Wednesday, 7 February 2018

Some thought's on the market's recent volatility

It's been a eventful week for markets. After a long period of subdued volatility and steady (and accelerating) gains, global markets suffered a pronounced setback, led by the S&P, which fell 7% in two trading days. Global markets followed, as did oil and commodity prices, while emerging market currencies fell and safe-haven currencies such as the Yen and USD rallied. The selling was indiscriminate, with everything dropping in unison, with few places (on the long side) to hide. What is going on, and how should investors be responding to it?

What was the trigger?

The proximate trigger was an uncomfortably-rapid rise US bond yields (with the ten-year pushing almost 3.0%), and growing fears that 'the Fed is behind the curve' trade could be arriving. I've said for sometime now that if US CPI starts printing 4-5% and it becomes clear that the Fed is not only behind the curve, but may be losing control of inflation, then global markets will be down 30-50%. That is because (1) major market indices are priced for an environment of continuing low rates and low inflation; and (2) higher rates and inflation could hurt underlying economies (by making credit more expensive, and draining capital flows to emerging markets), and at worst, usher in a stagflationary period. Investors and traders are aware of that risk, and so there has been (and likely will continue to be) a hair-triggered risk-off reaction to signs we may be going down that path.

However, another important contextual factor has been the fact that volatility has been in hibernation for quite some time now (the S&P 500's largest drawdown in 2017 was just 3% - the lowest on record - while the VIX plumed new lows), which along with steady gains, had driven an increased degree of investor risk appetite in recent times. Hyman Minsky once famously (and brilliantly) argued that 'stability creates instability', as the illusion of low levels of risk that steadily rising prices create encourages investors to take more risk and, in some instances, use more leverage. This creates an environment conducive to a sudden change in risk appetite when those illusions of low volatility and risk are dispelled, and when that occurs, many investors rush to sell at the same time.

The above impact has been amplified by the recent growth of ETFs and algorithmic trading/'robo advisors' in recent years, which are creating an environment where huge spikes in volatility are increasingly possible. The 1987 stock market crash was driven, to a large extent, by algorithmic 'portfolio insurance' - models that dictated an automatic cut in equity exposure in response to falling prices, in order to cap the extent of one's possible losses. On certain assumptions, this may have been a good idea when few investors were using it (although I'm not even willing to grant that), but when its use became widespread, the systemic consequences were overlooked, until a period of market weakness triggered a simultaneous flood of sell orders from portfolio insurance models that crashed the market. Needless to say, subsequently, portfolio insurance rapidly went out of fashion.

However, as Jim Grant likes to say, progress in most areas of human affairs is cumulative, but in financial markets, is cyclical. 30yrs on from the 1987 crash, and the lessons have been forgotten, and the conditions for a similar outcome is now recurring with the rise of robo-advisors and various ETF products. A great example of a dangerous modern day incantation of portfolio insurance is the 'low volatility ETF', which selects a basket of large liquid stocks demonstrating low volatility.

This product is unfathomably stupid, and is essentially custom-designed to blow up. Basically, the ETF will appeal to investors looking for a 'low risk' equity product, and flows into the ETF will result in the purchase of a basket of hitherto low volatility stocks. However, the problem is this: (1) if those low volatility stocks suddenly become high volatility, the ETF will have to sell them; and (2) if the low volatility ETF suddenly becomes a high volatility ETF, because the behaviour of the underlying stocks changes, then the holders of the ETF will say 'this is not what I signed up for - I wanted low risk/volatility exposure, so how can I be down 6% in a day', and will also look to sell. And when they do, the ETF will have to sell the 'low volatility' stocks it is holding, driving them down further, in a self-reinforcing cycle.

It is likely that the growing influence of ETFs and robo-advisors was a partial contributor to the severity of the recent sell-off. On the (probably relatively safe) assumption that ETFs continue to grow in popularity in coming years, we are likely to see more instability caused by such products.

Is this the end of the cycle?

In a seemingly spectacularly-poorly timed piece just over a week ago, I discussed Bill Miller's argument that rising bond yields could actually - perversely - be good for equity markets, as (in the context of QE) they could trigger a rotation of funds from bonds to stocks. I've also penned numerous pieces over the past year discussing how there is a risk we could be on the cusp of the biggest global equity market of all time. Have the events of the past week invalidated these arguments?

In my opinion, not at all. It is in the nature of financial markets to erupt into volatility and all out panic from time to time. However, it is important to separate the emotional reaction of investors in the short term (manifested in their behaviour), from the longer term underlying liquidity forces that drive markets. This means that it is still entirely possible Miller's argument about rising bond yields being good for markets this year will still prove correct. Allow me to explain.

