Good days, bad days

Market volatility is a simple fact of life – it is always with us and as a consequence we just have to deal with it. Sell side financial institutions like it because higher volatility prompts corporate and retail investors to look for some form of asset protection, giving them the opportunity to write more tickets. They also like it because it is possible to make very decent returns if you time the entry and exit from your positions correctly. Conversely, retail investors hate it because their portfolio value can whip around without any obvious fundamental explanation.

How the professionals deal with volatility

Equity volatility is conventionally measured using the prices of index options with near-term expiration dates. The global benchmark is the VIX, which measures volatility for the S&P500. It is currently trading at 22, which is slightly above its long-term average of 19.5 based on data back to 1990 (chart above). This is not excessively concerning. Indeed, as I have noted on previous occasions (here, for example) markets have been far too complacent in recent years as central banks have anaesthetised them with their huge asset purchase programmes. Given the exceptional uncertainty surrounding the economic outlook in the Covid era, it is probably a good sign that volatility is perceived to be slightly above average.

Excessive volatility spikes are rare: We have experienced only a couple of major volatility surges in recent years – once in the wake of the Lehman’s episode in 2008 and another in 2020 as the Covid crisis began to unfold. Institutional investors can hedge some of the risk by investing in an Exchange Traded Fund (ETF) which moves inversely with the VIX. Such indices are only suitable for short-term hedging purposes – those who try a buy-and-hold strategy tend to get burned very quickly. This makes them unsuitable for retail investors who seek more durable protection.

Avoiding the downside yields bigger returns than chasing the upside

As it happens, one of the better protection methods is abstinence. To demonstrate the impact of volatility on investor positions I looked at daily equity market data going back to 1990. Starting with the S&P500 I calculated what would happen if investors missed out on the days with the biggest gains and losses and assumed that on those days the portfolio value reverted to the level prevailing in the previous period. Arbitrarily assuming that investors missed out on the 30 biggest single daily gains, a portfolio which tracked the S&P500 since 1990 would be almost 83% below one which included all trading days. By contrast, excluding the 30 biggest daily losses would have resulted in a seven-fold increase in portfolio value. Putting these two factors together by taking out both the top 30 increases and decreases, the index would have ended up almost 22% higher than one based on the S&P500 alone (chart below). The results are broadly similar for the FTSE100: excluding the largest 30 daily gains and losses resulted in a gain of almost 14% versus one based purely on the benchmark.

In theory we can extend our analysis for the S&P500 back to 1928 without materially changing the results although the volatility in the index during the 1930s means that more than half the biggest daily swings occur before 1940. Arguably the macro environment today is very different to that in the 1930s with economic policy much more sensitive to market volatility. Accordingly it seems reasonable to exclude the 1930s from the calculations. Running the calculations since 1940, and maintaining our exclusion threshold to encompass the top 30 gains would lead to an 85% loss but excluding the top 30 losses would increase the value of our portfolio ten-fold. Excluding both the highs and lows would increase our portfolio value by almost 60% compared to the benchmark over the last 81 years.

If you don’t have perfect foresight, hedge

This demonstrates two key takeaways: (i) big movements in indices have a disproportionately big impact on future gains, perhaps because they trigger sentiment shifts which generate a change in market direction and (ii) avoiding the worst excesses of decline have a bigger impact on portfolio returns than chasing the big gains. Obviously the foresight to know when we are about to experience a massive correction is not gifted to most of us, therefore the best we can do is to hold a balanced portfolio comprised of assets whose prices are either inversely correlated with equities or not correlated at all. As I noted last summer, the 60:40 portfolio strategy which comprises 60% equities and 40% bonds is as good a way as any to hedge risks.

The upshot of all this is that investors who pursue a minimax strategy (minimising maximum losses) are likely to outperform those who follow a maximax strategy (the aggressive maximisation of gains). Indeed the latter is viewed by many in the media as the way in which sell-side investment operates and some hedge funds still publicly hail such an approach as the ideal investment strategy. But a maximax strategy is like building a football team comprising only strikers. Whilst strikers score the goals and grab the glory, the team is unlikely to win anything unless the defence is strong enough to repel the opposition. In football terms a minimax strategy allows the team to build a stronger defence which will allow them to be more successful over the longer term. When it comes to portfolio investment we cannot eliminate our exposure to volatility but we can take steps to reduce our exposure to it. As in other areas of life, buying some protection can considerably reduce our long-term costs.

