Last week’s cover of Barron’s commemorating the October 1987 stock market crash probably provides some contrarian support to markets. Regardless, the levels of automation and current risk-control strategies do harken back to that earlier period when portfolio insurance was all the rage. Like then, many investors today think a bid for their holdings lies just below current prices, but when the crowd decides to sell at the same time, it creates a situation in which markets can’t clear without sizeable losses. The current low volume melt-up has not seen real selling in months, so that is a bit more of a risk than usual.
Most importantly, the incredible flows to passive investing and volatility shorting tactics are the ultimate contrarian signals, like Trump’s tweets about big stock gains. Once highly successful hedge fund managers are dropping like flies, choosing to return outside capital. Investors that hedge risk like us remain about as out of favor as we can ever recall and we take comfort in that. Nobody wants to buy insurance when times are good. It’s that simple.
The world is turned upside down as investors have decided to pay for the privilege of taking risk as opposed to being fairly compensated for it. Along those lines, prices for volatility-linked instruments that can be purchased to hedge portfolios reside at historically low levels as the crowd wants to sell them short in a big way. Betting that good times will continue for a while longer is now incredibly popular. Recent years have even brought Mom and Pop into the game with ETF’s that allow for placing bets on what used to be arcane derivatives reserved for professionals like the VIX.
Short positions in equity volatility contracts have reached gargantuan levels, presenting a major risk if complacency reverses even modestly as the scramble to cover becomes a tidal wave. That stampede is betting on sunny days continuing when we have been enjoying about the longest stretch of sunny days in market history based on the data. We have read that some funds are being established to bet on rising volatility given how current levels stick out like a sore thumb on the long-term charts. That could make things more interesting.
For now, it seems that the desire to be part of the crowd and greed are reaching the intensity of prior peaks. However, we have never found that playing along with the crowd involved as much risk as well as an irrational adherence to a consensus view which clearly ignores major obvious risks like a lack of true organic growth.
While the zaniness of 2000 and 2007 were similar, and were not around in 1929, the degree to which one must pretend that we are in a normal cyclical recovery is much more pronounced at present. Despite narratives to the contrary, GDP and earnings growth have been lackluster to negligible for years whereas in those prior cycles the underlying economy had more of a real pulse.
Recent industrial production and employment data fly completely in the face of those lofty soft-data surveys like the ISM, even adjusting for the effects of the hurricanes. Poor bricks-and-mortal retail activity all year, slowing bank lending, and rising losses in credit cards all point to slower growth. Auto sales are still being maintained only by heavy discounting and it looks like housing is becoming a question mark sector.
The median stock trades at twice normal valuations now and is richer than in earlier highly ebullient periods. It is the most expensive equity market ever by a long shot. The central banks are pulling back from ten years of emergency measures in a slow fashion, yet investors view this as unimportant for now, having chosen to latch on to the narrative du jour, be it tax cut promises or the notion that “it’s a bubble so just play along.”
As a group of guys once said, “sometimes your cards ain’t worth a dime, if you don’t lay‘em down.” Paper profits are just that and sooner or later a reasonable contingent of investors will head for the doors to realize gains, if only because they simply have had enough. The reality is that, by definition, not all will be able to cash out and losses will be borne by most.
Importantly, the current extreme flatness of the Treasury curve points to the fact that future growth prospects are much more limited than the Fed will discuss publicly. It also points to the likelihood that monetary tightening is further along than most pundits seem to believe. It all certainly makes Trump’s choice for Fed chair a significant source of uncertainty regarding the future direction of policy.
Excitement over the budget-busting tax cut proposals that will likely prove mostly unachievable has only added to a pre-existing sense of extreme overconfidence. Watching those who had once raged about the doubling of the national debt over the last ten years now smirk when reminded of that is disheartening, but unsurprising.
We like tax cuts, but we don’t like deficits because they choke off future growth in an already highly levered economy and hand our kids a bunch of bills they don’t deserve to maintain our lifestyle. This is not the 1980’s of Ronald Reagan when debt levels relative to GDP were much lower and demographics more favorable. Projecting the same economic boost from cuts is unwise. The big-spending baby boomers are not getting younger.
At the same time, the proposed cuts appear to do little for the middle class and may actually raise taxes for some in that cohort. The pols are attempting to hoodwink the populace into a corporate tax cut through the legislative process with immediate benefits for the donor class and mostly crumbs for the rest. Having watched companies choose to buy back stock instead of investing or raising pay for ten years despite huge reductions of interest expense makes us quite skeptical that this will transpire as advertised. Regardless, the notion that these cuts won’t increase the deficit seems quite optimistic if not bordering on preposterous.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.