Bad Year.

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We are just eight trading days into 2016, and it is already one of the worst yearly performances in quite a while – down -7.5%.  The next two days will be critical, however, in determining if this is a trend or another speed bump in an already rocky market.

Using the S&P 500 as a gauge, we are down to levels that are consistent with last August and September, but just above those lows.  We are also at a level on the VIX – the indicator of future volatility – that is in line with September, when the market turned back around during the following four weeks.  It is NOT at the levels that we saw in August when there was real concern that the global markets were on the verge of collapse.

Put simply, this is not a market meltdown in the ways that we saw in 2008.  It is disconcerting, and on the heels of a very volatile and depressed 2015, it may be enough to push investors to be done with equities.  There are two core drivers of this market decline – China and Oil. China may very well be slowing down, but the reaction to these indications has been exacerbated by borrowed money and the interference of the Chinese government in the market. Similarly, oil prices will continue to drive many failures in the energy market, but the fundamentals shaping the low prices cannot continue for much longer.

We see some relief from these levels, but limited long-term upside until the economic picture improves.  The biggest unknown is corporate earnings announcements that will be coming out over the next few weeks.  Volatility will continue  as earnings surprises emerge, but the fundamentals are strong enough to dampen the market volatility in the medium term.

David

The Year Is Done!

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The year is done, and it is a challenge to find the bright spots.  There are a few – some tech giants did well in addition to specialized pharma.  With pharma in particular, cheap loans sponsored by the Fed’s policy, M&A activity drove most of the gains to be seen in the market.

The overall numbers, however were between disappointing and abysmal.  The major U.S. indices, the Dow and the S&P 500, both posted losses that were canceled out by the dividends.  Investment grade bonds were pretty much flat or down, and junk-rated debt was hammered in the last weeks of the year.

Most important, however, was energy.  With oil taking a 40% hit on the year after a terrible December of 2014, it sucked the life out of everything from drillers to industrials.  While this trend is temporal – oil demand will increase and supply will drop – the volatility has shaken the financial markets to their core.  Geopolitics have played a major hand in this dynamic – from OPEC’s admitted failures to Iran’s nuclear program – oil is the constant theme.

There is one major bright spot in 2015: our energy-based economy will eventually shift to more sustainable sources, and with 195 countries signing the Paris Climate Accord that trend might begin to accelerate at a meaningful pace.  We are unlikely to avoid serious environmental change, but we could avoid far greater consequences.  These trends, combined with the Fed’s movement into a new rate regime, promise for an extremely interesting, and hopefully clarifying, 2016.

We will explore all of these issues and more in our quarterly Market Update in two weeks.

All the best for a Happy New Year!

David Matias

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Managing Principal

Market Note – September 8, 2015

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Last week was another ride through the Volatility Machine. Here’s a look back at the past three weeks, keeping in mind that our daily stock price movements are roughly three times the daily movements of just a month ago.

We can begin the period on August 17, when we saw the first correction in stock prices in over two years. That week, the market was down -5.8%. The following week closed up +1% despite downwards movements of more than -5% through the week. And finally, last week, the market moved down -3.4% leading up to the holiday weekend.

So the volatility continues, and the movements down follow the volatility.  The move up in Week 2 was typical of a “dead cat bounce” when buyers come in seeking quick profits or short traders come to buy back their positions.  Last week, however, saw the continuation of selling with little reprieve.

Meanwhile, reasons for this sell-off are still being postulated.  China is having troubles, but the U.S. and European economies are on stable footing, and we don’t appear to have a systemic collapse of any single sector that would warrant such moves.

One interesting theory has to do with a type of hedge fund that trades based on volatility measures, called ‘Risk Parity’. While the strategy takes many forms, it is designed to move funds out of certain asset classes when the volatility measures start to spike in order to avoid downwards movements. Put simply, stocks start to gyrate, so these hedge funds sell.