Don't give up on the tried and trusted

There is a considerable degree of trepidation as we head into the Q2 company earnings reporting season. It is obvious that earnings will have taken a huge hit as consumer demand collapsed across the board. However, the main focus will be on guidance as investors treat the last three months as bygones. Dow Jones reported at the start of July that 157 S&P500 companies had reduced their outlook as of end-June with just 23 providing upgrades, whilst 180 have pulled them altogether which suggests that markets will be flying blind for a while to come.

Current consensus estimates point to a fall of around 30% in S&P500 Q2 earnings relative to Q1, which follows a 15% decline in Q1. If realised, this will put Q2 earnings around 45% below year-ago levels. Even assuming a rebound in the second half, the consensus suggests we are set for a 25% decline in 2020, which would be close to the 28% decline registered in 2008. It would not take a huge miss on the numbers to record the worst year for US corporate earnings since the 1930s (chart 1).  Moreover the concern is that the consensus is overstating expectations for an earnings rebound. In the wake of the 2008 crash it took more than three years for earnings to get within 10% of the previous cyclical high. This time around, the consensus view is that it can be achieved within 18 months.

 

Valuation metrics also look elevated as markets are priced for perfection. The one-year forward P/E ratio on the S&P500 is trading above a multiple of 25 and the price-to-book ratio is at 3.65 versus a long-term average of 2.65. Under normal circumstances such indicators would set the alarm bells ringing but as we are all too well aware, times are not normal. Discounted future cash flows have been boosted by central bank actions to cut rates to zero, and on the expectation they will not rise anytime soon it is logical that equity prices should rise. The lack of returns in other asset classes further raises the attractiveness of equities. Even sectors which have performed strongly over the past decade, such as property, are struggling. Whilst stocks may look over-bought and there are clearly risks associated with both the earnings and economic outlook, investors cannot bring themselves to bet against a strategy which has worked so well in the post-2008 world.

This impact of low interest rates and their effects on equity markets has once again raised questions of whether the traditional 60/40 portfolio rule is fit for purpose. This famous investment rule of thumb suggests investors should hold 60% of their portfolio in stocks and 40% in lower risk securities such as bonds. In theory this should produce long-term average returns which match equities but by allocating a sizeable chunk to bonds it smooths out the extreme highs and lows associated with an equity-only portfolio. The evidence suggests that this strategy has outperformed over the past 20 years. Using a portfolio in which the available assets are global equities, US Treasuries, the GSCI commodity returns index and an estimate of cash returns in the industrialised world, the 60/40 portfolio generated an average annual return of 4.9% between September 2000 and June 2020.

It has not always been the optimal portfolio. Immediately prior to the Lehman’s crash, the 60/40 portfolio was one of the poorer performers largely because it took no account of the commodity boom that was building at the time. Indeed, I well remember being told in 2006-07 that no self-respecting portfolio manager could afford to ignore commodities because returns were uncorrelated with other financial assets and consequently they enhanced portfolio risk diversification. How times change: Commodities are down 84% from their peak achieved in summer 2008 and they have proven poisonous to investor returns. The 60/40 portfolio has outperformed both safe and risky structures which assign varying non-zero weights to commodities and cash. Moreover, as the Credit Suisse hedge fund returns index shows, this simple strategy has matched hedge fund strategies in recent years which – given what investors pay hedge funds to manage their money – is a poor show on their part (chart 2). All told, on a 20 year horizon the 60/40 strategy has generated higher returns once hedge fund fees are taken into account.

This is not the first time the 60/40 strategy has been called into question – it seems to arise every time one or other of the markets appears out of whack. On this occasion low interest rates mean that the returns from bonds are likely to look very poor for years to come. But investors tempted to overweight equities, which are likely to benefit as a consequence, run the risk of getting caught out by volatility as markets continue to question whether current price valuations are justified (we can expect quite a lot of that in the months ahead). Since the intention of 60/40 is to offset the extreme highs and lows of equities, it may be worthwhile sticking with it for a bit longer. It is after all, a tried and trusted method and that is not a bad thing in our new, uncertain investment world.

A Nobel cause

Economics is a social science and although many economists do not like to admit it, it is bracketed alongside disciplines such as anthropology and psychology. Indeed, in the second half of the eighteenth century, when Adam Smith was setting out the principles of the invisible hand so beloved in market analysis, psychology did not exist as a separate discipline. The work of many of the early economists such as Smith and Jeremy Bentham, was closely intertwined with issues which are now the preserve of academic psychologists. Economics thus has deep roots in the field of psychology.

