Humans struggle to make absolute judgements. In general, whether we realise it or not, we tend to make relative judgements. If I paid you a salary of £1 million you would be happy – right? Well yes, probably. What if I gave you a salary of £1 million but you found out that your next-door neighbour was getting a salary of £2 million? What if you, having been to university for four years to obtain two degrees after lots of hard studying and great expense, were being paid £1 million but you found out that the people who collect refuse for the council were being paid £2 million? (I should stress no offence is meant to these workers, who have my utmost respect for doing a job that many would turn their noses up at.) Would you still be happy then? Probably not. Less so, at the very least. Our absolute situation is often not the means by which we judge our happiness. Keeping up with the Joneses is much more important to our emotional well-being than a standalone assessment of our socio-economic circumstances. As an aside, this is a massive reason why I am significantly concerned about the long-term mental health effects of social media. It is hard enough to keep up with the Joneses next door. It is impossible to keep up with the lifestyles projected for public consumption by everyone on any given social media site.

This sort of relative thinking is prevalent in the current discussion surrounding Germany’s new-found fiscal liberalism. Economists and observers of all stripes declare that Germany has plenty of “fiscal room” because its debt-to-GDP ratio is a mere 60% compared to 100% in the US and UK, 110% in France and 140% in Italy. This sort of thinking concerns me greatly. The current fiscal rules that exist in Europe mirror the Maastricht criteria laid out in the early 1990s as prerequisites for European monetary union. Countries should have debt to GDP of no more than 60% and budget deficits of no more than 3%. These criteria were deemed necessary in order to align economies and ensure that monetary union without fiscal union would not tear itself apart. Whether 60% is a magic number or not I do not know. (Remember when economists Carmen Reinhart and Kenneth Rogoff declared 90% debt to GDP to be a magical number past which “thar be monsters”? Memories are so short when political expedience takes primacy.) What I do know is that assessing there to be fiscal room on the basis that a highly indebted country is less indebted than a really highly indebted country is a step on the road to ruin. What should matter most is whether the fiscal spending is going to pay for itself in the end (through higher long-term economic growth). By that score, governments the world over are doing a simply terrible job and increasingly economists are giving them pseudo-scientific cover to do so.

This psychological dynamic has always been present in financial markets but my suspicion (I cannot prove this quantitatively) is that it has become more prevalent. At least it would appear so, based on how prices move. I do not believe this is because human investors making decisions based on a subjective assessment of future fundamentals have become massively more relativistic in their assessments. Rather, I believe it is because markets are increasingly subject to the forces of short-term investment styles that care little for fundamentals in any normal sense. (The psychological aspect then comes in through the widespread subsequent rationalisation of over-valuation on the basis of these relativistic judgements.) As we discussed last month, the sort of investors I’m talking about manage their portfolio risk in response to significant changes in volatility. The other main trigger for their investment decisions is price. To be specific, I am talking about most hedge funds, systematic investors of various stripes, momentum followers, and risk parity and what are called “vol control” investors – among many others. By and large these sorts of investors buy when prices go up and sell when prices go down in addition to, as discussed last month, selling when volatility goes up and buying when it goes down. These actions are self-fulfilling. When equity prices rise, volatility tends to fall – that means buying by these investors as they follow momentum and more buying by them as they seek to increase their positions to at least maintain levels of overall risk. Buying begets buying and markets barrel on, propelled higher by inherent momentum and inertia that is itself an outcome of momentum and inertia.

This dynamic is powerful and has been a critical aspect in the meteoric rise of US equity markets over the last decade. Yes, the Magnificent 7 are powerful generators of earnings and earnings growth and yes, the US economy has been by far the cleanest dirty shirt in the global economic laundry basket. But even accounting for these dynamics, the performance of the US equity market has been exceptional. That is why US equities trade at around 22 times earnings whereas in Germany it is 17 times and in the UK about 13 times.

Since I last wrote in the middle of April, amidst peak tariff fear and loathing this dynamic has once again come to the fore. Hedge funds and associated short-term investors sold equities heavily as prices fell and volatility spiked. Then, as tariffs were rowed back, prices rose and volatility fell and so the same investors piled back in. Make no mistake, the flow has been significant – one major bank I spoke to stated that on a recent Monday they had seen the second highest level of net equity inflows (in their prime broker business – i.e. hedge funds) in their last five years of data.

