March Newsclips – Stock Market Bubble, Private Equity and More…

March Newsclips – Stock Market Bubble, Private Equity and More…

March 22, 2024

The financial media is not interested in your “fiduciary fluency.”  We dig deeper to bring you some research and perspectives that, while off the beaten path, offer substantive lessons for long-term investment success.  In 2024, your wealth deserves evidence…not anecdotes. 

This month we explore the following questions:

  1. Are we in a stock market bubble?
  2. Is private equity worth it?
  3. Do stock pickers add value after taxes?

Let’s jump in…

Ray Dalio via Bridgewater Associates Daily Observations: Are we in a bubble?

Bridgewater Founder Ray Dalio outlines his firm’s conditions that qualify as a bubble in financial markets.  Founded in 1975, Bridgewater is the world’s largest hedge fund.[i]  A “macro” investor, the firm comprehensively studies a wide variety of global markets from stocks and bonds to currencies and commodities.[ii]

Dalio outlines seven key criteria indicative of a bubble.  He then methodically applies these to the US stock market and the “Magnificent 7”.  His analysis suggests the broad US stock market is not in a bubble with Bridgewater’s quantitative readings indicating the market is in the “mid-range” and “these levels are not consistent with past bubbles.”  Meanwhile, the "Magnificent 7" companies are “a bit frothy but not in a full-on bubble” but noted “one could still imagine a significant correction in these names if generative AI does not live up” to the current built in expectations.

Flatrock Take: Bubbles can destroy massive amounts of wealth no matter one’s station in life.  Just ask Sir Isaac Newton, by any measure a smart and accomplished individual, who lost today’s equivalent of tens of millions of dollars in the South Sea Bubble of the early 18th century.[iii]  So nothing quite captures the attention of the financial press and their readers like the word “bubble.”

Indeed, we lived through a veritable bubble in in the Tech, Media and Telecom (TMT) craze of the late 90s.  Prices relative to fundamental measures of value – one of Dalio’s criteria – were unhinged.  As John and his coauthors noted, only three of the ten largest capitalization stocks at the start of 2000 had fundamental measures (like sales, profits and assets) that also ranked in the top ten.[iv]  Prices had deviated from fundamentals.  Today, it’s the opposite.  Seven of the top ten by capitalization also are in the top ten by fundamental measures.  Only Tesla and Nvidia of the Magnificent 7 don’t rank in the top ten by fundamental measures of firm size. 

Michael Cembalest of JP Morgan recently noted, the Magnificent 7 rally has been earnings-driven rather than a disconnect of prices from fundamentals, calculating that only 1% of the return since 2019 has been rising valuations.[v]  The remaining 27% has come from sales growth and margin expansion.  We, accordingly, likewise think the term bubble is a tad premature.

Financial Times: Is Private Equity Actually Worth It?

The article discusses the potential investment case for the Norwegian sovereign wealth fund, the world’s largest at $1.6 trillion in assets under management, to invest in private equity for the first time.  The author surveys some of the key academic studies on private equity’s level and persistence of returns compared to public equities (where Norway invests the bulk of the fund.)  The article also touches on private equity’s diversification benefits and volatility, which many suggest is understated. 

Flatrock’s Take: Private equity may provide opportunities for excess returns but the bar needs to be set high to overcome:

  1. Fees – private equity funds typically charge 2% plus 20% of the profits over some threshold.
  2. Capital Gains Taxes – the standard private equity vehicle is a fixed life fund that seeks capital gains over 5-10 year periods.
  3. Cash Drag – As capital waits to be deployed over 1-3 year investment periods, it typically sits idle in lower yielding cash accounts.     

How high are the hurdles collectively?  We estimate that a California taxpayer would require over 8% per annum in higher returns before fees and taxes to match a custom index. At a 9% S & P 500 annualized return, that’s almost double![vi]  See illustrative example below:

For these reasons, we set a very high bar for underwriting private equity for Flatrock clients.  Most of our research is focused on areas where we find efficient structures to minimize fees (via co-investments) and cash drag (via secondaries.)

