Macro Letter – No 56 – 10-06-2016
Here comes summer – Did you sell in May?
- Are Central Bankers approaching the limit of their power?
- Individual stock volatility is reaching extremes relative to the indices
- When dispersion of stock returns is high the risk relative to reward also rises
- Some hedge fund strategies offer long-term benefits in this environment
This week’s letter is a departure from my normal format. Enclosed is a commentary on the prospects for the financial markets from my friend Allan Rogers whom I have been fortunate enough to know since the early 1990’s. Latterly the CIO of Loews Corporation’s Continental Assurance, Allan was a proprietary trader at Bankers Trust when the bank was in its heyday. Here is the note he kindly sent me on 14th May:-
Summer 2016 features a rising wave of frustration and voter antipathy toward most governing bodies and central banks, with good reason. Ballot box dynamics threaten numerous incumbent government officials. Demographic aging phenomena, technological innovation and minimum wage adjustments combine to thwart cyclical labor market improvement. As post-war economic models fail to anticipate these rapid market adjustments, Central Banks cling desperately to their Milton Friedman monetary theory and Keynesian fiscal assumptions, relying on their imaginations, luck, and prayer to launch wave after wave of novel liquidity infusions. So far, no good. In their haste to revive growth after the financial crisis, they have handcuffed the dealer liquidity providers with ill-conceived regulations that endanger the liquidity network plumbing whenever expectations shift abruptly. We have devolved into a nightmare of ZIRP, NIRP, QE, and God knows what’s next. But, rather than wring our hands over this dilemma, let’s contemplate sensible portfolio management strategy for a few minutes.
As discussed last year, foreign exchange currency reserves still exceed $14 trillion. Their potential deployment for economic stimulus remains intact. Sovereign wealth funds, mostly invested in equity proxies, provide additional support for equity markets. Central Banks are squeezing private investors as they desperately acquire dominant portions of the most liquid segments of risk-free(?) sovereign debt, corporate debt in Europe, and ETF’s and equities in Asia. As a result, P/E ratios are elevated and yields bear little relationship to economic fundamentals. As the political outlook befuddles the experts and aggravates voters, portfolio managers, facing new accountability regulations and third-quarter restrictions on Money Market Funds, need to become even more tactical in their asset allocation until clarity on Trump/Clinton, Brexit, etc. emerges later this year. Until then, counter-trading the price action makes the most sense. Even the hedge funds and private equity managers are struggling to perform in this turbulence as previous experience appears to provide useful insights. The erratic price action reminds me of the late 1970’s when thirty years of fixed rates were followed by the oil price shocks that ushered in the Volcker era. Desperate pension funds and insurance companies might applaud such a development now as their yield assumptions fall 100’s of basis points short of any hope of meeting their forward liabilities. In a market where the Yen and Euro rally despite explicit efforts to devalue them, one might surmise that their appreciation is only driven by the final unwinding of the massive Yen-carry trade by hedge funds facing redemptions after disappointing performance.
Amid all the chaos, do not expect central banks to abandon their printing presses. Syrian immigration issues in Europe and Trumpian nationalism will retard global trade and risk a replay of more intense competitive devaluation. When we do reach the point of exhaustion for monetary stimulus, central banks have NO exit strategy. Bond markets will break down abruptly, but until then, US Treasuries should out-perform all other sovereigns. 10 year notes may well flirt with 1% as NIRP experimentation continues. Debates about the number of Fed “tightening” moves are irrelevant. The outlook, going forward, is all about liquidity management. Although gold has rallied sharply so far this year, I suggest owning some gold, although one should heed the cautious brilliance of Stan Druckenmiller in conceivably buying a more significant percentage.
