funds are now in the second quartile and half are in the third quartile. Since the FTSE 250 peaked at the end of February passive funds, that have a normal allocation to the index, are slowly but surely closing the gap with their active competitors. 

The bubble induced by the QE effect is gradually dissipating and we can measure that by the relative position of passive funds in the UK All Companies Sector. Since all the passives are below the average return of the UK All Companies Sector over three and five years it suggests there is still a considerable amount of froth in the market, though less now than in February when all the passives were in the fourth quartile. 

It will be only when all the passive funds are in the top quartile that it will be clear that the QE bubble has truly deflated. That doesn’t mean investors should hold off until that happens but it does mean they might want to take account of what this measure is saying.

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