This break leaves investors with a big question: Were the last four months of 2018 a short-term aberration that should be overlooked, or an early indication of worse things to come?
What a difference a year makes. In 2017 stocks went up in almost a straight line and volatility remained amazingly low throughout the year. In 2018 stocks got dinged early but quickly recovered. For a time, it looked like things were getting right back on the same track, but in September stocks started reeling and weren’t able to recover by the end of the year.
This break leaves investors with a big question: Were the last four months of 2018 a short-term aberration that should be overlooked, or an early indication of worse things to come? The dramatic and violent nature of price swings added to the urgency of the question. The short answer is yes, things have changed, and in ways that will be very good for some investors and terrible for others.
For investors who don’t watch markets every day, the notion that “volatility returned” doesn’t begin to capture how dramatic price swings became.The Financial Times described one such interlude [here]:
The broader return of volatility was captured by Zerohedge [here] by comparing the number of days the S&P 500 rose or fell by one percent or more.
Turmoil in the markets also co-existed with turmoil in news flow. The FT listed several captions of concern [here] such as “De-Faanged”, “Turkey meltdown”, Italian alarm”, “Red October”, “Oil’s spill”, and “December mayhem”. Zerohedge also captured the chaos of the quarter with a chronology of headlines [here]. Amidst the turmoil one thing remained clear: Market action in the fourth quarter was a lot different than anything exhibited in a long time.
While all these items helped to unsettle markets, one of the most distinctive characteristics of the fourth quarter was how few managers were able to navigate the turmoil successfully. Almost every investment strategy failed. One quant hedge fund executive lamented [here], Honestly, nothing’s working.
Indeed, one might have expected hedge funds to make hay amidst the volatility. Bloomberg described [here],
Arvin Soh, a New York portfolio manager at GAM Holding AG, explained,
Nonetheless, Bloomberg reported,
In addition to almost universally bad performance, another unique characteristic of the fourth quarter was that the value style outperformed growth for the first time in a long time. Historically, value outperforms growth and is one of the most robust relationships in finance. For the last 10-, 5-, 3-, and 1-year periods, however, growth outperformed value, and by a considerable margin. That relationship flipped back in the last quarter.
These phenomena suggest that the fourth quarter was about more than just price fluctuations. Something important changed. Mohamed El-Erian captured the development in the FT [here],
This is a fairly powerful statement with important consequences. Lindsay Politi from One River Asset Management describes [here] what happened under the massive deployment of liquidity:
Mark Tinker of Axa Investment Managers provided a similar assessment [here],
One manifestation of the market monoculture that developed was that price discovery became impaired. Bloomberg, for example, declared at the beginning of 2018 [here],
Indeed, the persistent upward march of stock prices became imbued in popular culture. The FT noted [here] ,
Another manifestation was that several investment strategies including contrarians and value investors and fundamental investors were effectively “killed off”. Ben Hunt captures the dynamic [here]:
Now that liquidity tailwinds are diminishing, however, a starkly different investment environment is emerging. Merryn Sommerset Webb described in the FT [here],
Further, investors also have to pay more attention to risk and uncertainty. To date, investors have been able to take President Trump, to whom Grant’s Interest Rate Observer regularly refers as “the avatar of tail risk”, in stride. As Ed Luce highlights in the FT [here], that situation is changing too:
The net result is a double-whammy for stocks. Just at the same time that the buoyant effects of liquidity are diminishing, several tangible risks and uncertainties are increasing. The potential for significant revaluations is high.
Perhaps nowhere are these dynamics more apparent than in the technology sector. Richard Waters noted [here],
Almost as if to prove the point, Apple started off the new year by preannouncing lower than expected revenues. Kevin Hassett, chairman of the White House Council of Economic Advisors, made it clear that Apple’s experience was not just an aberration. He indicated [here],
A key point for investors to appreciate, then, is that the market paradigm has changed. El-Erian describes as well as anyone what can be expected for the foreseeable future [here]:
In particular, this is likely to involve more wild swings in the market. John Hussman describes [here]:
Recognition of, and adaptation to, these changes will present a difficult challenge for many. As John Hussman describes,
For those who can adapt, risk management will be a crucial exercise. El-Erian recommends [here]:
Risk management will also take the form of rediscovering investment discipline. When stocks always go up, you can come up with any narrative you want to explain why. Strong economic growth, transformative technology, disruptive innovation. It doesn’t matter. Take away the ability of central banks to control instability, however, and edge and odds become extremely important.
Ben Hunt describes such an analysis in regards to the trade dispute between the US and China [here]:
Hunt’s suggested response represents a clear break from the recent past, “I’m saying that when large institutional portfolios see more uncertainty in markets – not greater risk, but more technical uncertainty – they do not buy dips and they do sell rallies. They rebalance by selling winners, not by adding to losers. They take down their book.
In addition, the unwinding of excesses is also likely to affect the nature of market opportunities in other ways. While rising tides lift all boats, in the absence of such tides, boats are left to rise or fall on their own. As Sommerset Webb pointed out, the new environment “should also be absolutely thrilling to the active investment industry.”
The changing market paradigm also creates an opportunity to re-evaluate expected returns and investment horizon. The last 36 years comprise all or most of the practical experience of most investors but stand out in history as being unusually kind to investors. It is a great time to ensure that return expectations through one’s investment horizon are appropriately grounded. Politi’s advice regarding data models is also appropriate for establishing return expectations: “Success will come not to those who build the best machines but to those who make the best assumptions.”
John Hussman shared a similar perspective:
In summary, sometimes prices go down and they are normal fluctuations. Sometimes big, violent price declines reveal something deeper is going on. In this sense the fourth quarter brought in a brand new day for investors and one in which they are no longer “shielded by central banks’ monetary largesse”. This is likely to create all kinds of problems for investors who are overly optimistic about what stocks are likely to return and are too complacent to revisit their assumptions. It will also provide a fresh, new start, however, for long term investors who have been waiting patiently for better opportunities. Those opportunities are not overwhelming yet, but they are coming.
— Read on www.zerohedge.com/news/2019-01-11/investors-are-unaware-dangerous-change-market