We Didn’t See This One Coming – Sort Of
The coronavirus has created a disruption to our lives, relationships, business, and financial markets. But, as we look beyond the immediate crisis, market trends and investment opportunities can be analyzed and calibrated to take advantage of unprecedented opportunities.
Since major disruptions and market discontinuities occur on a regular basis (every 7 to 10 years is regular enough for this definition), understanding that these opportunities will arise and to be clearheaded about how to best take advantage of them, invest in the long-term, and capture disproportionate returns should be the rule – not the exception. The world may seem riskier, but risk-adjusted returns are much more favorable.
As we look at financial markets and analyze investing in various securities, we have entered an era of “The Great Modulation,” (as described by Andrew Lo of MIT www.mit.edu) where financial markets will experience heightened and compressed volatility for many years to come. We have been experiencing this effect at an increasing rate over the last several years. Arcadia expects this to be the market’s status quo and the context within which all investors must make their investment decisions from now on.
Current conditions have compressed spikes in volatility, underlining the fact that volatility has always been present, but is typically mispriced. The VIX was priced at 14, then popped to over 70. Each level was mispriced, as we are seeing now. But this is the ever-present inefficiency of the markets. Volatility is with us, regardless of a coronavirus. The market simply found a reason to overreact. There will always be a reason to overreact, and it’s in these circumstances where opportunities can be found.
Related to this, diversification through stock selection, which used to be achieved by investing in various stocks within the S&P 500, is no longer possible. The S&P 500 moves too much in lockstep, and five stocks (Apple, Google, Amazon, Microsoft, and Facebook) comprise over 15% of the index. In order to diversify, an investment fund must invest across asset classes, including fixed income securities, distressed debt, and other asset classes.
Currently, outstanding opportunities exist in fixed income securities. Senior leveraged loans have been sold off to such an extreme amount, that reasonable credit funds (such as those issued by KKR, Oaktree, and Apollo) are yielding over 20%. These securities properly chosen and with appropriate leverage can enhance return substantially while reducing overall risk. The combination of a diversified portfolio of equities and fixed income securities can achieve a better risk/return trade-off.
It is Risky Out There
Risk is enhanced because of this heightened “Modulation,” requiring investors to be more thorough in their analysis in order to separate “the signal from the noise.” Current market conditions make it increasingly difficult to see through this volatility, and an investor’s patience and analysis will be thoroughly tested.
Compressed volatility will also require investors to be more creative – use derivatives and futures as investments and hedges across asset classes – in order to achieve heightened returns, and protect against risk.
This new investment environment is driven by a complex combination of multiple decision-making systems, of which efficient markets are only a component. Globally connected capital markets, technological changes, and emerging economies have up-ended the stability of global financial asset prices. Also, factors such as fear (translated into a disproportionate avoidance of loss or irrational greed for profits) and other human behavior, are now magnified, impacting market We will no longer be able to escape this volatility because of economies and markets’ global nature and technological connection.
We are about to enter the most volatile market we have experienced in over a generation. Long-term investors will probably see high positive returns, but within any multiyear period, there will be extreme fluctuations, described this earlier as “signal versus noise.” We are going to be increasingly impacted by “noise” (market modulation and volatility caused by a variety of effects, from investor fear to government interventions, central bank shenanigans, and assorted other mischiefs), and we should not let that impact our overall understanding of the true “signal” of any investment – its fundamentals.
Strategies can take advantage of the noise to enhance returns (such as short-term options and futures), but do not lose sight of value-based investing ideals – the true signal.
Market modulation will interrupt rational pricing. We are having a moment of extreme downward pricing pressure on assets that are perceived as riskier, and upward pressure on prices for safer assets. This can be easily represented by the pricing differential between government securities and lower investment grade fixed income securities. One security has rallied substantially, while spreads between government securities and high-yield debt have widened dramatically.
A normal allocation between risk and reward seems violated. Human behavior, which impacts all markets and valuations, is a complex combination of multiple decision-making systems, of which logical reasoning is only one among several variables. Investors are mostly rational but quickly descend into irrationality as a reflexive, adaptive response to heightened volatility. At these times, great investment opportunities are created.
Globally connected capital markets mean that, like the coronavirus that quickly spread from a local epidemic to a global pandemic, a potential local financial shock in China propagated quickly to up-end stability in global financial asset prices.
These macro factors will make diversifying risk, achieving the highest risk-adjusted return harder to achieve. Markets may one day return to being efficient, publishing accurate, objective, and timely analysis and prices, but I doubt it. The underlying risk is never really priced appropriately over the long term and it will be even will be harder to fully understand in the future.
An integrated global approach to understanding all relevant parameters of an investing environment is essential. An investor must look across multiple asset classes, investing in specific securities within the most attractive asset classes, to achieve the highest risk-adjusted returns.