Despite the best efforts of the profession to move away from the imprecision of psychological concepts, many of the paradigms explaining economic behaviour failed to stand up to rigorous testing. Whilst these were initially explained away as anomalies which did not negate the underlying assumptions, developments in cognitive psychology from the 1960s began to be seen in some quarters as better explanations of certain forms of economic behaviour. Over the last 20-30 years, a number of these insights, derived from experimental psychology, have been applied to economic and financial decision making as better explanations of behaviour than the standard model. The new field of behavioural economics, for which Richard Thaler this week won the 2017 Nobel Prize for economics, examines what happens when we relax the assumptions of rationality and perfect information which underpin much of modern macroeconomics.

Amongst the range of judgement and decision biases which clearly violate the principle of rationality, behavioural economists have focused on factors such as overconfidence, wishful thinking, conservatism, belief perseverance, availability biases and anchoring (estimates based on an initial, often random, value). Using a combination of empirical evidence and thought experiments, academic researchers have demonstrated that some of these characteristics are at work in driving the expectations formation process. For example, evidence for the overconfidence hypothesis suggests that the confidence intervals assigned to outcomes tend to be too narrow. In a famous 1974 paper, Kahneman and Tversky[1] find evidence that whilst individuals often start off with an initial value in making estimates of future values, they are often reluctant to make big adjustments to this estimate when revising their assessment (the anchoring problem). This might go some way towards explaining why economists are reluctant to radically change their forecasts on a regular basis.

We could go on, but the point is made that there is enough empirical evidence to challenge the rational expectations assumption and thereby the idea that markets are efficient. This is a problem for many economists to deal with, for they have often spent years learning to deal with the sophisticated mathematics underpinning their stochastic models, which use rational expectations as a convenient simplifying assumption. It is an even bigger problem for the finance industry which spent many decades convincing itself that prices adequately reflect all available information.

One of the great ironies of a trading environment is that if rationality is common knowledge, there ought to be relatively little trading since a rational investor should be reluctant to buy if another investor is willing to sell. But the converse is true since the trading volume on world exchanges continues to rise. Indeed, much of the empirical evidence suggests that traders would make higher returns if they trade less frequently. Moreover, the same body of research indicates that investors are unwilling to sell assets which trade at a loss relative to the price at which they were purchased – behaviour which may well reflect an irrational belief in mean-reversion.

There are also clear patterns in purchasing decisions where there is evidence to suggest that investors buy stocks which have previously been big winners (in the hope that this performance will be repeated) or big losers (in the expectation of mean reverting performance). Neither of these is consistent with rational behaviour, but one reason why investors may follow such strategies is that they do not have time to systematically analyse the whole range of stocks. The choice of which to sell is limited to the range of stocks currently owned, but the range of stocks from which investors can choose to buy is enormous, and they are attracted to the outliers in what is known as the attention effect.

Clearly, markets display characteristics at odds with efficiency and expectations are not always formed rationally. The world thus owes a debt to Thaler and his colleagues for pointing out some of the absurdities in conventional economic thinking. Behavioural economic does not have all the answers. In the minds of many people it is just a collection of theories which can only ever be tested on small samples and thus its wider applicability is limited. But to the extent that it makes us think about some of the reasons why economics has not always come up with the right answers, Thaler’s award is well deserved.

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[1] Kahneman, D. and Tversky, A. (1974) 'Judgement Under Uncertainty: Heuristics and Biases,' Science, 185, 1124-1131

Rationality, not greed, trumps fear

The evidence of recent days suggests that financial investors are more inclined to take the risk of investing in emerging markets rather than the developed world. It is not exactly a new phenomenon: After all, the hunt for yield has been a recurrent theme of financial investing for much of the past eight years. But what is different today is that the EM universe is less stable than it was once perceived to be.

Non-agricultural commodity producers have suffered badly as the price boom of recent years appears to have come to an end. The election of President Trump, which threatens a round of US protectionism, will do nothing to help countries which depend on exporting to the west. Rising US interest rates, and the upward pressure this will impose on the dollar vis-à-vis EM currencies, will raise debt servicing costs. Moreover, the impact of rapid growth in raising wages in many EMs has reduced their competitive advantage at a time when many companies are looking to shorten their global supply chains. 

