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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

Research Note, Thailand – June 4, 2014

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You have possibly heard about the military coup that occurred in Thailand on May 22, 2014. In brief, the military imposed martial law and has dissolved much of the elected government. They are establishing a new economic plan, and have temporarily installed the head of the military as the prime minister. In short, democracy in one of the world’s strongest economies is now dead.

Like most news events, this is a story that requires a far deeper understanding to appreciate all of the ramifications. While an objective assessment would be prudent, I am clearly biased by my connections and friendships in the country. What I see is a logical progression that started many years ago with the dismantling of their democracy when Thaksin Shinawatra’s political party (Thai Rak Thai) was elected into power – the man whom this is all about.

A quick history of recent developments in Thai politics begins with Thaksin, a former policeman-turned business leader who was elected prime minister in 2001 through the support of the mostly rural and poor farmers of Thailand. Thaksin did some good for the country in the form of rural development programs. But the downside was corruption – he is a deeply corrupt politician who used his control of the elected bodies to neuter the country’s enforcement agencies and anti-corruption safeguards. In the end, he fled Thailand for Dubai with billions in illegal wealth, escaping a two-year prison term.

In the next act of this drama his sister, Yingluck Shinawatra, who was elected prime minister in his wake on essentially the same platform as her brother, brought further economic revival to the countryside. Her method was far cruder than her brother’s. She promised and delivered on artificial price supports for rice farmers by raising the price that the Thai government would pay per ton of rice. The effect was devastating for the government. Farmers benefitted, but the government incurred at least $4.4 billion in losses (WSJ, June 17, 2013) as the rice they bought rotted in warehouses while rice prices continued to decline due to global overproduction.

This might all have been put under the rubric of bad economic policy if it were not for her last significant move as prime minister – to propose amnesty for her brother to return to Thailand and Bangkok politics. It was this last straw that led to protests, riots, and various forms of political maneuvering, rendering the current government ineffective with no clear path for bringing in a newly elected government.

While it is still not clear what precisely triggered the military’s move at this point in the drama, it is not unexpected. Thailand has a long history of military coups, the vast majority of which are without violence or bloodshed. The military is loyal to the King and only acts when there is a significant threat to the royalist nature of the country. If things go as hoped, the military rule will eventually give way to a political body that is largely in line with the King and a pro-economic ruling party. The issues of corruption still exist, and it will be quite some time until truly elected bodies will be able to function as a democracy, but this is a positive step forward.

From an investor’s perspective, this is welcome news. The market value of our holding, an ETF based on the Thai SET 50 Index (THD), moved in a narrow range immediately following the coup and is now up 4%. The larger volatility in the related index occurred many months ago when uncertainty around the Yingluck government arose and the prospect of Thaksin’s return was real. That was when we first entered the position – after a 20% drop in the Thai index on the fears of a political upheaval.

 

Chart 1 – The Thai SET 50 has suffered tremendous volatility in the past year as the political situation deteriorated in the country. The Amnesty Bill, allowing Thaksin to return, was the trigger that eventually led to the current coup. The market abhorred the Amnesty Bill, yet welcomed the coup.

Chart 1 – The Thai SET 50 has suffered tremendous volatility in the past year as the political situation deteriorated in the country. The Amnesty Bill, allowing Thaksin to return, was the trigger that eventually led to the current coup. The market abhorred the Amnesty Bill, yet welcomed the coup.

 

Our focus now will be on how the military stabilizes the economy and sets a path for the transition to an elected government. The real damage has already occurred – Thailand’s economy contracted last quarter due to the turmoil and poor economic policies during Yingluck’s tenure. Nicknamed the “Teflon economy,” Thailand has one of the most resilient economies in the region, capable of strong growth based in Southeast Asia’s global expansion. With the elected government’s dysfunction out of the way, the country can return to stable growth as the civil administrators, business leaders and foreign investors are again able to return to the business of doing business.

All the best for an enjoyable summer.

David B. Matias, CPA

Managing Principal

Market Minute – April 22, 2013

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Last week was another one of those moments in the market which reminds us that we are in troubled times.  Taking a completely agnostic, statistical perspective on last Monday’s events in the gold market, we again had an event that demonstrates the unstable foundation of the market.  In this case, gold dropped by 5.8% on Friday, April 12 and then 7.7% on the following Monday, for a combined two-day drop of 13.5%.

For perspective, using the prior 1,000 days of trading data as a baseline, gold typically moves around 0.5% per day.  A 2% move is big (once every couple of weeks).  3% is rare (three times a year).  A bigger move than 3% is statistically remote.  A two-day move of 13.5%, under these conditions, has a probability of one-in-a-trillion or roughly once every four billion years.  So maybe my assumptions are wrong (that market returns are normally distributed), but then you would have to discredit an entire generation of financial theory and models.

So where does this leave us?  In the span of two days, gold prices (and a host of other commodities) moved in a way that is not supposed to happen unless we are facing the most dire of global circumstances.  In effect, something snapped in commodities.  There are a host of explanations as to why (Cyprus might sell all their gold, Goldman Sachs starting bad rumors, North Korea did it, Paulson did it…. and so on), but the result is rather simple.  We are in an investing world in which market mechanics are evolving into a dynamic that is both unpredictable and challenging to comprehend.

[To emphasize the volatility problem, yesterday someone hacked the AP twitter account and sent out a false report of an attack on the White House.  The Dow dropped 140 points in a few seconds, then recovered.  Someone made a small fortune on their put options.]

My suspicion regarding gold is that the Exchange Traded Funds (ETFs) which hold a large percentage of the World’s gold supply are causing distortions in the market and led to the market dislocation.  It is a rather nuanced explanation based on the way that ETFs are created, but the theory also helps to explain the Flash Crash of 2011.  Whatever the answer is, since 2008 we have been in a new world of investing and markets.  Gold is supposed to be a safe haven, stable asset with limited volatility.  While it still may be safe in the long term, it is now subject to the same randomness as the rest of the market.

I will later elaborate about other such events during the past three weeks, but the conclusions are the same.  Under the veneer of a bull market in US stocks, there remains tremendous unpredictability and dislocations continue to manifest.

As an investment manager, we have mitigated these risks through our asset allocation strategy and the manner in which we use specific securities.  And in all likelihood, the dislocation in gold is temporary.  But time will tell, as always.

Regards,

David B. Matias, CPA

Managing Principal

Protect Your Portfolio with Leverage

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Leverage is often used to increase returns, but when used properly, leverage can add protection to your portfolio.  Click below to view our Prezi presentation.

Vodia Capital: Protect Your Portfolio with Leverage on Prezi