05 Jun 2018
After a hiatus in 2017, volatility appears to be back. Are recent tremors in markets a catalyst for change or yet another false positive? Looking at a range of stress indicators, James Clunie, Head of Strategy, Absolute Return, believes regime change could be afoot.
Many investors in our strategy will know that “robust to change” is a maxim for our approach. Nevertheless, while the strategy has tended to perform well during periods of turbulence, the past year of gently rising stock markets has been painful. Change hasn’t been forthcoming.
If you are invested in our strategy, we appreciate your patience. Many of you recognise the fragilities in equity markets and understand the reasons why we are leaning gently, rather than aggressively, against these. Global equity prices are high by historical standards. Value versus growth is stretched. We know from history that when you pay up you usually get lower long-term returns. And after a sustained period of value underperforming growth, the future returns for value are usually superior. These are the long-term results. No one knows the potential extremes of these anomalies. There are no crystal balls when it comes to investing. Yet, following the recent spike in volatility, it is right for investors to ask: “Are we there yet?”
The short answer is that the recent uptick in volatility is not a reliable indicator of change on its own. To give us real confidence that conditions are evolving, we need to see evidence of stress across several indicators. Looking at our dashboard of indicators of potential stress in markets, something unusual does appear to be happening.
Bitcoin has been the ‘fantastic’ object of this market cycle. If you asked what was hot, exciting and new in markets over the past two years, the answer is Bitcoin. The crypto currency surged by some 1800% last year, before hitting the wall in late December. It has since fallen over 50% from its peak.
While Bitcoin is not directly correlated to equity markets, its plight could be a bellwether for a wider change in sentiment. Quantitative fund manager John P Hussman suggests the “the collapse of major bubbles is often preceded by the collapse of smaller bubbles representing ‘fringe’ speculations”1. Fred Hickey, editor of The High-Tech Strategist, has made similar claims, saying fantastic objects tend to break first at the end of a cycle. I haven’t seen evidence to support either claim, but Bitcoin’s collapse a month before the late-January sell-off in stock markets might be emblematic of a wider change in perceptions of risk.
Source: Bloomberg; Bitcoin in US dollars; 02.01.2017 to 21.03.2018.
We have since seen the collapse of other fringe bubbles: the short-volatility exchange-traded funds that went under in February, for example. More recently, the FAANG stocks have come under pressure.
Overcrowding and price surges in “glamour” stocks are quite common near the end of a bull market, typically signifying late-cycle exuberance. The delightfully named “FAANGs” – Facebook, Amazon, Apple, Netflix and Google – are the poster stocks of the current cycle and are potentially in a bubble. In 1999, Microsoft, Cisco, Oracle and Amazon were similarly loved. In the early 1970s, a group of blue-chip stocks labelled “the nifty fifty” were seemingly invincible; that is, until the 1973-74 stock market crash.
The popularity of exchange-traded funds (ETFs) has intensified the risks associated with the FAANGs. In 2017 alone, an estimated $50 billion was invested in S&P500 Index-related ETFs. The index weighting of these stocks grew from 9% to 11% at the same time2. The launch of dedicated technology and media ETFs with roughly a third of their assets invested in FAANGs is even more worrying. The FAANG stocks certainly have a bubble-like quality and looked invincible last year. While sentiment towards these stocks has started to turn in recent days, it is too soon to know whether this will be sustained. Nevertheless, it does appear that some investors in these shares are becoming more risk aware.
Global liquidity patterns can be a lead indicator of the stock market and data from CrossBorder Capital shows that developed market liquidity flows, especially in the US, are weak. This is due to a combination of factors like increased risk appetite and tighter central bank policies. According to CrossBorder, the large capital reversal from US assets might be a warning of heightened “bear market risk from Q2”3.
Source: CrossBorder Capital March 2018
The Hong Kong dollar is held in a tight trading band against the US dollar by the Hong Kong Monetary Authority. The currency has been weakening against the dollar and is now at the upper end of the permitted HK$7.75 to HK$7.85 trading band. Historically, moves to the extremes in this band have coincided with turbulence in equity markets. As the chart shows, the HKD tested the upper end of this band during the credit crisis, the darkest days of the crisis in Greece, and the pullback in markets early in 2016.
