Livewire Summer School: To dance, or not to dance?

Dominic McCormick

Investment Consultant

It's that time of year when investment professionals forecast the year ahead. But how useful are these? As one commentator put it; "strategists are forecasting a gain of around 7% for the S&P 500 in 2018. That's about how much they thought the S&P would rally in 2017. And 2016. And pretty much every other year." 

As the saying goes “forecasting is difficult, especially about the future”.  However, sometimes considering how to position portfolios is better based on an understanding of what has driven the recent past, especially if that period is unusual in financial market history. 

Now is one of these times. Crucially, there is the dilemma of the unusually low US (and global) market volatility of recent years and especially over 2017. The year had shown the lowest daily loss in the entire history of the S&P 500 index with 12 months of positive returns and not even a 3% correction for more than a year. This low volatility levitation of the market stands out against a century of financial market behaviour. The 'buy the dip' strategy has become so entrenched that there aren't any more dips to buy. 

Discern the major reasons for this abnormal market behaviour and I believe you have gone a long way towards determining how investment portfolios should be positioned in 2018 and beyond. Specifically, should you approach 2018 heavily invested in growth assets on the basis that low volatility is properly reflecting low economic/fundamental risk (especially given the low return on defensive assets)? Or is now a time when true underlying risk is significantly understated and it’s time to batten down the hatches?

At the risk of simplifying the picture I think there are two broad explanations (or paradigms) around this low volatility anomaly that lead to quite different conclusions about appropriate portfolio construction. 

1. The economic/earnings stability paradigm.

This paradigm relies partly on the view that markets are recognizing that stock prices historically have been too volatile given longer term underlying fundamentals. In particular, as economies have become increasingly dominated by services and economic growth less volatile.

In the shorter term there is the narrative around modest but increasingly synchronized world growth, with fewer countries in recession than at any time in recent history. This paradigm is also supported by an ongoing period of near record low interest rates and low inflation which many believes justifies high valuations given the lack of investment alternatives.

Related to this, central banks are seen to have done a good job managing economies and stand ready to step in if markets or economies falter, therefore limiting downside risk. (The 'central bank put'). 

2. The 'new' market structure paradigm

This paradigm suggests that recent low volatility is primarily because of a dramatic change in the mix of investment participants and strategies driving financial markets in recent years. In particular, that the US sharemarket has become heavily populated by non-fundamental participants with decisions increasingly driven by price trends and volatility rather than an assessment of value or growth characteristics of companies, sectors and the market overall. In this category of value-insensitive participants I would include many of the passive ETF flows/ROBO advice, Risk Parity, many corporate share buybacks, certain central bank buying of stocks, trend following CTA’s, volatility selling (directly and via packaged products) plus algorithm and AI trading learned from recent behaviour (such as 'buy the dip').

All of these elements are heavily responsive to price or volatility signals or other non-fundamental drivers and were much smaller, or even non-existent, in previous cycles and prior to major downturns such as 2007/8 and 2000/2. Collectively today these elements have become dominant drivers of daily trading. Meanwhile, active management that emphasizes fundamentals is rapidly losing market share as shown by outflows from active mutual funds. 

In what becomes a self-reinforcing positive feedback loop these market participants make investment decisions heavily based on price and volatility behaviour that their prior decisions helped to create and accentuate.  The risk at some point is that these positive feedback loops reverse and feed on themselves in a vicious downside cycle. 

Efficient or Fragile markets? 

Both of these paradigms recognise that valuations of equities, especially in the US, have become very expensive compared to history. The trailing GAAP PE of the S&P 500 Index is close to 26 compared to a long term median around 15. The Shiller PE at 32.5 is currently more than double its long term median of just over 16. On some measures, such as price to sales, valuations have never been higher. 

However, under the first paradigm these high valuations are seen as largely justified and rational. The market is efficiently assessing lowered market and economic risks.  It is true that even this paradigm suggests future long term returns will be low but these reflect the lower risks of the environment and lack of competition from interest rates. Under this paradigm valuations can therefore be expected to stay high. This view has arguably become the market consensus.

A recent Livewire piece by James Bloom of Kapstream perhaps summarises aspects of this view.

“Volatility in markets tells us that the smartest and richest financial professionals judge risk in financial markets to be at record lows, reflecting full and extraordinary confidence that should there be any hiccup with the financial market prices the central bankers will swiftly pull out their Bernanke capes and buy assets until stability returns." 

i.e. markets are largely getting it right, as the efficient market view of the world would suggest.

On the other hand, the second 'market structure' paradigm suggests high valuations are not sustainable and markets have developed an inherent instability that will be revealed at some point in the short to medium term.

While it is rational at the micro level for participants to embrace strategies that reinforce price and volatility trends, such strategies are combining to create a deeply inefficient and ultimately fragile market. In simple terms, it's a bubble, and arguably one of the more dangerous in history.

