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Ahead of the curve: Is the portfolio theory still valid?

May 29, 2020

A commentary by Jürgen Lukasser, Chief Investment Officer of LGT Bank Österreich, on the portfolio theory and the question of efficient capital markets.

Ahead the curve: ist the portfolio theory still valid

The US economist and Nobel Prize winner Eugene Fama is one of the fathers of the efficient-market hypothesis and modern portfolio theory. Without exaggerating, he is one of the ten most influential economists of modern times, as his research has made a significant contribution to the way asset prices are calculated today and to the fact that portfolios offer an optimal diversification. Fama, Robert J. Shiller and Lars Peter Hansen were awarded the Nobel Prize for Economics in 2013 “for their empirical analysis of asset prices”, as the committee explained in its decision.


Decoupling from the real economy?


In today's market environment, characterized by the enormous flood of money from central banks, the question of efficient capital markets arises time and again. It is increasingly being postulated that the stock market has completely decoupled itself from the real economy. In fact, the economic figures around the globe could not be worse. The corona crisis is causing GDP to plummet and unemployment rates to soar. At first glance, one could easily get the impression of decoupling by focusing solely on indices such as the S&P 500, which tracks large-capitalized companies. The US blue-chip barometer is down just 9% since the beginning of the year. If, on the other hand, one looks at indices of small or medium-sized companies, the price losses quickly amount to 20 to 25% for the current calendar year. This difference is due to very few stocks only.

The financial press invented the acronym for FANG shares (Facebook, Amazon, Netflix and Google) over five years ago. Today, in 2020, FANG have become FAMAA. Google is now called Alphabet, Microsoft has replaced Netflix and Apple has completed the quartet to form a quintet. These five technology giants make up a very concentrated portfolio indeed, but due to their enormous market capitalization they have been the main driver of the S&P 500 in recent weeks. The US leading index has recovered more than 30% since its low two months ago. FAMAA shares alone are responsible for a quarter of this performance, together the five companies already account for more than 20% of the market value of the S&P 500.


Quality has its price


There are multiple reasons for the dominance described above. All FAMAA shares belong to the category of quality shares. Excellent balance sheets, high cash flows and above-average visibility at the level of corporate figures are in demand in the highly uncertain global economic situation caused by the covid-19 pandemic. In addition, these corporations are regarded as profiteers of the corona crisis by capital markets, and due to the current market structure – characterized by an enormous variety of passive instruments (ETFs) – precisely these liquid large-capitalized companies are preferred. This is also the reason why in an environment of an ultra-expansive global central bank policy real quality is no longer cheap, but has its price.


Portfolio theory in a FAMAA environment


Do Fama’s results no longer apply in today's market environment with FAMAA, or, to put it differently, are the other 495 shares in the S&P 500 negligible? Of course not, and the current crisis will not be the end of careful portfolio diversification. On the other hand, the focus of market participants remains on companies that are winners in the medium to long term despite temporary economic headwinds. Various business models will no longer exist in their current form after the crisis. Companies with too low margins and a poor balance sheet will have a very hard time. The car rental company Hertz is the latest example of this: a few days ago, it had to apply for Chapter 11.


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