This theory would explain the massive selling that we have been seeing, specifically as all stocks are being sold off at the same time regardless of differentiation in solid earnings, high dividends, or both. If it is stock, it is being sold.  However, the theory doesn’t hold much water until we see the data on the hedge funds that will come out in several weeks.

Another variation on that theme is the explosion of risk parity strategies that are being mimicked by the retail asset managers.  While these strategies are far less sophisticated than the hedge funds, the premise is the same – sell before the market dives.  This simple approach of ‘get out the door first’ results in a self-fulfilling prophesy.

Whatever the reason, the trend that we are seeing stays the same.  Volatility has spiked, and with that spike, asset prices are going down.  A bottom will eventually form – and with that, we will see the stock price of good companies move independent of the market – but until that time this is a market that is moving in one big rush for the door.

Regards,
David Matias

 

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Managing Principal

Market Note – September 2, 2015

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Sometimes when one says that things “aren’t going well,” it is a polite way of suggesting that certain events are causing real trouble.  Last week’s market movements are well beyond the description that things didn’t go well – they were a disaster.

To keep the statistics brief – since you can’t have missed them – the Dow and the S&P both entered correction territory for the first time in four years.  Defined as losing 10% of their value from the high, the last leg was shaved off in the matter in a few minutes on the morning of Monday, August 24th.  Though there was a partial recovery by Thursday, the ferocity of the movement down is not to be ignored.

Spikes in the VIX 

A couple of the events we saw last week give me real concern.  First, the VIX, an indicator of the implied price of insurance on stocks, shot from the 20s to the 50s in the matter of an hour on Monday.  That index has sat in the teens for most of the past two years, and rarely edged into the 20s.  The last time it shot above 50 was 2008, when stocks proceeded to lose half their value.

In many respects, the VIX was responding to the present events and lost its usual forward-looking insights.  Specifically, the spot VIX was in the 50s while the forward VIX (contracts on the VIX that trade in future months) was still hovering in the low 20s, a relatively calm level given the market dislocation.  The most important point here is the magnitude of the movement in the spot VIX, and the fact that it hasn’t moved in this way since October 2008, shortly after Lehman collapsed and just before a vicious round of declines that finally brought the market to its knees in March 2009. The difference between now and then is the stability of the domestic economy, although don’t underestimate the power of volatility in driving down market values.

UntitledChart 1 – VIX from 2007 to 2015

During the past eight years, the VIX has surged on three prior occasions – the Great Recession, the Flash Crash and the U.S. Debt Downgrade.  Last week’s movement pushed again to those same surge levels, surpassed only by 2008.

Source:  Bloomberg

Pressure on Liquidity in ETFs

The second worry is the trading we saw in Exchange Traded Funds.  Since 2008, the ETF market has exploded, accounting for an increasingly significant amount of daily trading and assets held in retail accounts.  On Monday, the ETF market simply froze.  Trades that did execute were 30% away from their index value in some cases.  A large and growing sector of the stock and bond markets does not have the liquidity necessary to support timely exits for investors.

The statistics on ETFs are impressive – to date there are 1,400 ETFs, with the largest one, SPY, capitalized at $130 billion.  That would put it as the 33rd largest company in the U.S.  In total, ETFs represent $2 trillion in assets invested in the U.S., a substantial portion of total investments held in accounts.  The challenge with this security type is the way that they are created and dissolved.  In short, only certain trading firms are allowed to create a block of ETF shares by buying the underlying securities in the market and issuing the new ETF shares.  The process is reversed when there is a large demand for ETF share redemptions, with the potential to “force” large selling of the underlying shares.  With an ETF based on a large and liquid market, this is not usually a problem, but in the smaller ETF markets that are exploding, this creates extreme market stresses at exactly the wrong time – when the underlying shares are already stressed by a down market.

