The last week has been a very quick reversal of a nearly 14-month upswing in the global markets. Yesterday, in particular, was a wake-up call that markets are not always tame and conducive to making money. We offer below some answers to questions we have received and hope that they help. We continue to monitor the environment and will do our best to preserve our clients’ hard-earned savings.
What changed?
The market has been on an upswing that has lasted longer than any time period in history without a 5% correction. 422 days when the average is typically about 200 days. The actual reason for the swift move over the past week is hard to pin down. However, quick adjustment in interest rates (from ~2.5% to 2.8%) combined with readings of a pick up in inflation (though still at very modest levels) were part of the equation. These generated a fear that the Federal Reserve Bank would need to accelerate the pace of rate increases, potentially increasing the chances of an economic slowdown.
Should we do something?
On Monday, January 29th, Auour’s short-term signals became cautious as the rapid increase in the markets combined with the increase in interest rates caused us to believe the likelihood of a near-term soft spot had increased. We removed all leverage from our most aggressive equity product and increased cash to approximately 10% in all equity products. We also dramatically cut the equity weight in our balanced strategies with Global Balanced moving to 45% equity from 60% and our Multi-Asset Income strategy moving to 25% equity from 40%. Our Global Fixed Income also mitigated some risk by reducing exposure to the higher risk corporate and emerging markets as well as raising some tactical cash.
What caused the rapid deterioration over the past few days?
As we are only one participant in a market driven by tens of millions people, it is impossible to directly lay blame. Let us also remind ourselves that as of this writing, the S&P 500 has only retracted to levels last seen only two months ago. However, certain factors are reminding us of the speed (not the severity) of the very quick correction that occurred in 1987 caused by the broad adoption of portfolio insurance. In the 1980’s, large pensions were told that they could insure against market corrections through the use of derivative instruments. It became a self-fulfilling event which instigated a “run for the exits”, not driven by underlying company fundamentals.
Over the past year, it has become commonplace to see inexperienced investors bet against a rise in market volatility. This caused complacency to build and as we know, the market does what is most inconvenient for the majority of participants. The rapid rise in interest rates, the start of a market downturn, and the fear of government instability resulted in a rise in volatility. The rise in volatility created a panic among those betting against it and resulted in them covering their increasing losses. The absorption of that change in direction has resulted in a massive movement in the derivative markets, pushing markets down. Another case of a “run for the exits” that has little to do with underlying valuation or company fundamentals.
What do we do now?
Again, as only one participant in a field of millions, no one can accurately predict the short-term gyrations of the market. The volatility seen even within the last hour of writing this makes it difficult to gauge the value of short-term actions. Days like yesterday will take over emotions and blind you to logic. In 1987, the market dropped over 22% in one day yet if one looked at just the yearly numbers, the market was up over 5% for the entire year. Swings in markets driven by derivatives can produce wild daily and weekly rides but the fundamentals of the underlying markets are what dictate the long term.
We continue to evaluate the data and the global markets’ reactions to it. At this point, we do not see this as a systemic issue that could drive a deep and enduring downturn. Fundamentals around the world are very good. Interest movements to date are normal and well within our thinking of where they should be moving to. Events like the last week can and should raise fears. Yet, we take some comfort that our signals moved us into a more conservative allocation with tactical cash protection before this drop. Time and data will drive our decisions, not emotions.