The positive feedback loops recently elevating markets and keeping volatility low could reverse at any point and create a self-reinforcing downside move with escalating volatility. As trends reverse and volatility spikes most of the strategies/participants mentioned above could become price insensitive sellers or at least hold off further buying.  Remember a number of those participants utilize leverage. 

Perhaps 'buy the dip' traders and some volatility sellers would still be active but would they continue to be if the correction lasts longer, or is beyond the (small) size of recent experience?  Would some such trades, particularly systematic ones, be 'turned off' at some point? Meanwhile, given current very high valuations, true fundamental based investors would likely require significantly lower prices to become aggressive buyers.  

Of course we know that valuation alone is a poor near-term guide to market movements. Further, a characteristic of bubbles, especially self-reinforcing ones, is that the top is unpredictable and they tend to go on for longer than most expect. While many desperately look for a 'catalyst' for the unwind of a bubble, the nature of an unstable, self-reinforcing market means that it can come from almost anywhere, or even nowhere.  

For example, currently the US sharemarket seems to behave as if it cannot tolerate a simple 3-5% drawdown because such a correction could actually be the potential catalyst that feeds on itself and turns the market downdraft into something much worse. Historically 3-5% corrections have hardly needed any catalyst.

The path of the next downturn 

Not only does your view on the appropriate volatility paradigm affect how much you should be concerned about a potential downturn, but it also informs the likely duration and path of that downturn.

Under the stability paradigm, market downturns can still occur but would be seen as lower probability, especially near term, likely to be more modest in size and likely extended over time when they do occur. 

However, under the second market structure paradigm the probability of a downturn is high, even in the near term, and also there is a reasonable risk of a rapid, large, discontinuous move (even a market crash). 

This difference has significant implications for which investment signals and strategies will work in more difficult periods and how one should position portfolios going forward. 

For example, it seems many investors are waiting for signals of a significant economic slowdown or higher inflation before lightening equity exposure aggressively. Under the first paradigm this approach may make sense. However, under the second paradigm you can have a dramatic market drawdown suddenly without any warning of, or concurrent, economic deterioration. Think of the dynamics of the 1987 crash.  

The view also affects what strategies would work well as hedges in that downturn. For example managed futures should work well in a 'normal' downturn or bear market. However, in the second paradigm with the risk of sharp reversals and market discontinuities it is quite possible that managed futures could do poorly. I see many portfolios where managed futures is the core, and sometimes only, component of the alternatives 'bucket' being relied upon to do well in more difficult markets.

The position on the volatility paradigm also impacts the view on the active versus passive debate. Under the first paradigm index investing makes a lot of sense. Under the second paradigm it is likely that some of the greatest overvaluation and vulnerability to large drawdowns is represented in the large and popular indices that are most utilized by passive and trend following/momentum investors. Passive investing may be far from low risk under this paradigm.

Developing a view 

Of course the discussion above has simplified things significantly as markets could have elements of both the paradigms presented above. However, I believe it makes sense for investors to attempt to clarify at which end of the spectrum they sit.

There is certainly some truth to the arguments of the first paradigm.  Economic volatility has trended lower, a reasonable case can be made that inflation and interest rates can remain lower for longer and central banks certainly stand ready to support economies and markets even if participants are overconfident in their ability to do so. 

However, perhaps one shouldn’t get too complacent about the current benign US and global economy because it too may be partially supported by the current market structure and high valuations rather than being simply a reflection of it. Individuals’ current wealth and spending (and therefore the economy) is benefiting but this may be masking and/or delaying deeper vulnerabilities and risks.

I would feel more inclined to favour the first paradigm if there were no other reasonable explanations. However, the dramatic changes in market structure and participants of the second paradigm provide a reasonable explanation of a destabilising view of markets that doesn't require markets to be efficiently reflecting risk. Of course, accurately quantifying that explanation is difficult. 

Some well-known investors and commentators are certainly worried. David Swensen, Yale Endowment CIO, was recently reported in Bloomberg saying "the lack of volatility in the current geopolitical environment is a major concern and warned that another crash is possible." Paul Keating recently argued that markets are vulnerable to a correction no one is prepared for and "you can't quite understand the fact that markets are so relaxed and comfortable in the conditions we are in".

Of course even embracing the second paradigm doesn't give you any guidance on timing but it does suggest many investors should take some risk off the table now because there may be little or no warning and the downturn when it comes could be rapid and deep. 

For investors early in their investing life (and effectively dollar cost averaging from a small base) perhaps not much needs to be done. But for those further down the track with larger portfolios and especially those drawing on capital to live on, now may not be the time to be overly embracing market risks.   

Even if you believe primarily in the first paradigm you should consider the second paradigm as one scenario in stress testing portfolios to temper how much risk you take.