The ramifications have yet to be fully seen, but as we saw in the Flash Crash of 2010, it can significantly distort the market and effectively block the exit doors during a fire.  Thus far, the disruptions are temporary – lasting just a few hours – but the impact on market psychology is not yet understood.  More importantly, we don’t know what knock-on effects this might create in markets that are experiencing other unrelated issues.  In the case of a black swan event, this could be a factor driving the market to even further over-correction.

There are a dozen or so other data points that I could discuss, but the conclusion remains the same – the market radically changed its composure on Monday.  Going forward, we can’t expect to see the same sort of market behavior that we came to adore for the past four years.

Underlying Economic Conditions

The difference with this correction is that there is little new information in the market, and what we do know about the economy remains positive. The market itself was largely flat for the entire year – hitting a new high in May but failing to push beyond that high for some time.  That said, the lows have been extremely muted as well, with movement between this year’s low and high of just 7%, a narrow trading range that we haven’t seen in decades, if ever.

Meanwhile, the underlying economic conditions are in fact fairly promising.  Jobs in the U.S. are growing steadily and the housing market is heating up again after eight years.  Europe also has seen some signs of relief from its recession, with the Greek debt crisis behind them and growth starting to engage in many regions.  The data coming out in September, however, will be critical to the direction of the markets in the short term.  Any hint of a disturbance in the U.S. economy – real or inferred – will cause significant gyrations.  Combined with the continued uncertainty around the Fed’s interest rate policy, and you have situation that can lead to further volatility continuing through the fall.

While there may be hints of real trouble lurking in news of manufacturing data in the U.S. or China, the majority of material generated by the financial media is purely noise.  The devaluation of the currency two weeks ago leads people to now assume that the Chinese economy is on the skids.  I strongly disagree with this sentiment, pointing out that China is still experiencing extraordinary growth whether it be the 5% annual GDP growth that is likely or the 7% that they target.  Keep in mind that 5% growth in China is in dollar terms almost equal to the dollar growth of Europe and the U.S. combined.  China is growing – it is just a matter of how much and how that impacts demand in the rest of the world.

Conclusion

We will delve into the demand characteristics of Chinese growth and the other market issues in our quarterly Market Update, but for today the discussion is market volatility.  Whatever the cause – and eventually we will find out – the likelihood is that the massive swings are not over.  Volatility creates fear, and fear creates losses as investors head for the exits. We are unlikely to return to market highs until this current round of volatility and fear is purged from the market psychology.  As I mentioned, we are seeing events happen that have not occurred since the last market collapse in 2008.

As always, please feel free to call or write with questions or concerns regarding your account.  Our investment philosophy is geared towards capital preservation in volatile markets.  We will continue to exercise this prudence, while looking for opportunities in the current market environment.

Regards,

David B. Matias

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Managing Principal

Greek Shocker

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Today was another one of those moments in the history of finance that will be recorded as a “shocker”.  The Greek Prime Minister Alexis Tsipras, in an attempt to save his political career, is playing the ultimate brinksmanship by putting the fate of the European debt relief package up to the Greek voters.  By calling a referendum, he effectively dismantles the negotiations process and destroys his credibility with the rest of Europe.

The issues are simple yet complex.  In a simple sense, a rejection of the bailout package will generate a default on Greek sovereign debt and trigger a departure from the euro.  Anyone holding Greek debt will have to mark down its value severely and reflect the loss in their books.  Given the number of European banks and hedge funds that hold the debt you run the risk of seeing key institutions in the financial system need new investor capital to avert closure.  In the case of some hedge funds, it will be straight out failure.

With the banks and stock exchange closed for the week, and the referendum happening over the weekend, we’ve created the perfect storm for a financial shocker.  Placed on top of a holiday week for the U.S. and you’re increasing the market volatility even further.

While the risk of bank failure sounds similar to the Lehman Collapse of 2008, it is a vastly different situation.  First off, the total amount of Greek debt we are discussing is only $360 billion.  That sounds like a big number, but in the age of trillion dollar balance sheets it isn’t.  Second, this has been in the works for years now, giving key institutions a long time to sort out their reserves and plan for this contingency, or simply get rid of the investment.  Not that they would have done it well, but at least it has been done.

