Veteran warns of coming US equity market slump

Finance industry veteran Robert Haugen is warning of a forthcoming slump in the US equity market and is urging investors to take shelter in low-volatility stocks amid the threat of rising inflation.

Professor Haugen is an academic engaged by BNP Paribas Investment Partners as an adviser. He is a leading advocate of stock market inefficiency and a senior adviser on quantitative strategies.

On a whistle-stop tour of Asia, Professor Haugen put a graph (pictured) from the Federal Reserve Bank of St Louis under AsianInvestor’s nose showing how the US monetary base has almost tripled in a matter of months.

“The thing that I find so interesting about this graph is that no one is talking about it, this is not being addressed in the media,” says a flabbergasted Haugen. “This is such a dramatic thing. Why aren’t people talking about it?”

The Federal Reserve recently committed to buy an additional $600 million in US government securities in its latest round of quantitative easing, or QE2.

Convention has it that the sellers of these securities put the cash in their bank, which lifts reserves and raises the monetary base. Banks then lend the money out to other banks, creating a multiplier effect.

“But that is not happening, banks are sitting on all these reserves and they can move at any time of their own freewill,” stresses Haugen, who warns of a potential rapid rise in inflation on the back of a sudden lending binge, leading to sharp increases in interest rates.

“In other words this is going to explode as a function of what the banks do, and when it does it is not going to be good news for equity markets.”

Already inflation concerns are dominating the thoughts of investors elsewhere around the world, particularly in emerging markets.

Haugen advocates avoiding “story stocks”, which tend to be topical and in the news, and investing in low-volatility stocks “because when the market falls those are not going to fall by nearly as much”.

He highlights what he sees as an inverted relationship between risk and return in equity markets, in which demand for story stocks drives prices up, but expected future returns are driven down. “You don’t get a premium for bearing risk anywhere in the world,” he notes.

Haugen favours quantitative methods in which a statistical risk model is used to determine the variability of stock returns in a market or sector over a given period. Portfolio construction tools are then used to piece together a selection of stocks with the lowest volatility.

These low-volatility stocks tend to have a tilt towards small-cap and value and be uncorrelated themselves. He cites a balanced portfolio in such uncertain times as having 45% exposure to global equities, in which 20% is set aside for low-volatility stocks.

“In this scary world we live in you can get out of the equity markets without getting out by building a low-volatility equity portfolio,” he says. “In essence you reduce your volatility by a good 30% and enhance your return.”