The Mystery of Market Volatility

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This past week markets had a sudden and sustained sell off that lasted for two days, and though they bounced back a little on Friday, US markets had several negative sessions. The selloff in US markets, which began on Wednesday and extended into Thursday, roiled global markets as well, with extensive selling through Asia and Europe on Wednesday evening/Thursday morning. At the end of the week Asian, European and Emerging markets looked worse than they already were for the year, and US markets had been badly rattled. This week has seen an extension of that volatility.

Explanations for sudden downturns bloom like flowers in the sun. Investors and business journalists are quick to latch onto an explanation that grounds the unexpected and shocking in rational sensibility. In this instance blame was handed to the Federal Reserve, where members had been quoted recently talking about higher than expected inflation forcing up lending rates at an accelerated pace. This account was so widely accepted that Donald Trump was quoted as saying that “The Fed has gone crazy”, a less than surprising outburst.

TSX YTD
TSX year to date performance is currently just over -4.3%

I tend to discount such explanations about market volatility. For one, it seeks to neuter the truth of markets as large complex institutions that are subject to multiple forces of which many are simply invisible. Second, by pretending that the risk in markets is far more understandable than it really is, investors are encouraged to take up riskier positions and strategies than they rightly should and ignore advice that has proven effective in managing risk. Finally, I have a personal dislike for the façade of “all-knowingness” that comes along after the fact by people who have parlayed luck into “expertise”. Markets are risky and complex, and it would be better if we treated them like a vicious animal that’s only partially domesticated.

Dow YTD
The Dow Jones performance has been quite good this year, but in the past week lost just over 5%, bringing year to date returns to 2.94%

In fact, as markets continue to grow with technology and various new products, complexity continues to expand. At any given time markets are subject to small investors, professional brokers, pension funds, algorithm driven trading programs, mutual fund managers, exchange traded funds and even governments, all of whom are trying to derive profits.

So what does that tell us about markets, and what should we take from the recent spike in volatility? One way to think about markets is that they operate on two levels, a tangible level based on real data and expectations set by analysts, and another that trades on sentiment. On the first level we tend to find people who advocate for “bottom up investing”, or the idea that corporate fundamentals should be the sole governor of stock’s price. If you’ve ever heard someone discuss a stock that’s “under-performing,” “undervalued,” “out of favor,” or that they are investing on the “principles of value” this is what they are referring to. People who invest like this believe that the market will eventually come around to realizing that a company hasn’t been priced correctly and tend to set valuations that tell them when to buy and sell.

DAX YTD
Germany, the strongest economy in EUrope has already struggled this year under the burden of the EU fight with Italy’s populist government and ongoing BREXIT negotiations. YTD performance is -10.56%

The second level of investing is based on sentiment, informed by the daily influx of headlines, rumour and conspiracy that clogs our news, email inboxes and youtube videos. This is where most investors tend to hang their hat because its where the world they know meets their investments. Most people aren’t analyzing a specific bank, but they may be worried a housing bubble in Canada, or the state of car loans, or the benefits of a recent tax cut or trade war. The sentiment might be best thought of as the fight between good and bad news informing optimism and pessimism. If a bottom up investor cares about a company they may ignore general worry that might overwhelm a sector. So if there is a change in in the price of oil, a value investor may continue to own a stock while the universe of sentiment sees a widespread selling of oil futures, oil companies, refining firms and downstream products.

Shanghai Comp YTD
China is the world’s second largest economy and the biggest market among the emerging markets. Having struggled with Trump’s tariffs, YTD performance is a whopping -22.8%

As you are reading this you may believe you’ve heard it before. Indeed you have, as our advice has remained consistent over the years. Diversification protects investors and retirement nest eggs better than advice that seeks to “beat the market” or chases returns. However, it seems to me that the market sentiment is undoubtedly a stronger force now than its ever been before. As more investors come to participate in the market and passive investments have grown faster than other more value focused products, sentiment easily trumps valuations. Since we’re always sitting atop a mountain of conflicting information, some good and some bad, whichever news happens to dominate quickly sets the sentiment of the markets.

You don’t have to take my word for it either. There is some very interesting data to back this up. Value investing, arguably the earliest form of standardized profit seeking from the market, has remained out of favor for more than a decade. Meanwhile the growth of ETFs has continued to pump money into the fastest growing parts of the market, boosting their returns and attracting more ETF dollars. When the market suddenly changed direction on Wednesday, the largest ETF very quickly went from taking in new dollars to a mass exodus of money, pushing down its value and the value of the underlying assets. At the same time some of the worst performing companies went to being some of the best performing in a day.

