which asset managers and risk managers the world over must also come to terms. Volatility of asset returns is going up because the world is a more risky place than it used to be and because the traders and risk managers the world over are making similar decisions based on similar global macro trade-offs and outcomes. We are living in an era where there are significant positive feedback loops to the volatility of returns. My economic outlook is that we are in a bear market that is likely to continue for the foreseeable future. As a result, in order to mitigate volatility and increase returns managers will have to select more market neutral strategies, or stay in cash and attempt to time the market. Traditional buy and hold strategies run the risk of inducing
panic selling from clients when things turn bad. In other words, we are witnessing a convergence of trading strategies where portfolio managers must act like risk managers who must act like hedge fund managers . There will be little “free money” in terms of predictable returns on the table and a portfolio manager’s value added (alpha) will become readily apparent to the client. Traditional buy and hold strategies in this environment are going to underperform relative to market neutral strategies.
Portfolio managers are now living in a new world of performance. The interrelated drivers of asset returns in the nineties: falling interest rates, strong global growth, and increasing leverage are all set to become impediments to assets returns for the foreseeable future. What’s more asset returns between equities bonds and commodities have also increased in downside correlation. The western world is saddled with debt, high unemployment and a lack of demand as a legacy of the excesses of the last two decades. As a result, corporate earnings are going to struggle to grow for the next decade.
A glance at the performance of global indices on Friday, September 9th, reveals this more recent trend in global equity returns. When the market experiences a sharp selloff return correlations seem to approach unity. The global market is now integrated and as a result the imbalances in the global market are now integrated. This means one regions problems are now the world problems.
We are living at a time where almost every major economy is pursuing loose monetary policy and fiscal austerity. The implication of this is that economic agents are facing the same trade off everywhere and making similar risk management decisions based on using the same data and running the same statistical models. For those who place their faith in time series models: CAVEAT EMPTOR - THIS HISTORICAL DATA SET WAS NOT FORMED UNDER THESE MACROECONOMIC CONDITIONS. While I can't support this position empircally, and address it only anecdotely below, it is my assertion that the data generating process of the past varies substantially with the current process
Even though one could argure that I take liberties with my conclusions, the delinkage between current data generation and historical series should be obvious to anyone with a minimum background in statistical and economic analysis. Answer these questions - what is the appropriate reference point for data generation in today's economic climate? What other time was like just this? Is today's recovery indicative of past recessions?
As a result, the traditional processes for diversification and risk management based on historical correlations are of questionable value. They are very likely to provide less downside risk mitigation than historical data would suggest. Since many of the largest global economic agents are on the same side of trades, when these positions reverse we are likely to see shaper sell offs, that is, the volatility of individual and portfolio asset returns are likely to dramatically increase in the future. Given the degree of global adjustments required to restore imbalances and put the global economy on a sustainable trajectory, this trend is likely to continue for the foreseeable future. While every moment in time is unique in some way, the current economic situation is very much different from almost any other period in modern history.
How blind are we flying? It is impossible to know since we are in undiscoverd territory. More than ever, what matters now is judgement rather than statistical expertise. I present two examples to support my case that we are living in a a world where thinking is required now more than ever and statistical models of forecasting relationships are out of tune with the current nature of stochastic behaviour. The deep revisions to economic growth estimates and the behaviour of the VIX over the last couple of years.
After 15 years of economic prosperity, what has come to be called the Great Moderation, financial excesses predictably
developed into a credit bubble of such magnitude that it threatened the solvency of US and European financial system. Recovery is going to require an extended period of deleveraging that will be a drag on economic growth for years to come. But it seems the more things change the more they stay the same. The denial of last decade’s burgeoning credit bubble has been replaced by a denial of the realities of western economies’ resultant health and the policies that are required for recovery. The credit markets froze up in 2008; the financial system flat lined and required open heart resuscitation. And yet it appears that most of the mainstream economists and policy makers are treating 2008 like a run of the mill case of the flu or recession. This over optimism is evidenced by the tsunami of market forecasters cutting their growth forecasts.
It seems the world began mispricing risk soon after the financial collapse of 2008.. In December of 2009, the VIX, the near month volatility index of the S&P 500, was trading at sub 20. From my perspective this was far too low. I entered into a series of exchanges with a hedge fund manager, who was agnostic at the time. I started to wonder if the FED, with its monetary policies, was creating systematic risk in the economy. Earlier this year, the hedge fund manager sent me a blog link discussing this very issue. I quote from the link which itself quotes from an Artemis Capital Management, a volatility-focused investment management firm:
“The artificially low volatility in markets may contribute to a dangerous build up in systemic risk. Many investment banks and hedge funds use volatility as an input to determine leverage capacity. When the Fed artificially depresses spot
volatility it produces a feedback loop whereby large banks can increase their appetite for risk, increasing assets prices, and further lowering volatility. It should be no surprise that NYSE margin debt is at its highest level since July of 2008”
Artemis explained the phenomenon the following way.
