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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

Market Update – October 2010

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An Anxious Summer

It has been three years this fall since the financial crisis began, and by my estimation, it will be another seven years until we have fully recovered.  Yes, I see it as a decade-long event, beginning with the subprime crisis (July 2007) and reaching its height in the failure of Lehman Brother (September 2008).  Under that assumption, we’ve had a pretty good year.  The stock market is up 4% for the year (nearly half of which is dividends), the corporate bond market is up 12%, and commodities are up 4%.  These may not look like great returns, especially if you’re still trying to restore your retirement account from the collapse of 2008, but given the alternative it is pretty impressive.

This view is best understood when you look at the stock market against the VIX, commonly referred to as the “fear gauge.”  The VIX is a composite index that tracks the implied volatility on S&P futures.  Put into plain English, it is a measure of expected future losses.  The higher the VIX goes, the more expensive it is to insure against such losses.  The chart below shows that while the S&P has flat-lined for most of 2010, VIX looks like it went through a cardiac arrest.

SPX and VIX

Specifically, it was the “flash crash” on May 9 that created the anxiety and that stress lasted through the entire summer.  It was only when we arrived in the last week of August that the anxiety level returned to a more normal buzz and the US stock market began a 10% rise to recover the year’s losses.  The question remains – what caused such a stir in early May and why did it create such fear of equities.  While there is now a plausible explanation of the flash crash recently published by the SEC, in fact it could still happen again.  What we did experience through the summer was a rather tame pull-back.  Had things truly gotten worse in the economy and around the globe, we would have likely seen a persistent 20% drop or more.

Fortunately, the net result is a gain.  For the year to date the S&P 500 is up 4% with dividends, and the VIX is sitting at 23 – elevated but not unusually so.  For comparison, prior to the crash, VIX commonly sat in the low teens with 30 being a crescendo prior to a market decline.

My “decade-long recovery” prediction, while frankly a guesstimate, reflects the challenges that we face in all areas of the economy.  During this time, expect for economic growth to be slow and market returns to be in the single digits.  Under those conditions, a total return of 8% for the year is a very respectable figure.  With a 4% gain through the first three quarters, we’re on track to stay within those bounds.

Two of the factors that will determine a full recovery are employment and housing.  In fact, they are intricately tied together with bank lending at the root of the problem.  While large investment-grade public corporations have easy access to the credit markets (Microsoft raised 3-year paper at less than 1%), smaller businesses and private firms with less-than-perfect finances are having a nasty time of borrowing.  The mortgage market is even worse.  Mortgage assessments are driven by comparables, and with so many foreclosures out there the comps look awful in even the best neighborhoods.  To make matters worse, banks are simply not extending mortgages to folks without three years of steady income.

So with so many folks looking for work and valuations at such lows, it is simply impossible for most people to obtain a mortgage to buy or refinance.  With so much potential equity tied up in our homes, a large source of net worth has been frozen.  Complicating matters, it makes it nearly impossible to move cities to find work or change jobs.

Implied in all of this is the plight of small business, a common growth driver in the American economy.  No loans means little capital to expand and grow.  No growth, no new jobs.  The cycle continues.  While I am bullish on the American entrepreneur and our ability to adapt as a country, it will be years for the foundation to be repaired.

Repositioning of the Portfolios

To respond to these conditions, we are looking to reposition the portfolios accordingly:

Equities:  We increased some of our equity exposure in August when the market was experiencing a temporary low, although we continue to maintain an underexposure due to the current economic prospects.  The areas that we are increasing are related to cash or global growth.  Notably, companies with growing dividends are going to continue to be a focus along with industrials and medical technology firms.  Irrespective of the US’s prospects, these industries will continue to remain strong.

Alternatives:  To augment the equity exposure, we have increased our alternative asset class.  Ranging from commodities to REITs, these are assets that have low-to-zero correlation with equities yet maintain similar growth prospects.  The table below demonstrates these correlations against the S&P 500.  Although commodities have a similar growth prospect, a third of the time they move independently of the market.  Gold is far less correlated to stocks, and bonds are effectively not correlated at all.  Emerging markets, on the other hand, is almost always correlated with US stocks.  Incorporating lower-correlated assets allows us to maintain similar growth prospects in the portfolio with less extreme fluctuations in value.

 

SPX Correlations

Two-year daily correlations from October 2008 to October 2010. Because of the significant exposure to oil in the DB Commodity Index, it has a higher correlation over this period than prior to 2008.

 

Fixed Income: With the persistent fear in the markets combined with excessive monetary easing, bond prices have reached highs rarely seen.  Any issue that is less than 10 years is pricing at yields of 2-3%.  If you factor in any inflation into the economy during this period, your bond real-return is likely to be zero or negative.  As a result, we are selling any traditional corporate bond holdings that are less than a 10-year maturity.  This does not include any of the structured notes we currently hold or floating rate bonds, since most of these have mechanisms to generate solid returns in both recovery and stagnation scenarios.

We will closely monitor events this fall, with the election being the next hurdle in market stability.  As usual, uncertainly creates anxiety and just the resolution of the political shift in itself will help to stabilize equity returns.  Please don’t hesitate to contact us with questions or comments, and all the best for the fall.

Regards,

David B. Matias, CPA

Managing Principal