MW-FZ971_CSetff_20171211161201_NS
This chart shows that actively managed mutual funds have hemorrhaged money oer the past few years, while passive ETFs have been the chief beneficiaries, radically altering the investment landscape.

So what’s been going on? The markets have turned negative and become much more volatile because there is a lot of negative news at play, not because interest rates are set to go up too quickly. Sentiment, that had been positive on tech stocks like Amazon and Google gave way to concern about valuations, and with it opened the flood gates to all the other negative news that was being suppressed. Brexit, the Italian election, the rise of populism, currency problems in Turkey, a trade war with China and rising costs everywhere came to define that sentiment. As investors begin to feel that no where was safe, markets reflected that view.

Our advice remains steadfast. Smart investing is less about picking the best winner than it is about having the smartest diversification. A range of solutions across different sectors and styles will weather a storm better, and investors should be wary of simplistic answers to market volatility. Markets always have the potential to be volatile, and investors should always be prepared.

The Deceptive Nature of Indices

Index

An essential part of the business of investing involves figuring out how well you are doing. In some respects, the best benchmark for how well you are doing should be personalized to you. How conservative are you? What kind of income needs do you have? How old are you? While the case remains strong for everyone to have a personal benchmark to compare against their investment portfolios, in practice many people simply default to market indexes.

I’ve talked a little about market indexes before. They are poorly understood products, designed to give an impression about the overall health and direction of the economy and can serve as a guide to investment decisions. Large benchmarks, like the S&P 500, the TSX, or the FTSE 100, can tell us a great deal about the sentiment of investors (large and small) and what the expected direction of an economy may be.

But because these tools are usually poorly understood, they can contribute to as much confusion as they do clarity. For instance, the Dow Jones uses a highly confusing set of maths to determine performance. Last year General Electric lost about 50% of its market capitalization, while at the same time Boeing increased its market capitalization by 50%, but their impact on the Dow Jones was dramatically different. Boeing had an outsized positive contribution while General Electric had a much smaller negative impact.

The S&P 500 currently is one of the best preforming markets in 2018. Compared to most global indexes, the S&P 500 is ahead of Germany’s DAX, Britain’s FTSE 100 and FTSE 250, Japan’s Nikkei and Canada’s TSX. Yet if you are looking at your US focused investments, you might be surprised to see your own mutual funds lagging the index this year. If you were to ask an ETF provider or discount financial advisor why that is they would likely default to the answer “fees”, but they’d be wrong.

YTD FTSE S&P500 TSX
While the S&P 500 isn’t exactly “running away” it is doing considerably better than the TSX and the UK’s FTSE 100

This year is an excellent example of the old joke about Bill Gates walking into a bar and making each patron, on average, a millionaire. While the overall index has been performing quite well, the deeper story is about how a handful of companies are actually driving those returns, while the broader market has begun to languish. Of the 11 sectors in the S&P 500, only two are up, technology and consumer discretionary, while a further 6 were down for the year. In fact the companies driving most of the gains are: Facebook, Amazon, Apple, Alphabet (Google), Netflix and Microsoft. The 80 stocks in the consumer discretionary space not in that list have done almost nothing at all.

What does this portend for the future? There is a lot to be concerned about. The narrowing of market returns is not a good sign (although there have been some good results in terms of earnings), and it tends to warp investment goals. Investors demand that mutual fund returns keep up with their index, often forcing portfolio managers to buy more of a stock that they may not wish to have. In the world of Exchange Traded Funds (or ETFs), they participate in a positive feedback loop, pulling in money and buying more of the same stocks that are already driving the performance.

In all, indexes remain a useful tool to gage relative performance, but like with all things a little knowledge can be deceptive. The S&P 500 remains a strong performing index this year, but its health isn’t good. Healthy markets need broad based growth, and investors would be wise to know the details behind the stories of market growth before they excitedly commit money to superficially good performance.  

Did that make you worried? Don’t be scared, call us to set up a review of your portfolio to better understand the risks!

What “The Big Short” Can Tell Us About Market Risk

I81wBzBcSclL‘ve just had a chance to watch the movie The Big Short, based on the book of the same name by Michael Lewis. Michael Lewis has made a name for himself as a writer for being able to explain complex issues, often involving sophisticated math that befuddles the general population but is responsible for much of the financial chaos that has defined the last decade.

