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MV Weekly Market Flash: Volatility Is In the Eye of the Beholder

April 13, 2018

By Masood Vojdani & Katrina Lamb, CFA

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The unseen world is a very strange place. Quantum mechanics, the physics that describes the way things work at the subatomic level, has been validated as a scientific theory again and again since its discovery in the early 20th century. Quantum mechanical laws perfectly describe the workings of literally everything electronic and technology-related in our lives. For all its mainstream applications, though, the implications of quantum mechanics are positively exotic.

Particles exist here, there and everywhere. Pairs of entangled particles instantaneously affect each other across light years of distance. Single photons display wave interference patterns until observed, at which point the wave collapses into a particle with a definitive position in space. This act of observation informs the standard explanation taught to students of quantum physics. Known as the Copenhagen theory, after the home of pioneering scientist Niels Bohr, it posits that all matter exists in a state of superposition (i.e. here, there and everywhere) until observed, at which point it collapses into recognizable forms like trees, cute puppies and Bloomberg workstations. Don’t try to understand the deeper meaning of the Copenhagen theory. Bohr and his fellow pioneers didn’t. “Just shut up and calculate” is how they, and those following, have instructed every new generation of fresh-faced (and confused) physics students.

Don’t Look Now

The subtext of the Copenhagen theory – that observation creates its own reality – resonates in the present day world of stock market volatility. It has come as a painful lesson to investors who came late to the low-volatility party of late 2017 and took bets that the calm seas would carry on. The chart below shows the price trend for the CBOE VIX, the market’s so-called “fear gauge,” over the past twelve months.

When the VIX jumps in price, as it did towards the end of January, it implies a higher risk environment for equities. To look at the above chart is to surmise that something earth-shaking caused risk to jump nearly overnight as the calendar turned from January to February. And, yet, what actually happened? A jobs report showed that hourly wages had ticked up slightly more than expected in the previous month (2.9 percent versus the consensus estimate of 2.6 percent). An “inflation is back!” meme went viral and off to the races went the VIX. Pity the poor punter holding XIV, an exchange-traded note (ETN) designed to profit from a calm VIX. That ill-fated security lost 94 percent – not a typo – of its value in one day, and the ETN’s fund manager announced that the fund would shut down as a result.

Ninety four percent. On account of one lousy wages number. How could this happen? The answer, dear reader, lies in the observer. Risk is a statistical property, a measurement of variance in price. But – as we can see from securities like that poor XIV – it is also an object, a monetized claim. And that has deep implications for equity and other asset markets.

Goodhardt’s Law and the VIX

Charles Goodhardt was an economist who in 1975 made the following observation: “Once a measure becomes a target, it loses the very properties that made it a good gauge to begin with.” Goodhardt’s Law could also be called the Copenhagen Theory of Market Risk. Once you treat risk – volatility – as an object of buying and selling rather than just as a passive statistical measure, you distort what that measure is telling you. Referring back to the chart above, the world did not change in any meaningful way between Friday, February 2 and Monday, February 5. No macroeconomic statistic other than that one random wage number suggested that the economy had changed in any radical way. And yet if you held an asset on Friday morning betting on things staying more or less the same, you were wiped out by the end of the day the next Monday (even though things had more or less stayed the same). Fundamental risk hadn’t changed. But the perception – the observation – of risk created the reality of a 94 percent price drop.

This fact has profound implications for asset markets. The measurement of risk is absolutely fundamental to the models that have informed the construction of portfolios since Harry Markowitz and William Sharpe pioneered the concepts of mean-variance analysis in the 1950s and 1960s. When that measurement ceases to be a “good gauge,” in Goodhardt’s formulation, the ability to arrive at informed valuations for many other assets is itself at risk. Modern Portfolio Theory is the name given to Markowitz’s and Sharpe’s legacy. Increasingly, though, that legacy has to navigate a postmodern financial marketplace.

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MV Weekly Market Flash: Bad News Good, Good News Better

March 9, 2018

By Masood Vojdani & Katrina Lamb, CFA

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It hasn’t been quite the V-shaped recovery of many pundit prognostications. The S&P 500 briefly entered technical correction territory last month, and flirted ever so coquettishly with the 200-day moving average, a key technical trend variable. The ensuing relief rally has seen a couple peaks, but is still climbing the wall back to the record close of 2872 reached on January 26. A month and a half may not seem like a long time – and it’s really not a long time, in the great scheme of things. But other recent pullbacks have done a better job at channeling their inner Taylor Swifts to “shake it off.” The chart below show the pace of the current recovery (leftmost diagram) compared to the brief pullbacks experienced after 2016’s Brexit vote (middle) and the mini-freakout over Ebola in 2014 (right).