Alpha Architect: After-Tax Performance of Actively Managed Funds

Author Larry Swedroe discusses the challenges of active stock picking, emphasizing that higher trading costs, expense ratios, and taxes pose significant hurdles. Even without considering taxes, actively managed equity mutual funds consistently underperform their benchmarks, with the majority failing to beat their index counterparts over various time frames. After-tax performance further exacerbates the underperformance, with a vast majority of actively managed funds trailing their benchmarks, making the task of selecting outperforming funds exceedingly difficult.

Flatrock Take: The tax efficiency of indexing in equity markets and conversely the tax inefficiency of active investing gets too little attention.  Swedroe noted that the average domestic equity mutual fund underperformed by 1% before taxes.  After incorporating taxes, that number rose to almost 2%!  Missing out on 2% of compounding for many years is a material shortfall in after tax wealth over multi-decade stretches. 

But wait, it gets worse!  It’s not just the portfolio manager’s attempt to buy low and sell high that generates these sizeable tax bills.  In that case, at least they could theoretically take taxes into account in buy/sell decisions.  Instead, a portion of these taxes are attributable to other investors in the mutual fund deciding to redeem, forcing the manager to sell, and realize gains that then get passed onto you.  In other words, you get a tax bill not based on your decisions, not based on your portfolio manager’s decisions but on the decisions of other (impatient) investors. 

Owning active equity mutual funds in a taxable account unfortunately is business as usual for many advisors.  Under any tax jurisdiction that is a mistake but especially in high tax states like California and New York. 

Let us know if you would like to dive a bit deeper on any of these topics.  Markets fluctuate. Priorities change.  We’re here to help. 

Disclosures

Flatrock Wealth Partners LLC (“Flatrock”) is a registered investment advisor.

Information contained herein should not be considered investment advice or a recommendation to buy or sell any particular security. Flatrock renders investment advice on a personalized basis, only after gaining a full understanding of a client’s unique situation.  While every effort has been made to verify the information herein, Flatrock Wealth Partners makes no representation as to its accuracy.  Past performance is no guarantee of future investment results.  Data referenced is not meant to communicate or signify past, future or hypothetical returns of an actual investment portfolio.  Information is at a point in time and subject to change without notice. Information is derived from sources that are believed to be reliable, but are not audited by Flatrock.    

External links may contain information concerning investments, products or other information.  Flatrock is not responsible for the accuracy or completeness of information on non-affiliated websites and does not make any representation regarding the advisability of investing in any investment fund or other investment product or vehicle.  The material available on non-affiliated websites has been produced by entities that are not affiliated with Flatrock.  Descriptions of, references to, or links to products or publications within any non-affiliated linked website does not imply endorsement or recommendation of that product by Flatrock, LLC.  Any opinions or recommendations from non-affiliated websites are solely those of the independent providers and are not the opinions or recommendations of Flatrock, which is not responsible for any inaccuracies or errors. 

Please see our website https://www.flatrockwealth.com/disclosures

[i] Source: Pensions and Investments

[ii] Our own Caroline Greene was previously a part of the Bridgewater client service team.  Meanwhile, John followed them closely during his consulting days where he was a regular reader of their Daily Observations. 

[iii]https://www.historic-uk.com/HistoryUK/HistoryofEngland/South-Sea-Bubble/

[iv] Arnott, Robert. Hsu, Jason. West, John. The Fundamental Index - A Better Way to Invest. New York, Wiley, 2008.

[v]https://am.jpmorgan.com/content/dam/jpm-am-aem/global/en/insights/eye-on-the-market/five-easy-pieces-amv.pdf

[vi] For illustrative purposes only.  Assumes Private Equity has one-year investment period, seven years of growth, pays highest Federal and CA capital gains rate at liquidation at end of seven years then repeats two more times for a total of 24 years.  Management fees on invested capital.  Private Equity earns cash rate (4%) during investment period.   Public equities are pre-liquidation.