In over twenty years of professional involvement in financial markets, as a stockbroker, investment manager and market strategist (during which time I can show happily that active management can consistently beat markets…just in case John Authers reads this) I have seen just about everything…..and yet..and yet…while volatility is unnaturally low and central banks keep “supporting” asset prices I am more concerned about markets than ever before. And I will be blunt. If you are anything less than very perturbed by events unfolding you really should think about keeping some of your assets under the bed…..I jest not …..not even lightly.
In this environment an investor, whatever their strategy, needs to be extremely cognisant of risk and hence I relay the crux of a conversation I had with a chap from very large and very successful Macro Hedge Fund. Discussing their risk models he admitted they use a variety of measures, such as VaR (Value at Risk, a quantitative measure with a track record of not being very good at measuring actual risk) which they generally don’t pay much attention to (good!) but instead relied upon stress testing their portfolio to the worst possible outcomes.
This being a red rag to a Bear I pointed out that:
- Most major markets are valued between very expensive and absurd
- Record amounts of leverage are being applied on some exchanges….NYSE in particular
- Upward only High Frequency Traders (HFTs) are dominating US equity markets and their liquidity will vanish in a heartbeat in a sharp move down
- Dark Pool exchanges have been shutting down every time the main markets move lower with any pace (indicating these institutional trading clouds are likely upward only positioned)
- Liquidity providing market makers/specialists are out of most exchanges, so markets have become “Order Driven” rather than “Quote Driven”, meaning nobody is obliged to buy a falling asset to support prices
- Fixed interest market inventories are very low, meaning very little liquidity and hence the risk of big price moves
- As a result the chance of unexpected events gaping markets down 20%, shutting them down before they reopen and gap down another 20% as all the leverage tries to get out, before they shut down again….and rinse and repeat……then the worst case could be many markets are 60-70% down in a week regardless of what fundamental valuations result
He smiled and said “Yes”……………………I thought “Oh bu&&£~”
This is not hyperbole. Sadly more and more serious investors, particularly those that are not obliged to be fully invested in assets, are taking a similar view and there is a palpable sense of gloom amongst those I respect the most. Unfortunately the timing and nature of any reversal is uncertain and markets may remain positive for a while, however it would be remiss not to examine some core issues.
After the initial rebound from 2009 lows market valuations looked reasonably sensible for a while, although you could argue for several years many equities have been valuing an economic recovery far stronger and more balanced than any we have seen to date. However with UK and EU corporate earnings going nowhere for years and US ones so manipulated as to be often meaningless then the recent moves up make no sense at all unless you have thrown in the towel for all semblance of value investing (which in my view means investing; rather than speculating).
In timely fashion Citigroup have just released some research which effectively (and finally) comes to a similar conclusion:
“If there were any lingering doubt, this week’s gyrations demonstrate neatly that it is central bank liquidity, not fundamentals, driving markets………….Central Bank policy announcements are almost exclusively the driver of market movements at the moment, not fundamentals. Almost all fixed interest investors we meet bought into this idea sometime ago……In equities, there are still a few holdouts – but the longer that downward revisions to earnings are met with record highs the more widely accepted the idea becomes………………….At some point, of course, the risk is that the taps are turned off…..But with the underlying economy still weak, and vulnerable to a sharp sell-off in markets, we fear they will find that mangling, once started, is hard to stop. Particularly when they remain at least partly in denial as to the extent of it. “
They you go. Citi telling finally accepting the obvious, although their observation about equity investors myopia in the face of the obvious is deeply troubling. A quick look at the following chart, we highlighted last summer, shows there should be no doubt about the causal relationship that lies between equities and QE (represented by the Fed balance sheet):
Source St Louis Fed Click/Tap to enlarge
So if you are buying lots of shares and therefore aren’t investing, but simply speculating on central bank policies; policies that it is increasingly accepted don’t help the real economy much, if at all (and may in fact be actively deleterious to the real economy) then you wouldn’t want to get too over-leveraged would you?
Well apparently plenty are, with the latest version of the NYSE margin chart we’ve highlighted before getting properly scary (technical term):
Source: dshort Advisor Perspectives
The level of debt on the NYSE alone now equates to a quarter of all commercial loans in the US…..please take a moment to think about that.
Think about how much money could be lost if the market falls 10% overnight. Imagine lots of panicked investors selling to cover their margin calls, with those levered 10 to 1 possibly losing everything. This selling drives markets down more, scaring off potential buyers, who now are not obliged to make two way markets. Prices fall further and suddenly investors find themselves billions of dollars int he red, forcing further sales at any price….and so on.
Steen Jackobsen, the Chief Investment Officer at Saxo Bank has been warning of the liquidity trap, pointing out how the market has been steadily providing us with clues about the issue with the Treasury Flash Crash last October, the sharp fall in oil over a few weeks and then the massive snap in the Swiss Franc. Yet these isolated incidents, like tremors before a big earthquake have been pushed aside, ignored, explained away, resulting in volatility measures so low that I know of a Swiss bank that has been able to hedge the risk on an equity portfolio at such a tiny cost they have begun to deeply worry about the market that would allow them to do so.
Yet there is no place to hide. In 2000 as the Tech boom topped out you could buy old tech companies on PERs of 8 or 9, and make 30%-40% by the bottom of the Bear market (which was down 50%) three years later. In 07/08 you could earn 4-5% income carry in cash or gilts and in the latter make significant capital gains as markets tanked post-Lehman Bros.
Now? Almost all assets are either expensive, very expensive or ludicrously expensive unless a strong, sustainable economic recovery comes out of nowhere. A strong recovery oft talked about but very scarce on the ground and frankly most unlikely barring a change in the way mathematics works.
This would not be so bad but now even the IMF and the BIS (Bank of International Settlements, the Central Bankers Central Banker, or over recent years the Central Bankers conscience) are warning of the risk posed by markets and the asset management industry itself.
In my twenty plus years experience I have never witnessed such dangerous, distorted and fundamentally irrational markets. Never have I been so worried about a catastrophic, violent and economy changing crash that could overtake us in hours, yet may never occur, such is the, so far, all pervading nature of Central Bank monetary magic.
To be fair, for the long term investor there is the odd patch of potential value globally, where you can justify investing with an extended time horizon, accepting that if the worst happens you will still nurse loses for the short term. There are also portfolio hedging strategies available for those who can use them, enabling investors to remain largely invested as the run continues, but with much reduced risk (although then we get to edgy areas such as counter-party risk…but that’s for another post) but all investors should be aware that while things may look the stable for the moment it is probable that one day the world will likely change, and change radically, and we may not get much warning.