So at 42 days, we’re a bit behind the brisk pace of the Brexit (30 days) and Ebola (27 days) pullback-recovery events. But it’s not too much of a stretch to imagine the S&P 500 finding itself scaling the rest of that wall to 2872 in the not so very distant future. Over the course of the current recovery, investors have learned to build an impressive immunity to what one might consider to be bad news. In a sense this is an acquired habit, courtesy of the world’s major central banks.

It Was Just Nine Years Ago Today, Ben Bernanke Taught the Band to Play

Speaking of the “current recovery,” today is its nine year anniversary! Three cheers for the bull. On March 9, 2009 US equity markets hit rock-bottom, more than 50 percent down from their previous highs in the largest market reversal since the Great Depression. Investors in early 2009 were catatonic – many who had managed to keep their heads during the freefalls in September and October of the previous year finally capitulated in March, fearing there was potentially no bottom for risk assets.

Those who held off the demons of fear one last time were rewarded mightily as stocks found solid ground and began the long trek back. But it was not exactly easy street for those first tentative years. 2010 witnessed a handful of significant pullbacks and lots of angst. In 2011 the market flirted with bear territory (20 percent or more down) when the Eurozone crisis accelerated and the US Congress came ever so close to defaulting on the national debt. Other potential black swans lurked in the following years, from government shutdowns to the crash in oil prices to fears of a hard landing in China.

But as each news cycle came and went investors learned to stop worrying. Credit for this learned behavior can confidently be laid at the feet of Ben Bernanke, Mario Draghi, Haruhiko Kuroda and Janet Yellen, along with a supporting cast of dovish policymakers in their respective central banks. The “central bank put” was solidly in the money and increased in value throughout the recovery, even as the US Fed started to lead the way out of monetary Eden as it ended quantitative easing and began to raise rates. The investor calculus was simple: things will work out, and if they don’t, the banks will step in and bail us out. This way of thinking finally led to that unreal calm in the markets in 2017. Even the wackiest of political shenanigans failed to make an imprint on investors trained to embrace the Panglossian assurance of the best of all possible worlds for risk assets.

O Brave New World, That Hath Such Creatures In It

If the central bank put is the magic formula for maintaining calm, what to make of the tea leaves from recent statements by Yellen’s successor, Jerome Powell? The new Fed chair has been largely unimpressed by the recent market volatility and appears to see no reason for soothing bedtime stories to global investors. That should be a good sign: if the economy is doing well on its own, then markets should be able to take in stride the upward movement in interest rates and inflation that one would expect to follow from rising corporate sales and earnings. Nonetheless, it is a brave new world from the recent past.

Taken this way, it makes sense to ascribe the February pullback to nothing of any particular importance. The pullback started with a jobs report that showed wages growing at a 2.9 percent annual rate, higher than the recent trendline of 2.5 percent or so (though not particularly hot by historical standards). Trump threw some new fire on the flames last week with the unexpected announcement of punitive new tariffs on steel and aluminum. But the ingrained tendency to remain calm has largely prevailed. The general thinking on tariffs seems to be that they will fail to ignite an all-out hot trade war. Meanwhile, this morning’s jobs report had a double helping of good news, with a whopping 313,000 payroll gains alongside an underwhelming (therefore good!) average wage gain of 2.6 percent.

What if the wisdom of the crowd is wrong? What if dysfunctional politics and misguided fiscal policymaking still do matter? What if that productivity boom that is supposed to arrive any day now fails to show up, relegating the world economy to sub-par growth as far as the eye can see? Will there be another incarnation of the central bank put? Will it be as effective as it was for the last nine years? All questions without answers, for now. For the time being, though, it would appear that the news cycle will continue to leave investors unimpressed, where the smell of bad news must mean there’s a pony nearby. Your portfolio should enjoy this while it lasts.

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MV Weekly Market Flash: Hope Accelerates – Will Reality Follow?