1) Changes in the supply/demand dynamics of volatility:
Recent structural changes in the supply demand dynamics of volatility may be contributing to the distortions reflected in today’s vol surface.
First, a liquidity shortage on the long-end of the OTC volatility surface emerged as sophisticated players covered short positions following substantial losses on volatility derivatives in May (less supply).
A preference for longer-dated volatility hedging is emerging and also changing the demand picture:
Secondly, there has been a recent proliferation of new“tail risk” or “black swan” hedging strategies that have increased the demand for long-dated volatility and far out-of-the-money options (more demand).
3) Gamma selling is rife:
Thirdly , as margin debt has expanded many funds are now shorting spot volatility and buying long-vol to collect pennies from underneath the proverbial steamroller (short-term supply, long-term demand).
So what are the implications for investors? These are not good times for buy and hold strategies. The underlying drivers of growth in the stock market: economic growth, leverage and interest rates -are either neutral or contrary. The market is likely to be range bound.
A range-bound market is ideal for setting an asset allocation and picking up the benefits of rebalancing. Someone who is *really* committed to an allocation may also sell out-of-the-money covered puts and covered calls (looking to get paid for accepting the constraints of algorithmic rebalancing); current levels of implied volatility may make this seem more attractive.
I like David Rosenberg’s view of how to play the current situation a summary of which was posted on the excellent website, Zerohedge. I include it below.
Hedge funds that really hedge the risk or relative-value strategies that can go short low-quality and high-cyclical equities while going long a basket of high- quality and low-cyclical equities will be a money-maker in this environment. Those that have the capacity to short economically-sensitive stocks that trade at cycle-high P/E multiples may have an advantage in such a weakening macro and market environment.
A focus on hybrids or income-equity portfolios that have low correlations with the direction of the equity market and generate a yield far superior than what you can garner in the Treasury market makes perfect sense.
And if there is anything out there that is remotely close to "recession proof" it is corporate balance sheets and so an emphasis on credit is going to be critical — the idea is to be selective and identify those entities that have a single-A balance sheet but pay out a BBB yield.
We are believers that gold and gold mining stocks will prove to be profitable investments as the economic downturn inevitably prompts more money printing, not just out of the Fed, but other major central banks as well.
Commodities in general, energy and raw food in particular, should be a core position, as they are behaving less cyclically and more as a secular growth theme linked to the rapidly rising incomes in the emerging market economies.
The economy and risk assets typically hit a speed bump in a recession. That much is true, but investment ideas and opportunities within the market can still flourish even in a bear phase or a correction — cash should not have to be an
The key is to be positioned appropriately for the part of the business cycle we are on the cusp of entering. In a nutshell, what that means is carefully- constructed investment strategies and portfolios that preserve capital, minimize cyclical exposures, enhance yield and thereby provide for significant risk- adjusted returns—even in a recession. In light of these heightened volatile
times, we also realize that this is not necessarily a buy and hold market, and the ability to move into equity markets and take advantage of weakness should also be a part of the strategy.
Where I diverge from David’s view is that I would probably be more willing to go into cash if I thought valuations were too out of whack. For instance, the market, as I alluded to in my discussion on the VIX, was mispricing short term risk. When I think valuations are too high and market risk pricing is too low then I believe I would move into cash. Let me underscore, once more, the importance of relative valuations and market risk as essential to investing over the next decade.
I am also more biased towards business tech stocks that improve productivity because I think businesses, ripe with cash, are going to be investing in more capital to lower their labour costs over the next decade.
I would echo David’s emphasize on the importance of long/short strategies and add that derivative strategies need to play a role in investment returns. Portfolio management and hedge fund management are converging.
We have more risk because the world economic prospects have worsened. We have more risks because major economies are facing similar challenges and responding in similar ways. Incentives facing agents are simillar all over the world. With everyone acting the same way and being in the same situation it is difficult to imagine that cost effective insurance is available, that the benefits of diverisifcation will reach historical levels or that statistical analysis will provide the key to naviagting the current investment climate. Our old maps are of limited value.
Like Alice (in Wonderland) we find ourselves in a strange new land.
“Which road do I take?" (Alice)
"Where do you want to go?"(cat)
"I don't know," Alice answered.
"Then, said the cat, it doesn't matter.”
Unfortunately for portfolio manangers, risk managers and hedge funds - everything counts in large amounts.