The principle of our story is Dr. Michael Burry, a shrewd investor whose unique personal qualities gives him the patience to tear apart one of the most complicated financial structures in modern finance. Having done that he creates a new market for a few people who had the foresight to see the US housing bubble and how far the crash might reach. The story is captivating and the tension builds to what we know is the inevitable conclusion of the worlds biggest crash, but there is a problem with the story.

No matter what they do in the movie, we know how it all ends. That hindsight undercuts the real tension in the film, the risk that these few traders and hedge fund managers took with other people’s money to bet against what were largely considered to be safe investments. In some ways, the US housing crash is unique because of how much institutionalized corruption had seeped into the system. The ratings agencies who sold their AAA ratings for the business, the mortgage brokers who pushed through unfit candidates into subprime adjustable rate mortgages, the analysts and financial specialists that repackaged low grade mortgages into AAA rated bonds; it took all of them and more to create the biggest market bubble since the South Sea.

Their smart move seems like lock, but if you look past the drama the heroic brokers of our story were taking a huge gamble with other people’s money. From Dr. Michael Burry down through the rest of the characters, hundreds of millions, billions even, were tied up in investments that few understood but carried incredible potential for losses. The confidence that our heroes show in demanding “half a billion more” as they come to understand the scope of the problem seem smart in hindsight, but they were making big bets. Bets that could have easily ruined people’s lives and finances.

This is the true nature of risk. Things are only certain in hindsight. At the moment we need to make decisions rarely do we possess the kind of clarity that we believe we should have when dealing with markets. If we look to current markets what can we honestly say we know about tomorrow? Markets are chaotic, oil prices are in the tank, central bankers are talking about negative interest rates (while some have gone and done it), and then we will have 2 or 3 days of market rallies. What picture should we draw from this? What certainty do we have about tomorrow’s performance?

Screen Shot 2016-02-12 at 12.47.52 PM
From Bloomberg

Our problem is that when we are inclined towards certainty we are also inclined towards fantastic risk. In fact we won’t even believe there is risk if we are certain of an outcome. And we are prone to lionizing people who risk it all and are proved to be right, while forgetting all those people who made similar gambles and lost everything, leading us to repeat a mistake that has undone many.

The story we need isn’t the one about the people who bet big and won. We need the story about the people who bet smart and navigated confusing and risky markets and came out fine. That story sadly won’t have the kind of impact or drama that we long for in a movie, but it’s the story that each and every investor should want to be part of.

Are Economists Incompetent or Just Unhelpful?

 

 

boc

When economists get things wrong their missteps are practically jaw dropping. Despite making themselves the presumed source of useful information about economies, interest rates and economic management, often it seems that the economists are learning with the rest of us, testing ideas under the guise of sage and knowledgable advice. Their bias is almost always positive and the choices they make can be confounding.

As an example, let us consider the case of the Bank of Canada (BoC).

If there are perennial optimists in this world they must be employed at the BoC, for no one else has ever stared more danger in the face and assumed that everything will be fine.

For those not in the know, the BoC publishes a regular document called the Financial System Review, a bi-annual breakdown of the largest threats that could undo the Canadian economy and destabilize our financial system. Because they are the biggest problems we tend to live with them over a long time and thanks to the Financial System Review we can see how these dangers are presumed to ebb and flow over time.

For instance, two years ago the four biggest dangers according to the BoC were:

  1. A sharp correction in house prices
  2. A sharp increase in long-term interest rates.
  3. Stress emanating from China and other Emerging Markets
  4. Financial stress from the euro area.

Helpfully the BoC doesn’t just list these problems but also provides the presumed severity and likelihood of them coming to pass and places them in a useful chart.

Here is what that chart looked like in June of 2014:

Screen Shot 2016-01-18 at 2.53.43 PM

The worst risk? A Canadian housing price correction. The likelihood of that happening? very low. Meanwhile stress from the Euro area and China rate higher in terms of possibility but lower in terms of impact.

By the end of 2014 the chart looked like this:

Screen Shot 2016-01-18 at 2.52.26 PM.png

Unchanged.

Interestingly the view from the BoC was that there was no perceivable difference in the risks to the Canadian market. Despite a Russian invasion of the Ukraine, the sudden collapse in the price of oil and the continued growth of Canadian debt, the primary threats to Canada’s economy remained unmoved.

So what changed by the time we got to mid 2015?