February 23, 2018

By Masood Vojdani & Katrina Lamb, CFA

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Every fiscal quarter, publicly traded companies and the securities analysts who cover them engage in a series of time-honored rituals. The rituals follow the elaborate pantomimes of a Japanese Kabuki drama, and the underlying message is almost always the same: Hope Springs Eternal. Consider the chart below, which shows quarterly earnings per share trends for the S&P 500. 

How to Speak Kabuki

Here’s how to interpret this chart. The green line represents projected earnings per share for the next twelve months. Basically, analysts project what they think will happen to the companies they analyze in the year ahead, based on the economic context and all the usual industry- and company-specific competitive variables, and those assumptions boil down to the one NTM (next twelve months) EPS figure. This chart shows the composite NTM EPS for all the companies in the S&P 500. For example, on January 31, 2017, the composite estimate for what S&P 500 shares would be worth a year hence (i.e. at the end of January 2018) was $133.17 per share.

The red line illustrates the actual earnings per share for the twelve trailing months, known in finance-speak as LTM (last twelve months). So if the green line represents the hope, then the red line shows the reality, or what actually happened. As you can see, the actual LTM earnings per share for the S&P 500 on January 31, 2018 was $118.08. It wasn’t $133, as the analysts had forecast a year earlier.

Moreover, the chart shows that this “reality gap” plays out in virtually every quarter, year after year. What often happens as earnings season approaches is that analysts start to dial back their earlier predictions to bring them closer to reality. In so doing, they are playing another important role in the Kabuki drama: managing expectations. Earnings season is only partly about the actual growth number; it is also about whether this number is better than, or worse than, what was expected. The downward revision that customarily takes place in the weeks before a company reports has the effect of lowering the bar, so that whatever number the management team actually reports has a better chance of beating expectations.

This Time Is (Sort of) Different

Clear as a bell, right? In summation: expected earnings are usually rosier than the actual figures that come out later, and the elaborate play-acting between management teams (forward guidance) and securities analysts (downward revisions to expectations) contrives to deliver happy surprises to the market.

Except that the script is a bit different this year. Analysts are actually raising – not lowering – their expectations for 2018 earnings performance. Let’s consider the case for Q1 2018. This is the quarter we are currently in, so we don’t know how the companies are actually going to perform. What we do know is that the analysts’ consensus estimate for Q1 S&P 500 earnings as of today is 17.1 percent growth. When the same analysts made their Q1 forecasts at the end of last year, the estimate was 10.9 percent. That’s a big difference! And not just for Q1. The analysts’ Q2 estimate is also significantly higher today than it was seven weeks ago. In fact, the consensus estimate for full year 2018 earnings growth is 18.2 percent, which is 8 percent higher than on December 31, when analysts predicted growth of just 10.3 percent.

That difference – the difference between 18 percent and 10 percent – matters a lot for equity valuation. If companies in the S&P 500 grow their earnings by 18 percent this year, then a similar rise in share prices will not make stocks any more expensive, when measured by the price-earnings multiple variable. That would ease investors’ worries about a potential share price bubble. Double digit price growth matched by double digit earnings growth is arguably the best of all possible worlds for long equity investors.

Here is the one caveat. Much of the apparent optimism in the current earnings projections comes from one single fact – the tax cuts enacted in December that were disproportionately skewed towards corporate tax relief. You can see from the green line in the above chart just how dramatically expectations accelerated right around the time the relief package took shape. More than any other factor, the tax cuts help explain why, contrary to the usual practice, earnings estimates have been raised rather than lowered as reporting dates come closer (though we should also note that a weaker US dollar, should it persist, could also be an earning tailwind for companies with significant overseas activities).

More to Life than Taxes

Investors should take in this seemingly good news with a measure of caution. First, to the extent that the tax relief does make a strong impact on the bottom line (which would be the case for companies that actually pay something close to the previous statutory tax rate, by no means a majority of S&P 500 companies) it will be a one-and-done kind of deal. The growth rate will kick up for one fiscal year cycle of “comps” – comparisons to the previous year – and then stabilize at the new level.

Second, there are other variables in flux that could at least partially offset the tax advantages. Corporate borrowing will be more expensive if (a) interest rates generally continue to rise and (b) credit spreads widen in response to higher market volatility. Companies in more price sensitive industry sectors may have to address issues of how much new inflation they can pass on to their customers. And, of course, corporate top lines (sales) will be dependent on the continuation of global economic growth leading to increased organic demand for their products and services.

