By almost any measure, U.S. stocks are expensive—but this can remain the case for years to come because of an ever growing appetite for equities by retirement funds, according to economist and author Andrew Lo.
Lo is a leading authority on behavioral finance, having provided some of the most definitive explanations for the financial crisis in 2007-08. After the crisis, Lo helped set up the new Office of Financial Research under the U.S. Treasury Department, which aims to provide better data and insights about the industry.
Read Andrew Low: This is your brain on stocks
“Having a large number of passive investors buying and holding index funds for the next 20 years will cause the market’s value to continue to rise,” Lo, director of the MIT Laboratory for Financial Engineering and author of several books, including the recently published “Adaptive Markets: Financial Evolution at the Speed of Thought,” told MarketWatch in an interview.
Fund flows out of active equity funds and into passive index funds over the past decade have accelerated, and data suggest the trend will continue.
According to Bank of America Merrill Lynch, over the past nine years, passive funds saw steady inflows in each year since 2009, while active funds saw outflows in six out of nine years.
Lo suggested that the trend of institutional and retail investors moving away from allocating to hedge funds and active mutual funds has accelerated thanks to the ease and popularity of index and exchange-traded funds. The biggest implication of this shift is an increased allocation to equities using funds designed to ‘stay invested’.
But could this eventually lead to a stock-market bubble?
“To answer whether the stock market is overvalued I would need to know who all of the buyers and sellers are. How many pension funds, foundations or hedge funds are looking to buy? How many use active equity managers and on what time horizon. I need to measure the flora and fauna of the financial ecosystem,” Lo said.
In his book, Lo offers an alternative theory that explains how markets work. The prevalent efficient market hypothesis or EMH, which assumes market participants are rational and information that impacts the price of securities is available to all at the same time, is incomplete and inadequate to answer questions pertaining to valuations, Lo argued.
According to EMH, past moves in prices cannot predict future price moves, as they are independent of each other or random and therefore it is impossible to beat the market. Much of this theory was built on rules borrowed from physics.
Lo’s alternative adaptive market hypothesis, to which he has dedicated his entire career, complements EMH with behavioral finance and principles of evolution.
“The market should be viewed as a biological ecosystem, where market participants are continuously evolving and adapting to the environment that is also constantly changing,” Lo said.
Most fundamental analysis doesn’t take into account the short- and long-term dynamics of the market and therefore is inadequate at valuing it, according to Lo. “In the words of Benjamin Graham, in the short run the stock market is a voting machine and in the long run it’s a weighing machine,” Lo said.
Graham, an investor, professor and the mentor of billionaire Warren Buffett, used this expression to explain that in the long run, the market assesses a company’s ability to generate profits. In the short run, however, the company’s popularity can drive up or down prices without the regard to its fundamentals such as earnings and earnings potential.
But other market forces, such as increasing demand from retirement funds could drive up prices over the long term.
“Over the long run, markets are looking pretty good, because there is a large number of pension funds with huge asset pools that need to deploy their capital in ways that would allow them to earn a reasonable rate of return given the liabilities that they facing,” Lo said.
According to a 2016 Moody Investors Service report, state, local and federal governments face shortfalls in funding pension liabilities to the tune of $7 trillion. Moody’s predicted governments will have to increase taxes or cut distributions over the next several decades, but even with those actions, these pension funds require high returns (only available from riskier assets such as equities) to meet their obligations.
This of course, doesn’t mean that the market won’t see pullbacks. And the next selloff may well be amplified not by spooked investors reacting to headlines, but by hedge funds and high-frequency traders who shut down their computer-driven trading programs in response to a sharp market move, thus draining liquidity from the system.
“In the short run we do have hedge funds and high frequency traders that are making markets much more reactive to data, some of which is information and some of which is fake news. These HFT traders can disappear at a moment’s notice, taking liquidity out of the market,” Lo said.
Lo said investors should approach the market always aware of the possibility of a massive selloff.
“Investors need to do a fire drill from time to time in their own heads and say, ‘if the S&P SPX, -0.05% drops by 15% over the course of the next three weeks, what will I do?’ If you don’t have a plan then you know that you are going to be reacting purely emotionally and that is a recipe for disaster,” Lo said.