The travails of the BRICS countries are symbolic of all that has changed in recent years. Brazil has laboured under the burden of a corruption scandal that has seen the president replaced and the economy fall into recession. Russia suffers from sanctions imposed in the wake of the Crimea incursion – an event which has been exacerbated by the decline in energy prices. India is the one exception to the general trend, although even here the strange decision to demonetise large parts of the economy points to a government capable of following economically harmful policies which will impact on growth this year. Chinese growth has slowed sharply, although the much-feared boom and bust is not immediately apparent. 

Meanwhile South Africa – which does not deserve to be mentioned in the same league as the other BRICS countries – is being hammered by falling commodity prices and exceptional economic mismanagement. We can also add in Turkey for good measure, another market previously viewed positively by investors, which has undergone radical political change since last year’s coup attempt and where the government’s exertion of even more pressure on a nominally independent central bank has done nothing to support investor confidence. 

Faced with all of these problems, why are investors even contemplating going back to these markets? First of all, many EMs are cheap following the sharp collapse in key emerging currencies in the wake of the 2013 taper tantrum, so it is still possible to find value if investors are prepared to take the risk. But perhaps what has prompted investors to look further afield is the fact that the stability which traditionally favoured developed markets is being eroded by the rise of populist politics. The unity of the EU is threatened by Brexit, and faced with a lack of returns and mounting political uncertainty in continental Europe, it may pay to look beyond the safe haven trade for the time being. Indeed, the Trump rhetoric has not proven to be as damaging to EMs as was feared in November. It may yet prove to be the case, in which case fund flows will reverse, but there is simply no point in hanging around waiting for an event which may take years to materialise – if indeed it does so at all.

But perhaps the crucial point is that there appears to be evidence that growth in EM economies is beginning to pick up. The Institute for International Finance last week reported that its EM growth tracker in January pointed to the fastest rate of monthly activity growth since June 2011. As emerging markets increasingly become bigger consumers rather than simply exporters of low cost goods to the west, they will continue to gain in importance.

A report published a couple of years ago by PwC (here) highlighted that current trends in demographics, capital investment, education levels and technological progress suggest that by 2050, seven of the world’s top 10 economies will be what we currently describe as emerging economies. According to the report, those with the greatest growth potential are those with demographics on their side. Thus, India is projected to grow by an average of 5% per annum between 2014 and 2050 to propel it to second place in the global standings on a PPP-adjusted basis whilst Nigeria can grow at a rate of 5.5% per year to take it into the world top 10. We should always take such projections with a grain of salt, but they do make the point that there is a huge degree of untapped potential in many of these countries: population size alone suggests that Indonesia, Nigeria and even Pakistan have the potential to become significant economies.

What all economies require to grow rapidly, however, is institutional stability. If they cannot achieve stable government, many of the big EM economies will remain stuck in low gear. But whilst in the next few years we may not see the stellar growth across the EM universe which characterised the period 2002-2012, these economies continue to offer great catch-up potential. Investors ignore them at their peril.

All I want for Christmas ...

… is a Ferrari 250 GTO. Admittedly it’s not a modest request – the last recorded auction price of this widely revered classic was a cool $38 million and there is one on the market today for a reported asking price of $56 million (here). When new in 1962, they cost $18,500. To put this into perspective, I have converted this using prevailing exchange rates into sterling values in order to compare with other so-called safe asset values such as housing.

According to data from the Nationwide Building Society, the average price of a UK house in 1962 was £2,600 – around one-third of the price of a Ferrari 250. By 1965, when the 250 was auctioned for the first time, the selling price was 25% of the original list price and it could be purchased for 40% of the average UK house price. Up until the early 1970s, the selling prices of the 250 were never higher than average house prices but from the middle of the decade, prices began to ramp up hugely (see chart). 

The first $1 million sale occurred in 1986 and by the late-1980s – the peak of the bubble in classic car prices – the 250 GTO was selling for prices in excess of $10 million which was 125 times the price of an average UK house. Following the early-1990s crash, which saw Ferraris changing hands for a mere $3.6 million (42 times house prices), prices began to edge up again but it took until 2010 for prices to exceed the previous 1990 peak. It is notable that the ratio of Ferrari prices to house prices has already gone above the 1990 level and if the current prospective seller realises their expectations, the buyer could in theory buy more than 200 houses for the same money.

