Happy (Third) Anniversary: Now What?
Advanced Investment Partners
By Jon Quigley
April 26, 2012
During the trading day on March 6th, 2009, the S&P 500 Index® hit its intraday bottom of 666.79. In the ensuing three years the Index has advanced over 100%. Along the way, we’ve witnessed the collapse of some of the older and more hallowed names in the financial industry buh-bye Lehman Brothers, so long Merrill), endured the most severe recession in at least 25 years, suffered through incredible spates of market volatility, and gathered a few gray hairs (or lost some hair) along the way.
Dating back to the beginning of the unwinding housing bubble, the US equity market has endured nearly five years of unprecedented volatility. It’s in times like these that it’s most important – and most difficult – to invoke Peter Lynch’ famous admonition, “The secret to making money in stocks is not to get scared out of them.”
The best way to persist with an investment plan through such volatility is to understand why volatility has been so extreme. We believe careful examination reveals both structural and event-driven causes.
Structural Causes: The change from fractional trading to decimal trading was supposed to increase liquidity and decrease bid/ask spreads. It’s possible, however, that this was an important element in the decline of the market maker/specialist’s role on the exchange “floor” (floor probably belongs in quotes nowadays!). It’s quite possible that the volatility-dampening effects of actual “wingtips on the ground” wasn’t fully appreciated until algorithmic/program trading cannibalized floor traders on the way to reaching a dominant critical mass.
Program trading now accounts for nearly 60% of the average daily trading volume. It’s now known that this trading causes thousands of trading “microfractures” on an ongoing basis. In addition, the proliferation of levered ETFs designed to provide 2-3x market exposure (or inverse market exposure) appears to contribute to increased volatility in close proximity to market open/market close.
Source: UBS, US Volatility & Correlation Monitor
Outside of the market itself, we might add the burgeoning federal debt to the list of structural causes. At such a high level of debt, the margin for policy error is reduced, and this also contributes to increased volatility.
Event Driven Volatility: In recent memory, stock volatility soared during 1998’s Russian Debt Crisis and the ensuing Long Term Capital Management meltdown, 2000-2002’s bursting of the Internet bubble, and 9/11.
During the past 5 years, the housing crisis-induced recession and the European debt crisis each also resulted in considerable market volatility. In combating the effects of the above, the US government pursued a policy of massive fiscal and monetary stimulus (TARP, TALF, Cash for Clunkers, HAMP, QE1, QE2, Operation TWIST).
Trading in bank stocks has been especially volatile given all of the above, as traders frequently re-assess their bets on which banks will survive. The days of investment banks’ proprietary trading (prop) desks as key profit centers have faded. Regional banks which are highly exposed to hard-hit housing markets remain vulnerable. Even the banks’ siren song of a steep yield curve appears to have betrayed them; if we substitute the CPI for the short rate, we see the yield curve is in fact inverted. There’s also considerable weight (see Gross, Bill) behind the view that rates are too low to encourage risk-taking from this point forward. All of this decision under uncertainty means Keynes’ famous “Animal Spirits” become increasingly influential.
“Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” – John Maynard Keynes
What are the Implications - and Who Cares? Which market participants are most vulnerable to market volatility? Those who are drawing down principal simply to pay current expenses, and therefore cannot capitalize on the buying opportunities market volatility affords:
• Underfunded Municipalities are highly sensitive. Growing pension liabilities, reduced income from real estate taxes, and less friendly state budgets have made them more susceptible. They do have some control over driving revenues via taxation, but taxation power is limited (people can re-locate).
• Underfunded State pension plans face many of the same problems, but are higher up the food chain and therefore less vulnerable.
• Retirees without current income and relatively small nest eggs are vulnerable to (downside) volatility.
Who might benefit from continued/renewed volatility? Those who have a current income stream and are not drawing principal are able to take advantage of volatility:
• Most pension plans have current “income” via active contributors, and many are converting from defined benefit to defined contribution.
• HNW individuals are most likely to benefit from volatility. They are not touching principal, and can effectively deploy reserve funds to assets which have suffered most recently.
What does all of this mean for active managers who rely on stock selection?
Tough market for stock pickers
The confluence of the conditions described above adds up to a tough market for stock pickers. The combination of market volatility, pair-wise correlation of stock returns, and the return differential between the best and worst performing stocks has a major impact on the relative performance of active strategies.
Overall market volatility is largely driven by variations in risk appetite, which is in turn driven by earnings visibility (low visibility induces risk aversion, high visibility encourages risk taking) and economic policy (stimulative policy encourages risk taking in the relatively short term). When earnings visibility is low, policy change has an out-sized affect on animal spirits. And with limited visibility over the past several years, we’ve seen this outsized affect:
• When rounds of domestic economic stimulation occur, we’ve seen significant “risk on” trades.
• With rounds of stimulative policy coming from the European Central Bank, the Bank of Japan, and the Bank of England, we’ve also seen “risk on” trades.
• When we’ve seen positive signs of demand from China, we’ve seen “risk on” trades follow.
Conversely, we’ve seen the “risk on” trades fade in favor of more conservative positioning in the following situations:
• Data pointing to a continued sluggish economic recovery
• Data suggesting the Chinese economy is slowing
• Hints that the Fed may be done providing stimulus
Volatility in and of itself should not have an impact on active managers per se. Rather, it’s the internal rotation during these “risk on/risk off” bouts which makes portfolio positioning more difficult. It’s nigh impossible to be positioned conservatively during a risk averse period (such as late last summer), and turn the portfolio holdings on a dime to outperform after a sudden “risk on” rally. Instead, a successful manager will position the portfolio to capture most of the upside in a “risk on” rally, and avoid some of the downside during a “risk-off” trade. We accomplish this by remaining flexible in our approach in this highly uncertain environment.