Screen Shot 2016-01-18 at 2.51.26 PM

The June 2105 FSR helpfully let Canadians know that, presumably, threats to Canada’s economy had actually decreased, at least with regards to problems from the euro area. This is curious because at that particular moment Greece was engaged in a game of brinkmanship with Germany, the IMF and the European Bank. Though Greece would go on to technically default and then get another bailout only further kicking the can down the road, the view from the BoC was that things were better.

Interestingly the price of oil had also continued to decline in that period, and the BoC had been forced to make a surprise rate cut at the beginning of the year. Debt levels were still piling up, and there was a worrying uptick in the use of non-regulated private lenders to help get mortgages.

None of that, according to the analysts at the Bank of Canada, apparently mattered. At least not enough to move the needle.

The December 2015 FSR is now out, and if we are to take a retrospective on the year we might point to a few significant events. To begin, the economy was doing so poorly in the summer that the BoC did a second rate cut, which was followed by further news that the country had technically entered a recession (but nobody cared). Europe’s migrant crisis reached a tipping point, costing money and the risking the stability of the EU. Germany’s largest auto maker is under investigation for a serious breach in ethics and falsifying test results. China’s stock market began falling in July, and the Chinese government was forced to cut interest rates 5 times in the past year. The United States did their first rate hike, a paltry 25 bps, but even that has helped spur a big jump in the value of the US dollar. Meanwhile the Canadian dollar fell by nearly 20% by the end of 2015.

And the Bank of Canada says:

Screen Shot 2016-01-18 at 2.49.58 PM

Things are better? Or not as severe?

In two years of producing these charts, despite continued worsening of the financial pictures for Canada, China, the EU and even the United States, the BoC’s view is still pretty rosy. What would it take to change any of this?

Whether they are right or not isn’t at issue. It’s the future and it is unknowable. What is at issue is how we perceive risk and how ideas about risk are communicated by the people and institutions who we trust to provide that guidance. This information is meaningless if we can’t understand its parameters and confusing if a worsening situation seems to change nothing about underlying risk.

As you read this I expect the Chinese and global markets to be performing better this morning on reassuring news about Chinese GDP. But I would ask you, has the risk dissipated or is it still there, just buried under positive news and investor relief? It’s a good question and exactly the kind that could use an honest answer from an economist.

 

Walking the Tightrope

Tightrope-Graph_181538393_crop02As we bring this year to a close, markets continue to frustrate. The US markets, along with most global markets and especially Canada, are all negative. Over the past few weeks Canada has dipped as low as -13% on it’s year-to-date (YTD) return. In speaking with some people within my industry, expectations to finish flat for the year will be sufficient for a pat on the back and considered solid performance.

Years are ultimately an arbitrary way of organizing time. January 1st will simply be another day from the standpoint of the earth and the sun. Neither China’s nor Canada’s problems will have solved themselves when markets reopen in 2016, but from the perspective of investors a new year gives us a chance to reframe and contextualize opportunities and risks in the markets. The surprises of 2015 will now be part of the fabric of 2016, new stories will come to dominate investor news and new narratives will popup to explain the terrain for Canadians.

So when we do get to our first trades in January, what kind of world will we be looking at? What opportunities and risks will we be considering?

The risks are very real. After a steep sell off in Canada we may be tempted to think that the Canadian market is cheap and ideal for investment. I’ve had more than one conversation with market analysts that suggests that things could change very quickly. Cheap oil, a cheap dollar and rising consumer spending to the south could all spell big opportunities for Canada.

S&P TSX Index
Though it has recovered substantially since the lows of early 2009, the TSX is a real underperformer. It’s last high was August of 2014, and since then has simply lost ground. It is also hovering now around its 2011 value.

But this argument has another side. Since 2007, despite lots of volatility, the TSX has barely moved. In February of 2007 the TSX was at 13083, and at close on Friday last week the market was 13024. The engines of Canada’s economic growth from the past few years have largely stalled. Commodity prices have fallen and may be depressed for some time, with exports of everything from timber to copper and iron being reduced significantly. Oil too, as we have previously said, is unlikely to bounce back quickly. Even if oil recovers to around $60, the growth of cheap shale energy will likely eclipse Canadian tar sands, and will not be enough to restart some previously canceled projects.

 

MSCI EM Chart
MSCI EM: The MSCI Emerging Markets index has shown solid losses this year, but has yet to regained it’s last high at the beginning of 2011, and has been sideways and volatile for the past few years.  