Human beings are emotional, and in the short term, they can sometimes be consumed with emotion and behave irrationally. However, emotions are ephemeral. They don't last. And when emotional impulses subside, they are replaced with more rational, considered thought. Regret often ensues in the cold rational light of hindsight, as the fog of emotional impulse lifts. This dynamic manifests in markets. When investors' emotions are running high, you see irrational behaviour. However, emotions cannot be sustained at fever-pitch levels for long. And as soon as they subside, you will then start to quickly see not only rationality, but also pre-existing liquidity and macro forces, reassert themselves (if you're trying to pick a turning point in markets, ask yourself what is the intensity level of emotion that investors are currently feeling, and how likely is it that the intensity will sustain or increase further from current levels; as soon as emotions climax and starts to revert towards equipoise, markets will turn).

In the very short run in markets, anything can happen, because emotional reactions can cause a bunch of investors to panic and sell at the same time. The structural forces of liquidity are irrelevant to these very short term moves - it doesn't matter how much liquidity there is; if investors get scared they will sell, and prices will fall. However, in time - sometimes in a matter of days - emotions will revert back towards the mean. And as soon as that happens, markets will at first stabilise, and then begin to again be driven again by underlying economic and liquidity forces.

We have seen repeated examples of this over the past 5-10 years. Although the broader trend has been one of supportive liquidity and economic factors driving markets higher, the taper-tantrum drove emerging markets stocks into free-fall in 2H13; concern about the health of China's economy, and its August 2015 currency devaluation, spooked markets, hammering stocks through 2H15 and into early 2016; and fears around the Euro area breakup hammered markets in 2011. And yet in all cases, markets found their footing and then recovered vigorously, as the economic and liquidity cycle had not turned. Emotional fears trumped in the short term, but the economic fundamentals trumped over the long term.

This is where Miller's argument may still prove valid. Recent market movements have not been caused by an actual turn in the liquidity cycle. Global central banks are still printing more than US$100bn monthly! Instead, recent market weakness has been caused merely by investor fears that a turn in the liquidity cycle could be imminent. But such a turn has not yet happened.

What this means is that it is still very possible that supportive liquidity conditions, coupled with some rotation from bonds to stocks that Miller argued for, allows for markets to quickly recover from their recent set-back and continue higher. I would never invest on the basis of this argument alone - bottom up value considerations for the individual stocks I hold are always paramount. However, I would not be at all surprised if we have already seen a short term bottom, and that markets move higher from here. Miller might still turn out to be right.

What should you do?

My opinion on this is fairly clear: provided you can find attractive stocks to own on their own bottom-up fundamentals, you should not try to guard against market drawdowns like we have seen over the past week. Instead, you should simply accept (ahead of time) that it is in the nature of markets for sell-offs like this to happen from time to time; at all times avoid holding stocks you would regret not selling were their price to fall; and then when a market-wide sell off does occur, absorb it with nonchalance, and to the extent you have capacity, selectively add to your holdings (or reallocate funds) in response to the dislocation while at all times remaining strictly rational.

Wouldn't it be a better strategy to try to 'hedge' one's exposure - either by holding a lot of cash; holding index shorts or index puts, or being long the VIX (long volatility) - so as to protect against such a market outcome? Although that might sound like a sensible strategy, in my opinion the answer is actually a resounding no (in most cases), because the practical reality is that the cost of hedging and protecting against a market decline is, in most cases, extremely high relative to the actual hits likely to be absorbed by downturns over time (Peter Lynch once said that "more money has been lost by investors preparing for the next correction, than in the corrections themselves", and he was right).

I know many investors that have been defensively positioned and long volatility for 12-24 months waiting for this selldown. It has been a painful wait, and the losses incurred during that wait have far outweighed the gains made over the last week. Historically, the returns made from writing and rolling S&P 500 put options against the index and then holding a long cash position have also matched the returns generated by the S&P 500 itself. What this means is that historically, you have given away 100% of your market return to 'hedge' against a market decline. You might as well just hold cash.

The problem is that cash's expected return is also close to zero. Consequently, if you choose to hold cash over individual stocks with an expected return of, say, 10%, then your expectancy of opportunity cost loss with respect to holding cash is about 10% pa. Yes, cash has option value in market declines, but that option value pays off infrequently and has a cost of 10% a year. Over five years, 10% compounded adds up to a cumulative 61%, which would then require a 38% market draw-down to get you back to even. That is a risky and unattractive proposition in my view. Cash, in my view, should be used only as a last resort option if you cannot find anything sensible to buy, not as a hedge against market corrections. And given that there are about 100,000 stocks listed around the world, finding 20-30 or so that are attractively priced should be well within the capabilities of any serious investor with a broad mandate.