Source: Bloomberg; HKD/USD spot rate; 03.01.2005 to 21.03.2018
We are monitoring IPO, high yield bond and squeeze ETFs, which provide insights into market sentiment and signs of exuberance. Typically, stocks tend to underperform for years after they are listed, so I would expect an IPO ETF to do the same. The Active Alts Contrarian or “Squeeze” ETF, which holds a basket of highly shorted US stocks, should in theory drift lower due to informational advantages shortsellers tend to have. Junk bond ETFs can provide a good sign of credit stress, providing a gauge for corporate health and market risk appetite. None of these ETFs are signalling stress. The IPO and Squeeze ETFs have been quite strong, suggesting enthusiasm. The junk bond ETF has started to roll-over, but not in any meaningful way.
Turbulence indices reveal if there are any unusual co-ordinated movements between assets. Turbulence is often a forerunner of volatility and volatility is often a forerunner of lots of interesting movements in markets. Evidence suggests that periods of excessive turbulence often coincide with “excessive risk aversion, illiquidity and devaluation of risky assets”.4 State Street’s Turbulence Indices are currently at high levels.5 However, the data can be quite choppy – high one day, low the next – so is not always reliable. In summary, roughly half of our indicators are showing signs of stress, which suggest that something unusual is happening in markets. We must emphasise these are not tools for forecasting change and we tend to look at them in combination rather than individually. They are signals of potential stress in markets that we are using to help us try to divine our way through.
When it comes to the strategy, we have two options: pre-position in readiness for change or wait for change and follow it fast. We intend to do both.
Our portfolios are currently leaning against the prevailing tendency in market. The strategy is long value stocks and short growth, and long in the UK and short in the US (although not exclusively). We also have a selection of hedges against bad scenarios, including long positions in call options on the S&P500 Index to mitigate against a potential melt-up scenario. The gross equities exposure is relatively modest. The net equities position is close to zero and the strategy’s beta is negative as short positions tend to be riskier stocks than the longs. The strategy is diversified across a high number of long and short positions, and each of these is of relatively modest size. We are leaning, rather than pushing, against the current regime.
The more confident we are that the regime has changed, the more we will – stock-by-stock – look to increase position sizes. We will be particularly conscious of how individual stock news – a deterioration in balance sheet, for example – interacts with changes to the market regime. We can envisage the gross equities exposure getting to 150% under certain conditions, roughly double the risk currently in the strategy. This would mostly come from idiosyncratic stock selection and a continuation of the current style and country allocations, and would probably result in a negative net equity position.
Regime change is difficult to identify with absolute certainty. While conditions appear to be evolving, we plan to evolve with them rather than acting pre-emptively. This approach should help us avoid being caught out by false positives but gives us the flexibility to react quickly as the market signals grow in strength. Being sensitive to the prevailing regime has enabled us as specialist short-sellers to survive what was an amazing bull run in markets last year. As the regime changes, we would hope to expand on what we do and thrive in a change of market conditions.
Risks
The strategy uses derivatives, which may increase volatility; its performance is unlikely to track the performance of broader markets. Losses on short positions may be unlimited. Counterparty risk may cause losses.
1 https://www.hussmanfunds.com/comment/mc180302/
2 http://www.mauldineconomics.com/editorial/4-reasons-you-should-run-awayfrom-spy-ivv-voo-and-other-sp-500-etfs
3 CrossBorderCapital, Global Liquidity report, March 2018, pg.3
4 Mark Kritzman CFA and Yuanzhen Li, “Skulls, Financial Turbulence and Risk Management”, Financial Analysts Journal Volume 66, Number 5, 2010
5 Source: http://newsroom.statestreet.com/press-release/state-street-global-markets/state-street-launches-turbulence-indices-assist-institution
Important information:
This document is intended for investment professionals and is not for the use or benefit of other persons, including retail investors. This document is for informational purposes only and is not investment advice. Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. Past performance is no indication of current or future performance. The views expressed are those of the fund manager at the time of writing (March 2018), are not necessarily those of Jupiter as a whole and may be subject to change. Every effort is made to ensure the accuracy of any information provided but no assurances or warranties are given. Jupiter Asset Management Limited is authorised and regulated by the Financial Conduct Authority and its registered address is The Zig Zag Building, 70 Victoria Street, London, SW1E 6SQ, United Kingdom. No part of this commentary may be reproduced in any manner without the prior permission of Jupiter Asset Management Limited.