Finally, the only way that companies can consistently grow their earnings above the overall rate of GDP growth is through productivity-enhancing innovations to their value chains. There may be a new wave of such innovations just around the corner – or there may not be. How these developments play out over the coming months will determine whether the current rosy predictions of the analyst community play out – or whether they quickly go back to that familiar old Kabuki script of hope and reality.

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MV Weekly Market Flash: The Dollar Is Sitting Out This Party

February 16, 2018

By Masood Vojdani & Katrina Lamb, CFA

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So, everything’s back to normal, right? The sharp pullback that began with the hourly wage number exactly two weeks ago has assumed its usual V-shape, with 5 straight trading days in the green following the technical correction level of minus 10.2 percent reached on February 8. Just like that silly Ebola freak-out back in 2014, this one looks like it will pass over, a brief squall yielding back to calm seas without so much as a full day spent below the 200-day moving average.

Right?

Yields Go North, Dollar Goes South

The good news, for those who prefer their equities portfolios neither shaken nor stirred, is that the continuing rise in bond yields is failing to inject fear into risk-on asset classes. The 10-year Treasury yield broke through 2.9 percent on Wednesday, even as the S&P 500 recorded yet another intraday gain of more than 1 percent. Those inflationary fears would seem tempered, even though Wednesday’s news cycle also served up a core CPI growth number a bit higher than consensus expectations. For the moment, anyway, the stock market seems comfortable enough with higher rates.

Which brings us to today’s big question: what is up with the US dollar? The chart below shows the downward trajectory of the dollar against the euro over the past six months, during which period the 10-year yield soared from just over 2 percent to the recent 2.9 percent.

All else being equal, rising rates should make the home currency more, not less attractive. Investors prefer to invest where returns are higher. Moreover, the dominant economic narrative around the US for the past half-year or so has been positive: above-trend growth, strong corporate earnings and high levels of business and consumer confidence. What’s not to love? Yet, even while the spread between the 10-year Treasury and the 10-year German Bund is 0.45 percent wider than it was six months ago the euro, as seen in the chart above, has soared against the dollar. And the pace has only accelerated since the beginning of 2018. Yes, the dollar jumped ever so briefly as a safe haven mentality took hold two weeks ago, but it fell back just as quickly – even while the 10-year yield reached new 4-year highs.

Supply and Demand, Yet Again

We’re starting to feel like Econ 101 professors around here lately, given how often the phrase “supply and demand” shows up in our commentaries and client conversations. We think it may be the single most important catchphrase for 2018, and in it lies a plausible explanation for that odd relationship between the dollar and bond yields. The supply-demand road inevitably leads back to China.

China’s central bank buys US government debt – lots of it. Chinese foreign reserves exceed $3 trillion, and the vast bulk of those reserves exist in the form of US government securities. Two things happen when Chinese monetary authorities (or any other foreign institution) buy US paper, all else being equal. First, the price goes up, and thus the yield, which moves in the opposite direction of the price, goes down. Second, the dollar goes up because Treasuries are a dollar-denominated asset. You see, it really is all about those supply and demand curves.

Recent evidence (including a weak Treasury auction last week) suggests that Chinese Treasury purchases are somewhat lower than they have been in recent years. That rumor back in early January, though quickly disputed, may have a kernel of truth to it. Foreign buyers indeed may have less appetite for Uncle Sam’s IOUs. Maybe they expect more inflation down the road (which would assume higher nominal rates). Maybe other factors are afoot. Whatever the reasons, reduced demand from non-US sources would indeed have the likely effect of pushing up rates and pushing down the dollar at the same time.

If this is the case, then we may be in for more bumpiness in equities. The S&P 500 digested the move to 2.9 percent very smoothly. We may see in the coming weeks whether the story plays out the same way at 3 percent or more. There will be a truckload of Treasuries coming down the road as we borrow to fund all that new spending and those tax cuts. More supply, in other words, potentially chasing less demand.