Similarly, the Emerging Markets have been badly beaten this year, driving down the MSCI EM Index to levels well below the early year highs. But those levels also reflect the ongoing and worrying trend. The MSCI EM Index (a useful tool to look at Emerging Markets) isn’t just lower than it’s previous year’s high, it’s lower than it was back in 2011, and in 2007. In other words we’ve yet to surpass any previous highs, and when faced with the reality that the United States will likely be raising rates for the next few years, the EM will likely continue to lose investments to safer and higher yielding returns in the United States.

 

MSCI EAFE
MSCI EAFE: The EAFE has faired better than some others, but closing in on the end of the year we look to be at roughly where we were at the beginning of 2011. The MSCI EAFE Index is a benchmark to measure international equity while excluding the United States and Canada.

In an ideal world a new year would be a chance to wipe the slate clean, mark the previous year’s failings as in the past and move forward. But what drives markets (in between bouts of panic selling and fevered buying) are the fundamentals of economies and the companies within them. So as celebrations of December 31st give way to a return of regular business hours, investors should temper any excitement they have about last year’s losers becoming the new year’s winners. The ground has shifted for the Canadian economy, as it has for much of the Emerging Markets. Weaknesses abound as debt levels are at some of their highest and global markets have largely slowed.

It is a core belief that investors should seek “discounts”. The old adage is buy low and sell high. That advice holds, but investors should be wary as they walk the tightrope between discounted opportunities, and realistic market danger. Faced with a world filled with worrying trends and negative news an even handed and traditional approach to investments should be at the top of every investor’s agenda for 2016.

Correlation: Or How I Learned to Stop Worrying About the Market and Love Diversification

140617strangelove
The look of a nervous investor who needs more diversification

This year has seen further gains in the stock market both in Canada and the United States. But after five straight years of gains (the US is having its third longest period without a 10% drop) many are calling for an end to the party.

Calling for a correction in the markets isn’t unheard of, especially after such a long run of good performance. The question is what should investors do about it? Most financial advisors and responsible journalists will tell you to hold tight until it 1. happens, and 2. passes. But for investors, especially post 2008, such advice seems difficult to follow. Most Canadians with any significant savings aren’t just five years closer to retiring than they were in 2008, they are also likely considering retirement within the next 10 years. Another significant correction in the market could drastically change their retirement plans.

Complicating matters is that the investing world has yet to return to “normal”. Interest rates are at all time lows, reducing the returns from holding fixed income and creating a long term threat to bond values. The economy is still quite sluggish, and while labour numbers are still slack, labour participation will likely never return to previous highs as more and more people start retiring. Meanwhile corporations are still sitting on mountains of cash and haven’t really done much in the way of revenue growth, but share prices continue to rise making market watchers nervous about unsustainable valuations.

In short, it’s a confusing mess.

My answer to this is to stay true to principles of diversification. Diversification has to be the most boring and un-fun elements of being invested and it runs counter to our natural instincts to maximize our returns by holding investments that may not perform consistently. Diversification is like driving in a race with your brakes on. And yet it’s still the single most effective way to minimize the impacts of a market correction. It’s the insurance of the investing world.

This is not you, please do not use him as your investing inspiration.
This is not you, please do not use him as your investing inspiration.

The challenge for Canadians when it comes to diversifying is to understand the difference between problems that are systemic and those that are unique. The idea is explained well by Joseph Heath in his book Filthy Lucre. Using hunters trying to avoid starvation he notes that “10 hunters agree to share with one another, so that those who were lucky had a good day give some of their catch to those who were unlucky and had a bad day…the result will be a decrease in variance.” This type of risk pooling is premised off the idea “that one hunter’s chances of coming home empty handed must be unrelated to any other hunter’s chances of coming home empty handed.”  Systemic risk is when “something happens that simultaneously reduces everyone’s chances of catching some game.” This is why it is unhelpful to have more than one Canadian equity mutual fund in a portfolio, and to be cognizant of high correlation between funds.

The question investors should be asking is about the correlation between their investments. That information isn’t usually available except to people (like myself) who pay for services to provide that kind of data. But a financial advisor should be able to give you insight into not just the historic volatility of your investments, but also how closely they correlate with the rest of the portfolio.

Sadly I have no insights as to whether the market might have a correction this year, nor what the magnitude of such a correction could be. For my portfolio, and all the portfolios I manage the goal will be to continue to seek returns from the markets while at the same time finding protection through a diversified set of holdings.