In this climate, equity markets offer the most promising net returns, IF one is willing to trade them actively. “Buy and Hold” is a death wish. For over ten years, opportunistic equity traders have encountered volatile, but profitable equity markets. As we sit close to record high prices and valuations, why now? Amid illiquid markets, individual equities experience incredible price volatility despite the tame VIX market. The table below details the price ranges of the Dow Jones Industrials over the previous 52 weeks. If a money manager budgets an annual return of 7-8%, as many pension funds do, then opportunistic trading of these large-cap, blue chips makes achievement of those returns possible. Incremental usage of options and dividends sweeten the results. But, you must trade these ranges, or, only buy weakness. I know this runs counter to indexing and most notions of prudent investment, but look at the table and draw your own conclusions. Incidentally, these ranges are not atypical, even in years where the averages experience only modest annual changes.
|Stock||52 wk low||52 wk high||52 wk range||% change|
Source: Yahoo Finance
These data observations, while hardly profound, illustrate the range of possibility for trading profit, even in the largest stocks. Notice that the average price range of individual equities is more than twice the range of the large-cap averages, as reflected in their ETF’s. If you need to earn 8% per annum and the average Dow Industrial offers a 43% annual trading range, you don’t need to channel Jesse Livermore to achieve your objective. These results do not include dividends or option writing benefits.
This series of macro letters is entitled “In the Long Run” so you may, quite reasonably assume that I have “sold out”. I have not, but Allan, highlights the essence of the dilemma facing long-term investors looking ahead. During the past eight years interest rates have fallen in several countries to the lowest levels since records began. Being long government bonds below ones own rate of inflation (and there are few people whose living costs genuinely rise as slowly at RPI, HICP etc.) is irrational, since your real return will be negative – switching to “risker” assets makes sense.
With the Fed expected to tighten, if not this month then very soon, and other central banks contemplating how they may unwind the QE experiment, it seems likely that government yields may rise, credit spreads widen and equities decline. As Mark Twain once proclaimed, “History doesn’t repeat but it rhymes” the aforementioned scenario occurred in January and February – this spooked central bankers who promptly enacted the secret “Shanghai Accord”. The next round of “risk off” will be different.
Strategies not Asset Classes
It is well documented that the average “long only” portfolio manager underperforms the benchmark over time. Unconstrained investing, either of a “long only” absolute return type or “long/short” makes sense, but make sure your expectations are realistic. Assets such as commodities have a structurally negative real-return, even if they can perform strongly on a cyclical basis. Even “risk free” government bonds can suffer restructuring or be subject to default.
Alternative investments may provide a solution but many liquid alternative strategies (by which I mean Hedge Funds) are highly correlated to equity or fixed income indices, although they offer similar returns with substantially lower volatility. Others, are either negatively or non-correlated. For example, the discipline of the short biased manager is undervalued, given that they actively bet against the long term trend of the stock market. As an addition to a portfolio they can offer a form of active risk management. At the end of April the Barclay Hedge – Equity Short Bias Index was +3.37% YTD whilst the Equity Long Biased Index was still languishing at -1.85%; that is 1.52% of Alpha if the general market is your index.
Two other strategies worth maintaining an exposure to are Global Macro and Managed Futures. Global Macro incorporates the widest array of approaches and exposures – at the index level it is unsurprising that it rarely does well, choose carefully and keep the faith. Managed futures is also diverse but there is still a concentration on systematic momentum and trend following strategies which provide negative correlation during equity bear markets and non-correlation during other periods. It also has the advantage that you can, usually, discover the investment process prior to investment. If style drift should subsequently occur this is your signal to redeem; otherwise you should not need to intervene. It can be a remarkably light touch investment.
I could describe a number of other strategies which have merit in the current market conditions but in the interests of brevity I will close with a recent assessment of the three main risks to financial markets according to Gavekal’s Anatoly Kelestsky:-
- The June 23 “Brexit” vote in the UK
- US elections on November 7th
- German elections in mid-2017
Allan Rogers sees this as a traders market whilst ex-Dallas Fed President – Richard Fisher, speaking at the Mauldin SIC event last month, described his portfolio positioning as “Fetal”. Perhaps this year, more than most, the old adage “Sell in May and go away, return again St Leger’s day” (2nd October) may be apposite.