If someone had bought this wonder of engineering new in 1962 and sold it for $38 million in 2013, they would have realised an annual average return of 16%. Had they waited until 1965 to buy at auction, they would have realised a gain of 21%. It’s a much better rate of return than housing, where prices have risen at an average rate of 8.5% since the early 1960s. However, the FTSE All-Shares index has posted an average return of 13% since 1962. Investors would not, of course, have realised such stellar gains as they would have had to adjust their equity portfolio holdings in order to replicate the index which would have resulted in transactions costs which eat into returns.

On balance, therefore, the Ferrari 250 looks like a great investment compared to other forms of asset. But we are not all fortunate enough to have the wherewithal to afford such an outlay. Most classic car enthusiasts have to start much more modestly and prices have risen much more slowly over a longer horizon. In any case, the market is highly segregated with top brands showing significant gains whereas at the lower end of the spectrum price inflation has been less dramatic. However, the Historic Automobile Group International (HAGI) index suggests that over the last five years, classic car prices have risen by between 25% and 30% per year. I would attribute this at least in part to the low rates of return on financial assets which have forced investors to look at alternative investment products. It may be a market which, when it pops, does so with a vengeance.

Unfortunately for me, I do not own a classic car, so I am speaking from observational rather than practical experience. But as a reader of classic car magazines in my youth, I used to scan the adverts to check what I may one day have been able to afford. In the late-1970s I recall seeing an ad for an Aston Martin DB5 which was described as being in need of some loving care. I subsequently came to realise that meant a total wreck which was probably held together by rust. However, it was on sale for a mere £750 (no – I have not missed a zero) which was cheap even by the standards of 1978. I barely had 75p to rub together in those days so it was a little out of my league. But a DB5 in even fair condition is today valued at £438,000 with a top notch model able to fetch £958,000. Allowing for £10,000 of maintenance to bring it up to concourse standard, that would have provided a cool annual return of 12.5% over the last 38 years.

They do say that this is the season when dreams come true, so if you’re listening Santa … Merry Christmas!

A world turned upside down

An asset manager recently told me that their fund has turned away clients on the grounds that they will not be able to guarantee investor returns in this low interest rate environment. As if that was not surprising enough, the fund was promptly swamped with money because clients respected the fund manager’s honesty, and obviously believed that they were a fit and proper person to manage their wealth.

This first thing this illustrates is the difficulty of generating any form of interest income in the developed world – a problem which is only going to get more acute in the coming years as increasing numbers of baby boomers retire and find that their pensions are worth a lot less than they expected. The BoE shows no sign of concern that low interest rates are a problem for savers. Last month, chief economist Andy Haldane indicated that he sympathised with savers “but jobs must come first.” Michael Saunders, the latest recruit to the BoE Monetary Policy Committee, recently noted that “If we thought the adverse side effects of monetary policy easing outweighed the potential boost, then our willingness to use the tool of easing … would be much less … I do not think we are at that tipping point, but that is something we have to be constantly on the alert for.”

In my view this is a complacent assessment of the problems we face. At its most basic, the point of reducing interest rates to ultra-low levels is to bring forward future consumption to the present. As a result, part of consumption activity which would otherwise take place in the future has simply been brought forward in time.  But if you have half an eye on retirement, it will be difficult to convince today’s consumers to spend income now rather than put it away for the future. Indeed, most modern macro models impose a lifetime budget constraint on consumers. And in a low inflation, low interest rate environment that constraint bites hard. Arguably, perhaps, one of the reasons that Japan’s low interest rate policy failed to generate a recovery in the 1990s and 2000s was because in an ageing society, consumers were looking further ahead than the BoJ. Maybe Saunders is right that we are not yet at the tipping point. But we may be a lot closer than many policymakers seem to believe.

The other point the anecdote illustrates is that savvy investors prefer the truth to spin. If an adviser tells me to find other ways to save rather than giving it to them, I am going to find them generally more trustworthy than someone who is going to spin me a line. It is heartening to know that there are honest people out there in finance and that they are doing what the regulator asks of them (I never doubted it: Pretty much all the people I know in finance are honest, but it’s the cheats who make better newspaper headlines). Traditionally in the city, a broker’s word was their bond and if they broke it, their reputation was on the line. But in the world of short-term trading, the incentives to cheat were sufficiently high that a small number of people were tempted to do so, on the basis that they could retire on the proceeds of one lucrative trade. That is less true today. And it was never really true of money management, where fund managers tended to be better rewarded the longer their track record. However, today’s world, where customers flock to those managers who cannot  guarantee above-average returns, is one which has truly turned upside down.