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]: "On December 24, US equity markets posted their biggest recorded crash for a Christmas Eve. But on Wednesday [the day after Christmas] they recorded their biggest rally for almost 10 years."
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. In the fourth quarter there were 28 such days which was well above the "Q4 average of 14 since 1958". The fourth quarter tally was also considerably higher than that for the entire year of 2017 which "hit a new post-recession low of 8."
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], "Wide swings in prices, a waning bull market and rising rates were seen as the elixir that the $3.2 trillion [hedge fund] industry needed to overcome years of subpar performance." Arvin Soh, a New York portfolio manager at GAM Holding AG, explained, “Big picture, hedge funds are strategies that are meant to deliver during periods of uncertainty and profit from dislocations, which we have seen plenty of this year.” Nonetheless, Bloomberg reported, "hedge funds got pummeled in last month’s market swoon and are headed for their worst year since 2011."
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], "[A] better way of thinking about what is unfolding relates to a broader change in the major determinants of asset values and stability. Investing is no longer primarily about taking advantage of massive deployment of liquidity that lift all financial boats."
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: "The environment [of quantitative easing] causes some strategies to flourish and multiply, while others die off. The abnormally long, QE-fueled bull market killed off anything that wasn't, at its core, a short volatility strategy. Now, whether it's risky credit, levered equities, or risk parity, almost all strategies are taking similar risks. QE has done something much more damaging than the Fed could have imagined. It changed the very nature of the market, destroying the diversity of the market ecosystem, and making it incredibly vulnerable to the smallest change in the macro environment."
Mark Tinker of Axa Investment Managers provided a similar assessment [here], "The fact that a decade of quantitative easing has produced a lot of products that rely on spread, carry and leverage has left financial markets vulnerable to an unwind of these strategies."
One manifestation of the market monoculture that developed was that price discovery became impaired. Bloomberg, for example, declared at the beginning of 2018 [here], "The stock market never goes down anymore" (h/t David Collum from his Year in Review [here]). Indeed, the persistent upward march of stock prices became imbued in popular culture. The FT noted [here] , "the bestselling T-shirt on StockTwits, a website for day traders, shows a basketball player dunking on a bear, emblazoned with the acronym BTFD — or “Buy The F***ing Dip”. The design is meant to underscore "how shrugging off temporary sell-offs has repeatedly proven a winning [though not particularly thoughtful] strategy."
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]: "All those buy-side analysts and PMs finding 'alpha' from their 30 worksheet-long FCF [free cash flow] models and their oh-so sharp questions posed to management at 1×1 meetings and their oh-so observant site visits to this facility or that facility have, in fact, been fired. All of these Masters of the Universe like Lee Cooperman and Stan Druckenmiller have turned their hedge funds into 'family offices'. Not because they WANTED to. Because they HAD to."
Now that liquidity tailwinds are diminishing, however, a starkly different investment environment is emerging. Merryn Sommerset Webb described in the FT [here], "The surprising thing here is not so much that markets have tanked, but that given that they [markets] are supposed to be discounting mechanisms, taking in and reacting rationally to all available information, it didn't happen sooner." One consequence is that "investors have to start focusing properly on cash and valuations."
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: "It is only a slight exaggeration to say that Jim Mattis, the outgoing US secretary for defence, was the last grown-up in Donald Trump’s 'axis of adults'."
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], "One [factor affecting tech stocks] was a reaction to the prospect of rising interest rates, and a sense that the benign economic and financial conditions that had supported the tech-led bull market were drawing to a close. The other [factor] was caused by the opening of a trade war with China in which some tech companies stood to find themselves in the front line."
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], "There are a heck of a lot of US companies that have sales in China that are going to be watching their earnings being downgraded until we get a deal with China."
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]: "While some investors may hope for a return to calmer times, a more probable outcome for 2019 is that it is framed by a trifecta of an uncertain global economic outlook, technically unsettled markets and central banks less able to counter the added instability associated with political developments." El-Erian summarized, "Having been shielded by central banks’ monetary largesse for so long, markets will continue to unwind some of the excesses that had developed."
In particular, this is likely to involve more wild swings in the market. John Hussman describes [here]: "In stocks, I continue to believe that the market is positioned for rather violent losses over the completion of this cycle, though undoubtedly punctuated by periodic rebounds that are fast, furious, and prone-to failure. These tend to emerge in the form of what I call ‘clearing rallies,’ which relieve short-term oversold conditions. They should be used to make any needed portfolio adjustments."
Recognition of, and adaptation to, these changes will present a difficult challenge for many. As John Hussman describes, "My old friend Richard Russell once said that every bear market has a 'hook' – something that investors believe, but isn’t true, and encourages them to keep holding and hoping all the way down. Believing that Fed easing creates a 'put option' under the market is one of those hooks."
For those who can adapt, risk management will be a crucial exercise. El-Erian recommends [here]: "Critically, having more cash in investment portfolios goes beyond building resilience for the multitude of transitions facing the global economy and markets. It also offers investors who are so inclined both the option to take advantage of the technical overshoots that inevitably occur during indiscriminate sell-offs and volatile trading markets."
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]: "You have no edge in this game. You don’t know the odds of this game. Not because you’re not smart enough and not because you’re not trying hard enough, but because the edge and odds in a game of Chicken are unknowable. And anyone who tells you otherwise is lying to you and/or lying to themselves."
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." Finally, he recommends, "You should, too. And you should do it first."
The unwinding of excesses is also likely to affect investment strategies, not the least of which involves outperformance of the growth style relative to value. Morgan Stanley analysts noted [here], "markets are on the cusp of regime change where willingness to pay for growth stocks will be damped by rising interest rates." Specifically, they stated in their 2019 outlook, "We think there is a major leadership change occurring from growth to value which could be more long-lasting than most appreciate".
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: "Look, my interest is in making sure that investors have positions that they are able to hold through the complete cycle… If they’re carrying more risk than they could endure through the course of a bear market, they should cut back now. I’m not going to wave my arms around about doom and gloom, but I think it’s a crucial time for investors to think about the risk they’re taking."
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.