Instead of guarding against a short term market drawdown, what you should do is concentrate on only ever owning stocks that are already cheap, and buying more of/reallocating to stocks that have been irrationally punished when downturns do ensue. If you own and buy the right stocks (ones that have been undeservedly caught up in indiscriminate selling), those stocks will rebound extremely quickly when markets stabilise, whereas overvalued areas of the market that deserved to be sold off, generally will not. In other words, instead of guarding against a short term market drawdown, you want to ensure you are well positioned to make it all back very quickly in a market rebound, and that above all, you avoid permanent losses of capital.

The main thing is to remain rational and dispassionately deconstruct exactly what is happening and why. Human beings need to impose 'order on chaos' to feel comfortable and able to function in the world. If you're confused, you will panic and quite likely do the wrong thing. You can see that investors are confused when they are indiscriminate and sell everything, and are unable to parse stocks that justifiably should be sold, and those for which such selling makes no sense. However, as time passes, that confusion will lift, and rationality will reassert itself.

With respect to the most recent sell-off, what was forgotten amidst the confusion is that global economic growth remains strong, and that rising rates/inflation is coming in response to strengthening economic activity. Consequently, this was a valuation/interest rate driven sell-off, not a fear of an imminent recession/financial crisis sell-off.

Even granting that liquidity conditions are set to tighten up a bit from here (and that remains to be seen), it made sense for expensive bond proxies (consumer staples, expensive & leveraged infrastructure, etc) and other overheated areas of the market, such as tech, to be sold down some. However, it didn't make a lot of sense for a company like General Motors, which was already priced at 6.5x earnings with a strong, net cash balance sheet, and a 10-15% total shareholder yield (dividends plus buybacks), to be pummelled 10% - particularly when rising rates are occurring in response to strengthening US labour markets and consumer spending - something that is good for the outlook for auto demand. There is no reason to think we are heading into a US recession any time soon, and in any case, the stock is already priced for a significant drop in profitability. It made no sense for GM to be punished on account of it being a 'cyclical' given the nature of this sell-off, which ought to be hitting stocks whose valuations have been inflated by low interest rates.

Nor is it immediately apparent how a repricing of asset prices in developed markets in response to rate normalisation should impact the valuations of stocks in places like Russia, which have been cut off from the effects of QE (sanctions have been in place since 2014, and short term interest rates in Russia got as high as 17% in 2014), and are only now just starting to enjoy the benefits of the recent run-up in oil prices from US$50/bbl to nearly US$70/bbl (there is still a lot of room for oil prices to moderate before this benefit is eliminated). And yet markets sold Russia just as severely as it sold overvalued US bond proxies.

It also isn't immediately apparent why higher interest rates should have lead to a 10% decline in Beijing Airport's share price, since unlike many of its overvalued developed market infrastructure peers, it has a strong balance sheet and was already trading on an extremely attractive 9% FY18e free cash flow yield. These are the places one should look to buy (I bought a bunch of BCIA at HK$10.70 yesterday; more GM around US$40; and topped up on Sberbank as low as US$18.42). One should avoid stocks that are still expensive despite the recent drawdown, and buy stocks that were already cheap and yet have been shown no mercy. 

What have I been doing? I was in the fortunate position of receiving some new fund inflows at the beginning of the month, and was in an approximate 9-10% cash position when the recent draw-down occurred. I have been vigorously putting it to work over the past few days, snapping up bargains left right and centre, implementing more than 100 individual trades and reducing my cash weighting to 3% by the US open last night. It's been an extremely productive (and fun) couple of days.

Despite booking large mark-to-market losses over the past week or so (I was up approximately 13% gross in January, but was down as much as 5% gross in February at the nadir yesterday - albeit still ahead about 8% YTD, and at the time of writing I'm down about 3% in February), I've also been in incredibly good spirits. As I said to a client, we should be celebrating the market offering us more opportunities, not mourning.

As I've discussed in past musings, the two things that worry me most in markets are (1) expensive markets; and (2) low volatility. These two things significantly lower the extent of the investible opportunity set, and make it harder to deliver sustainably high returns. I've therefore been extremely pleased to see markets cheapen and erupt into volatility - it holds out promise that there will continue to be good opportunities for stock pickers with a flexible, pragmatic approach, moving forward.