In the end, this is most likely to blow over by the end of the summer and make way for the positive effects of the growing and massive economies around the world.  The damage to the euro, and the implications for future exits by rogue economies, would persist for years.  And Greece will again issue debt, this time denominated in grape leaves.

The complexity is fear, and the reaction to fear, which is based in the unknown.  A default by a euro denominated country has never happened.  The follow-on effects are simply too subtle and complex to predict.  So in typical investor fashion, every asset is punished until a resolution is in hand.  Historically, it takes only a couple of weeks to recover from such a shock (Bloomberg, “A Freight Train of Unknowns Confronts Investors with Greece“).  But in that rare occasion, such as 1987 or 2008, the recovery can take up to a year.

Time will tell, but until we see a true shift in fundamentals, we view this as a nasty but passing storm.

David Matias.

Frozen in Place

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Frozen in Place:

Bloomberg.com had a very interesting insight this morning on the movement of the S&P 500 for this year-to-date.  As of this morning, the market was up around 2% year-to-date, a mediocre performance in a bull market but deeply disappointing for investors after the double-digit gains of the past few years.  But more interesting is the range of movement in the stock level – a total of 6.5% total movement between the high and low for the year.

Going back at least 20 years this volatility of the major gauge hasn’t been this low.  The “deer in the headlights” action of the market is attributed to the mixed economic indicators and the anticipation of Fed action sometime this year.  If rates go up too fast, it could stall the economy, driving down stocks.  If the Fed does nothing, it might indicate that the data is pointing to already weak economic performance.  Something in between is what the market is looking for, but until that happens we are likely to continue in this “in-between.”

It doesn’t mean to show that volatility is low in general.  To the contrary, currencies, commodities and fixed income have all seen significant gyrations this year, with more to come if there isn’t some clear direction soon.

In my opinion, this pause in the market is a very good thing.  It gives corporate earnings a chance to catch up to stock prices, and sets the groundwork for a strong rally in the fall if we see the economic growth is truly able to take hold for the long term.  The indicators that we continue to look at are employment and housing – two key factors to supporting the consumption-based economy here in the US.  Last month’s employment numbers were impressive, starting to take a bite out of the historically low labor participation rate.  But that trend needs to accelerate to really create liftoff in the economy.

More in our Market Update at the end of the month.

News & Noise

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Our 24/7 news cycle produces both news and noise that filter through the markets. It can be difficult for investors to distinguish between the two and stay focused on their primary investment objectives. As a result, investors tend to make emotionally driven investment decisions, which leads to volatility, and volatility drags on portfolio returns.

Back in March the Federal Open Market Committee (FOMC) made quite a bit of noise when it changed its wording. The committee removed the word “patient” from its guidance regarding when monetary policy might be changed. Although the move generated much commentary, it really was nothing more than a symbolic step towards a potential rate increase. There was no change in monetary policy. It was just noise and the S&P 500 dropped -2.75%.

But there are other, and perhaps more consequential, factors at play that have contributed to this year’s volatility. The strong dollar for example, has put pressure on corporate earnings. A strong dollar impacts a company’s international operations and slows growth as their products become more expensive overseas. Falling oil prices and the uncertainty that resulted from the mixed messaging around it has also led to volatility.

Other factors such as economic growth, company-specific factors and industry conditions all play a role in contributing to the overall volatility. Just as falling oil prices drag on the earnings of energy companies, they drag on earnings for the energy sector overall, which in turn hurts earnings of the S&P 500.

All of this gets oversimplified in the headlines leaving people to sort out the news from the noise. In the end, it does not require a great investment of time to distinguish between the two and make good investment decisions as long as there is a disciplined process to ensure the ability to hone in on what is important.