In building diversified portfolios investors have the advantage of never having to take the decision to be 'all in' or 'all out'.  Fortunately it’s not as black and white as 'to dance or not'.

Bitcoin – microcosm of a broader bubble?

Does the current cryptocurrency boom have anything to do with this discussion or is it still too small to be a significant factor in global finance?

Cryptocurrencies certainly have the volatility that sharemarkets currently lack, although in the last year they have also shared markets’ tendency to recover any losses extremely quickly. Cryptocurrencies have learned the Pavlovian 'buy the dip' trend following behaviour that’s dominating markets generally.

Further, while Yellen is right that relatively few are participating in the cryptocurrency boom/bubble, I suspect its publicity is whetting the appetite for investors to take on greater risk elsewhere in their portfolios as they see risk taking being so handsomely rewarded, for now at least. 

Indeed, one could argue Bitcoin is a 'turbo charged' version of the broader global risk asset bubble, driven to unsustainable levels by self-reinforcing feedback loops and years of extreme monetary policy. Could Bitcoin have taken off in a world of more normal monetary policy and interest rates? 

If the global 'everything' bubble unwinds, cryptocurrencies may well be amongst the worst performers, disappointing many supporters who see them as a low-correlated, if extremely volatile, diversifying asset. 


Rosy forecasts of strategists, economists and central banks as we look forward to 2018 provide false comfort when we consider their poor track record of predicting turning points in markets or the economy. Many don't realise that markets typically reach major peaks, and have maximum risk, when the economy has been doing well for some time, consumers are happy and investors are complacent and 'all in.'

As usual, the focus is on producing narratives that justify current valuations and project recent trends forward. Of course, this too is rational from a business perspective although it means the industry generally does a poor job of protecting investors at those times when risks are truly elevated and markets particularly vulnerable.

So instead of relying on forecasts, which are often driven by marketing, to predict the short-term future, perhaps it's better to stop and focus most effort on simply explaining the recent behaviour.

You may still come to incomplete or wrong conclusions regarding the market drivers or the longevity of those drivers.  However, I think you will at least have a better sense of how markets play out compared to those who are just punting on what economic or earnings growth will be over the next year or picking a year end index number reflecting a 'normal' upside move.  You will also be in a better position to react as things change by focusing on the elements actually driving markets now rather than speculating on what theory or convention suggests may drive them in the future. 

Arguably, now is a time for deep thinking about the risks and challenges of portfolio construction. Instead, strong returns have ignited a placid complacency even amongst financial professionals whose main job is to manage those risks. Many seem to see the last year’s strange positive market behaviour as simply a bonus to celebrate rather than a riddle to explain.

The challenge for many is that a strong case can be made for both paradigms in the current environment, but this often means many come to no view at all. As one prominent equity manager commented when I suggested that even their normally cautious CIO had become bullish; "We are not bullish - we are just fully invested bears".

If the second paradigm is closer to the truth, savvy investors should become more concerned as the bubble develops, not less. But I currently see the opposite of this. Like the slowly boiled frog or the happy daily-fed turkey in the lead up to Christmas, the good recent experiences are implicitly or explicitly projected forward as we get more comfortable, as long as earlier fears are not confirmed.  

Cautious voices are increasingly ignored and seen as irrelevant. However, I suppose they are irrelevant because even if these cautious views prove correct, few are acting on them and by the time they do it will probably be too late. But that has long been the nature of markets. 

As John Hussmann says; “The problem with bubbles is they force one to decide whether to look like an idiot before the peak or an idiot after the peak.”

Clearly, it is tempting to simply go with the flow and rely on the first paradigm and/or bullish narratives to justify staying fully invested. Indeed, doing anything different is made difficult because hedging portfolios currently is not easy - cash rates and the returns on most defensive assets are too low and the ongoing cost of protection has been a big drag on some portfolios.  Some hedges that worked well in previous crises – such as bonds, managed futures, even foreign currency exposure (let alone new 'diversifiers' like cryptocurrencies) are far from guaranteed to do well in the next crisis. Still, some neglected areas, such as gold exposure, may well deliver in a difficult environment, partly because it has lagged in the bull market and offers one of the few contrarian opportunities around.     

Meanwhile, as concerned professional investors grapple with these issues, many amateur investors holding a mix of passive ETFs consider themselves investment geniuses.

This is not about predicting the next crisis. It's about positioning such that one can survive and ultimately prosper when the probability and potential damage of such a crisis is high. If you believe the second paradigm is the main explanation for the low volatility levitation of markets then that probability is currently high.  

As David Swensen also said; "The defining moments for portfolio management" come in those crisis years "and if you ignore that you're not going to be able to manage your portfolio." 2018 will be an interesting ride. 

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Dominic   McCormick
Investment Consultant
Investment Consultant

Dominic has been involved in investment markets and financial services for more than three decades. He currently consults to a range of organisations in in the areas of investment research, investment strategy and listed funds.

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