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MV Weekly Market Flash: The Peril and the Promise of Higher Rates

February 9, 2018

By Masood Vojdani & Katrina Lamb, CFA

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Watch the bond market: that was a core theme of our recent Annual Outlook and earlier commentaries in this brief, suddenly volatile year to date. Benchmark Treasury yields jumped on the first day of the year and never looked back. For the first month equities kept pace with rising yields, delivering the strongest January for the broad US stock market since 1987. Then it all went pear-shaped. Yields kept rising, while risk-on investors developed a case of the chills and sent stocks into a sharp retreat. The S&P 500 saw its biggest intraday declines since 2011, and the fastest move from high to 10 percent correction – 9 trading days – since 1980. Investors, naturally, want to know if this is just a long-overdue hiccup on the way to ever-greener pastures, or the start of a new, less benign reality.

The Expectations Game

The chart below shows the performance of the S&P 500 and the 10-year yield for the past 12 months through the market close on Thursday.

What caused that abrupt change in sentiment? Investors seemed perfectly happy to watch the 10-year yield rise from 2.05 to 2.45 percent last September and October, and again from 2.4 to 2.7 percent over the course of January. What was it about the move from 2.7 to 2.86 percent to precipitate the freak-out in stocks? The most widely cited catalyst has been the wage growth number that came out in last Friday’s jobs report; after growing at a steady rate of 2.5 percent for seemingly forever, the wage rate ticked up to 2.9 percent in January. According to this train of thought, the wage number raised inflationary expectations, which in turn raised the likelihood of a faster than expected rate move by the Fed, which in turn led to portfolio managers adjusting their cash flow models with higher discount rates, which in turn led to the sell-off in equities this week.

Algos Travel in Packs

There is a kernel of truth to that analysis, but it doesn’t really explain the magnitude or the speed of the pullback. For more insight on that, we turn to the mechanics of what forces are at play behind the actual shares that trade hands on stock exchanges every day. In fact, very few shares trade between actual human hands, while the vast majority (as high as 90 percent by some estimates) trade between algorithm-driven computer models. The “algos,” as they are affectionately known, are wired to respond automatically to triggers coded into the models.

On most days these models tend to cancel each other out, sort of like the interference effect of one wave’s crest colliding with another’s trough. But a key feature of many of these models is to start building a cash position (by selling risk assets) when a certain level of volatility is reached. Even before the selling kicked in last week, the internal volatility of the S&P 500 had climbed steadily for several weeks, while the long-dormant VIX was also slowly creeping up. The wage number may or may not have been a direct trigger, but enough of these models read a sell signal to start the carnage. Rather than waves canceling out, it was more like crests meeting and growing exponentially. More volatility then begat more selling.

The Case for Promise

So we’ve been given a taste of the peril that can come from higher rates. What about the promise? Here we leave the mechanics of short-term market movements and return to the fundamental context. The synchronized growth in the global economy has not changed over the past two weeks. The Q4 earnings season currently under way continues to deliver upside in both sales and earnings growth, while the outlook for Q1 remains promising. If wages and prices grow modestly from current levels – say, for example, so that the Personal Consumption Expenditure index actually rises to the Fed’s 2 percent target – well, that is in no way indicative of runaway inflation.

This should all be good news; in other words, if the current global macro trend is sustainable, it would strongly suggest that the current pullback in risk assets is more like a typical correction (remember that these normally happen relatively frequently) and less like the onset of a bear market (remember that these happen very infrequently). Higher rates have an upside as well, when they reflect positive underlying economic health. With one caveat.

The Debt Factor

Call it the dark side of the “reflation-infrastructure trade” that caught investors’ fancy in late 2016. The US is set to borrow nearly $1 trillion in 2018, much of which is to pay for the fiscal stimulus delivered in the administration’s tax cut package. That borrowing, of course, takes the form of Treasury bond auctions. A weak auction of 10-year Treasuries on Wednesday is credited for pushing yields up (and stocks down) late Wednesday into Thursday. These auctions, of course, are all about supply and demand. Remember that brief freak-out in early January when rumors floated about China scaling back its Treasury purchases? Supply and demand trends stand to weigh heavily on investor sentiment as the year progresses.

Now, a great many other factors will be at play influencing demand for Treasuries, including what other central banks decide to do, or not do, about their own monetary stimulus programs. Higher borrowing by the US may be offset if overseas demand is strong enough to absorb the expected new issuance. Time will tell. In the meantime, we think it quite likely that the surreal quiet we saw in markets last year will give way to more volatility, and to sentiment that may shift several times more as the year goes on between the peril and the promise of higher interest rates.

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