Slower moving, more traditional, more fundamentally driven investors have largely sat and watched. The moves down and then up have happened so quickly that many will just not have had time to respond. Maybe they have a quarterly investment meeting and thus between meetings all they will have noted is volatility.

So, we return to absolute versus relative judgments. In an absolute sense, the rate of economic growth in the US is currently low. Both hard and soft data tell us this (with the usual volatility, uncertainty and question marks around forward versus backward-looking, surveys versus measurements, seasonality, the effects of COVID and low data quality due to low response rates). Tariffs have been imposed and their imposition is a headwind to growth and a risk to consumer spending and corporate profit margins. In a relative sense, the situation today is dramatically less concerning than the situation which prevailed on April 3^rd. Where should risk asset prices be as a result of these different assessments? In most cases the market is telling us, via prices and valuations, that the relative assessment is the right one – risk assets are more bullishly priced now than before the announcement of any tariffs. We are sceptical that this assessment is robust – though, to reiterate, we suspect that in most cases investors of a fundamental nature would share our judgement to some degree. The extent of the recovery rally is a function of the actions of those who seek to answer a completely different question. They care not a jot for an assessment of value in the context of economic policy. Rather they choose to care deeply about rising prices and falling volatility. If we are right, this rally could easily continue and could take us significantly higher. But in doing so it will make such assets look even more overvalued in the context of the economic and earnings outlook and the risks around them.

I want to conclude by making a generic point on relative valuation. There is no “right” answer to the questions of “what is the correct credit spread?” or “what is the correct price-to-earnings multiple?”. Not at an individual stock level or at an index level. Thus, you will often find investors, strategists and commentators leaning into these relative assessments. Such and such a bond is cheap relative to its sector or to its credit rating. UK equities are cheap relative to US equities. That sort of thing. It is understandable and, if trades and strategies are expressed in those terms then it can make a lot of investment sense. What I mean by that is if you assess UK equities to be relatively cheap and US equities to be relatively expensive and you thus buy the former and sell the latter and their prices converge then you make money. A good investment decision. Also, one which doesn’t rely on the market moving in a given direction. You are ambivalent as to whether US equity prices fall, UK equity prices rise or both. As long as their valuation convergence is driven by relative UK equity price outperformance then you are happy (if the valuation imbalance is driven by changes in earnings without any commensurate change in equity prices, then you are less happy, but such instances are very rare indeed).

My concern arises from the overuse of such relative valuation metrics and in particular their use both through time, out of context and in relation to estimates of “fair value”. If US equities traded at a price-to-earnings multiple of 23 times yesterday, but trade at 22 times today that does not make them cheap (cheaper yes, but cheap? No). If European equities traded at 17 times earnings yesterday, while US traded at 22 times and in a month’s time US equities trade at 21 times earnings and now Europe trades at 23 times that also does not make US equities now cheap. If investors only assess valuation in a relative sense, then in the end we lose all connection to the underlying cash flows that are the most important long-term aspect of investment in financial assets. Follow that thought to an extreme conclusion (please excuse my reductio ad absurdum) and one might consider buying a stock trading at 100 times earnings because the other major stock in that sector trades at 110 times earnings (or because that same stock traded at 120 times last week). The implied rapid growth in earnings can be the only rational justification for an investment in either of these companies. And, while, of course, such dynamics do occur, it is the assessment of that earnings profile and the potential risks around it which are the significant aspects of the analysis required to justify such an investment. In no universe is 100 times earnings cheap in and of itself. Beware any investor or commentator telling you otherwise – that is top-of-the-market stuff and historically ends very badly. To illustrate this point, I will finish with a well-known quote from the former CEO of Sun Microsystems, Scott McNealy, made in the aftermath of the bursting of the late 1990s tech bubble:

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”

The share price actually topped $235 during the tech bubble, but eventually fell back to around $10 which was the price at which Sun was acquired by Oracle in 2009.

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This article is provided for general information purposes only and should not be construed as personal financial advice to invest in any fund or product. These are the investment manager’s views at the time of writing and should not be construed as investment advice. The opinions expressed are correct at time of writing and may be subject to change. Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.