As we look to expectations of future returns, exchange traded fund investors should still manage risks and maintain a long-term investment strategy.
In the recent webcast, A Feeding Frenzy: Navigating Investments in the GameStop Era, Meb Faber, Co-Founder and CIO, Cambria Investment Management, highlighted the lofty returns that many market participants are anticipating over the next few years and the potential risks of growing too complacent.
“We think these are far too lofty based on current valuations, and investors may be in for a rude awakening at some point down the road,” Faber said. “We’re not alone, our sentiment is mirrored by other firms that produce quantitative research and outlooks based on valuations.”
Looking at valuations, the S&P 500 CAPE ratio is at its highest level since the dotcom bubble era. The value line median price-to-earnings is trading well above its 10-year simple moving average. Additionally, Faber pointed out that the price-to-revenue ratios of the largest 10% of S&P 500 components are trading above their dotcom bubble peak and significantly higher than the median and smallest 10% of S&P 500 components.
Meanwhile, the average investor is now more exposed to equities and the potential risks of high-flying valuations. Stocks as a percentage of household financial assets adjusted for pension funds stood at 41.4% as of September 2020, compared to the historical mean of 27.7%. Faber noted that this allocation is higher than the peak leading into the great financial crisis, but not quite as high as the peak during the dotcom bubble.
We may even be witnessing some market euphoria that is reminiscent of previous bubbles. Bullish buying of call options by small traders has ramped up over the past year. Margin debt is in territory we’ve only seen a few times in the past. Furthermore, trading activity in expensive stocks with extremely high enterprise value-to-sales has surged.
“There may be excesses in the market,” Faber said. “Discerning investors may want to consider some thoughtful strategies to help them avoid potential speculation the best they can.”
Faber argued that investors should seek value regardless of what markets you are investing in. Cambria offers a line of shareholder yield ETFs, including the Cambria Shareholder Yield ETF (NYSEArca: SYLD), Cambria Emerging Shareholder Yield ETF (EYLD) and Cambria Foreign Shareholder Yield ETF (FYLD) that may offer value for investors. Faber noted that all three funds trade at a significant discount when compared to the S&P 500 Index.
The underlying indices consist of stocks with high cash distribution characteristics and comprised of the companies with the best combined rank of dividend payments and net stock buybacks, which are the key components of shareholder yield. The underlying indices also screen for value and quality factors, including low financial leverage.
Instead of solely focusing on dividend payments, the shareholder yield ETF strategies invest in stocks that couple strong dividend payments with share repurchases and debt paydown. The fund manager believes that this type of screening process may be a better way to identify stocks that possess strong cash flows and reward shareholders with higher yields.
Investors also face potential risks ahead as an overpriced market has a higher likelihood of experiencing steep drawdowns or lower performance. Nevertheless, Faber pointed to the Cambria Tail Risk ETF (Cboe: TAIL) as a way to help investors diversify a portfolio by mitigating any further downside risks. The ETF is also the lowest cost fund in the Morningstar Bear Market Category, with an expense ratio of 0.59%.
TAIL is engineered to hedge against significant US equity market drawdowns, and is managed with exposure to US Treasuries and a ladder of out-of-the money puts on the US equity market.
A put option provides the buyer the right to sell the underlying index to the put seller at a specified price within a specified time period. In the event of a decline in the underlying index, the put may help reduce the downside risk. Consequently, the put option becomes more valuable as the underlying market weakens relative to the strike price.
“We feel TAIL has performed exactly as we’d expect. As the market sold off, TAIL experienced gains. As the market has recovered since it’s low in March 2020, TAIL has declined,” Faber concludes. “Over this period, TAIL has outperformed it’s Morningstar category.”
Financial advisors who are interested in learning more about navigating the current market conditions can watch the webcast here on demand.