In more normal environments, stocks trade on their individual merit; there is less correlation among individual stock returns, and wider spreads between the best and worst performers. In periods of low visibility and excessive policy change such as recent years, we see quick, massive sea changes in stock market leadership. Individual company fundamentals become far less important in terms of influencing stock prices – at least in the short term. Instead, entire groups of stocks trade together, be it groupings on a sectoral basis, a beta basis, or even a share price basis (low priced shares are considered more risky). This lack of distinction between individual stocks makes the job of the stock-picking active manager much more difficult:
Will the environment for stock pickers improve?
As we noted earlier, volatility in and of itself isn’t necessarily a negative for active managers. The best managers actually prefer a highly volatile market in terms of finding favorable entry points for individual issues. Volatility has dropped over the past several months, and as of mid-January the correlation of returns within the market has also declined. At a minimum, this means an improved environment for active managers in the near term.
We also see significant differences in terms of volatility and correlation across market cap segments. While the smaller-cap market segment in the US has exhibited higher total volatility, the correlation of returns has been lower than either the mega-cap or large-cap segments. We believe this largely explains the recent success of active managers in the smaller-cap segment versus the relative lack of recent success for larger-cap managers:
Longer term, we also believe the table is set for active managers. The increasing prominence of passive strategies (via both traditional Index strategies and increasingly prominent ETFs) takes individual stock valuations further and further from their intrinsic values. Such passive strategies treat all stocks with the same broad brushstroke, with prices moving in tandem – even when fundamentals would suggest otherwise. As individual stocks move further from intrinsic value, they will attract active managers at the margin.
The Overall Outlook
We have the usual litany of concerns to deal with, especially on a global scale. The sovereign debt situation for the periphery of Europe remains a very real problem. The situation in the Middle East is as unsettled as ever. Some say China is in the midst of a real estate bubble, and growth will inevitably slow. Profit margins in the US are at a record high, and have nowhere to go but down. The US recovery is painfully tepid, and structural unemployment is a real problem. Finally, of course, the painful work of repairing our budget problem looms in the background in this election year.
No wonder investors and pension plans remain very defensive. Treasuries continue to receive strong inflows, and low volatility strategies are attracting strong attention, as do commodities. But are these assets really safe harbors?
The four central banks which matter – the Bank of Japan, the Bank of England, the Federal Reserve Bank, and the European Central Bank (plus Switzerland) each have exploding balance sheets. The powers that be have decided to battle the frightened animal spirits and combat debt problems by via monetization, which will bring inflation when animal spirits capitulate.
In the face of rising inflation, or even speculation of rising inflation, bonds should become increasingly volatile. If fixed income becomes the more volatile asset class, might we see a re-allocation to equities?
What if we do get increased inflation? Benjamin Graham notes very early on in “Security Analysis” that common stocks are the best hedge against inflation. If an investor wants to increase allocation to common stocks while hedging against the litany of risks listed above, perhaps the US is a good place to be, rather than emerging markets.
A Barbell Strategy
Over the course of 2011, stocks with high dividend yields and substantial share repurchase programs outperformed their counterparts. These stocks have short duration, and do especially well in periods of high volatility. Conversely, smaller cap stocks provide fuller participation in “risk on” periods. Keeping a toe hold in each camp can be an effective strategy in this uncertain environment.
While such a strategy may result in less than 100% upside participation, it should also curb downside volatility. Active managers exhibiting a return history with lower volatility than their benchmark should be preferred in a volatile environment. In the highly volatile, highly correlated LargeCap market segment, our strategies have garnered close to 90% of the doubling over the past three years. Our SMidCap (aka “Smaller Cap”) strategy has garnered well over 100% of the smaller-cap segment’s more-than-double over the past three years. (Our MaxCap strategy matched the S&P 100 return over the same period). We accomplished this with significantly lower overall volatility than the market.
Ultimately, investors should remind themselves that time is the best way to hedge against volatility. As holding period increases, the probability of a loss decreases (2):
1. Financial black swans driven by ultrafast machine ecology.” By Neil Johnson, Guannan Zhao, Eric Hunsader, Jing Meng, Amith Ravindar, Spencer Carran and Brian Tivnan. arXiv, 7 February 2012
2. The percentage chance of purchasing the S&P 500 Index® or the Russell 2500 Index® at the end of any given month, and selling the index at a lower value from the January 1979 forward.
This information has been prepared for informational purposes only and Advanced Investment Partners, LLC (AIP) is not soliciting any action based upon it. The material is not intended to provide specific advice or recommendations but, rather, a basis from which strategies can be built, taking into account the specific objectives of each portfolio, in terms of return, time horizon, and risk constraints, as well as diverging investment perspectives and assumptions. The material contains information regarding the investment approach described herein and is not a complete description of the investment objectives, policies, guidelines or portfolio management and research that supports this investment approach. Any decision to engage AIP should be based upon a review of the terms of the investment management agreement and the specific investment objectives, policies and guidelines that apply under the terms of such agreement.
Opinions expressed are AIP’s present opinions only and are subject to changes based on market, economic and other conditions and may not actually come to pass. Any historical price(s) or value(s) are also only as of the date indicated. Past performance is no indication of future returns.
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