Though the root causes vary widely, traditionally “volatility events” have a pattern, occurring roughly every 10 years. Black Friday in 1987, the Asian Financial Crisis that kicked off in late 1997 and the Global Financial Crisis that began in 2008 all impacted the markets and investors in significant ways, but there were certain rules to the chaos that managed to hold true.
“This time it’s different” goes the old cliché, but this time it really is different. For the first time in the 25 years that I have been managing risk, two relationships that were so consistent that they could be considered “elemental facts” of the market no longer hold true and the implication of these un-couplings could have profound impacts on the portfolio construction process.
The first “elemental fact” is that emerging market volatility trades higher than U.S. volatility. Not anymore. For instance, in June, the VIX traded higher than the CBOE Emerging Markets ETF Volatility Index (VXEEM) on ten of the twenty-six trading days.
The second “elemental fact” is that when the VIX spikes this high for this long the root cause could always be found in the credit markets. However, due to government purchases in credit markets, that relationship has evaporated.
In other words, equity markets are hedging for a crash, while credit is implying “nothing to see here.”
A Bull Market In Dysfunction
U.S. equity markets seem more than a bit dysfunctional at the moment. This has been a rally many investors don’t fully believe in, and as a result, they are buying very expensive puts to protect against downside risk, which shows just how much future uncertainty is being priced into that market.
In equities, the lack of clarity around earnings combined with the new normal of “expectation management” on earnings per share beats (meaning it’s easier to beat when expectations are so low) and the residue of the Fed’s intervention in the credit markets continues to make traditional aspects of investment analysis difficult to decipher. Investors must be asking themselves (as much as I am), if the S&P P/E is 8 when the 10-year treasury is at 15%, where should the P/E be with the 10-year near 0?
And don’t ask investors in Europe or Japan if you’re looking for a ray of light. Recent history indicates that zero percent rates have not been positively correlated to returns in either Japanese or EU stock markets.
To all this existing dysfunction, add the fact that we find ourselves in a presidential election year, and a race to the finish that will likely be more rancorous than any in perhaps living memory, and the prospect for increased market volatility only grows.
How Investors Are Responding And How Should They Respond?
The retail market appears to have lined up on the single stock call buying side, while institutional traders, such as hedge funds and banks, appear to be large buyers of index puts to hedge exposures. Interestingly from a global investing perspective, this is predominantly happening in the U.S. and not foreign markets, which is very reminiscent of 1999.
Investors of all types have been flocking to gold and buying puts to hedge against inflation and downside volatility, respectively. Those moves make sense but there is a third leg to the stool that also needs to be included to allow for exposure to more potential upside amidst all this downside protection: equities. Here though, selectivity is key, and in our view global equities currently look like they have a lot more room to run in terms of valuation, especially compared to the S&P, which has more and more come to be dominated by a handful of big-name (and richly valued) tech companies.
Investors would also do well to consider their bond exposures amidst the current conditions to make sure their expectations around risks and rewards still hold true. The idea that there is a negative correlation between stocks and bonds is actually not true (make that a third “elemental fact” I’m taking issue with).
It had been a bull market in bonds for decades, but with rates at zero and a Fed that is explicitly promising to keep them there for the foreseeable future, that bull run appears to be over. In fact, I would argue that investors looking for decent rates of return and a modicum of safety in their portfolios should consider moving out of bonds entirely. Gold, put-focused strategies and global equities, used in combination, appear much better positioned to provide investors with not only downside protection but exposure to parts of the market that may be poised to generate more upside.
So, while some of the “elemental facts” that have driven key thinking around portfolio construction for the past several years are no holding true, there is one thing we do know: things tend to get worse before they get better. We saw this in the last major market crisis and the crises that came before.
But no one sends up a flare when a crisis has run its course, and the current environment may yet drag on, so for those financial advisors and investors who are considering fundamental portfolio changes, looking at the lapses in these elemental facts may be a good place to start.