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?

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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.

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.