Fear not friends, and back to the drawing board foes. I’m alive and well. Thanks for the several notes of concern.
A few readers mused whether the – ahem – tumult of the past few days had sent me into exile?
Had my 100% all-in bet on a low volatility ETF blown up, taking my wealth and credibility with it?
Alas, no cigars. It takes much more than a 5% swing in my portfolio to send me packing. Besides, this is too much fun.
All week I mentally drafted and redrafted a post about the fascinating return of market volatility in the past 10 days.
Unfortunately though I first had no time to write it, and now I’ve no Internet. More on why below.
It’s probably just as well. Whenever the stock market makes the mainstream news, there are worse rules of thumb for long-term investors than to turn that news off.
Watch the rugby instead! I found this past week or so invigorating, but I’m a fanatic. You don’t need to be.
Musing on the markets
Here’s a few quick thoughts – feel free to skip if you’ve sensibly developed an intolerance for one person’s speculations:
- Talking heads on CNBC and elsewhere blamed the volatility on robot traders and ETFs and the new era of Skynet and Robocop. This is mostly nonsense. Volatility has always existed in markets, especially at times of regime change, which is what I think this. (Regime change is loosely a systemic change in fear levels or rate or inflation expectations or a momentum change).
- Hilariously, the same pundits have spent two years blaming the very low volatility we’ve had on robot traders and ETFs. Equally nonsense. The market has been through low volatility periods before, too.
- If anything novel was dampening volatility, it was almost certainly very low interest rates since the financial crisis. It is that regime that seems to be ending.
- Higher bond yields were always going to be reflected in changing equity valuations. That is one reason why I have warned those who feared bonds were excessively expensive to remember that equities are partly priced off bond yields. See my article on the problem with low interest rates [1] for more.
- I personally believe the market has detected the return of inflation, and is repricing accordingly. To some extent the sudden and sharp disruption to the long-prevailing millpond conditions was probably because lots of active money (e.g. hedge funds) had been betting explicitly on low volatility. But as I allude to in that article I linked to above, it’s also because equities are priced partly off long-term yield expectations.
- None of this works like clockwork, not least due to technical factors. So for example bonds and equities can go down at the same time together, and will if the market expects increasing yields in the future. Repositioning an entire market structure creates its own short-term dislocations! It’s over months and years we’ll see what was really going on, not hours or even days. Diversification doesn’t deliver minute-by-minute compensations.
- It is completely true that several daily rebalanced and in some cases leveraged exchange-traded products ‘blew up’ when volatility returned and promptly screamed off the charts. A few closed down. The products didn’t fail as such – they did what they said they’d do, in these conditions. You were silly if you’d bet the farm on them. Surely nobody did?
- More relevant (far bigger) are the so-called risk-parity funds that try to balance equities and (usually leveraged) bonds to the optimal point for the best risk-reward returns. As volatility increases, their risk models change, which means they need to rebalance, which can prompt selling, which will increase volatility, which feeds into the model, and so on.
- To that limited extent there was a feedback mechanism in the market. But I still think it’s wrong to blame ‘robots run amok’. Humans would do the same thing, only more slowly. Higher volatility means more value at risk in a portfolio. For some money managers that can prompt selling riskier assets (shares, maybe certain kinds of shares) to reduce risk.
- Once this (supposed) ‘de-risking’ began, it was going to go on for a while. Personally I think it will likely continue for some time to come, and we may well see a small bear market develop over the next few weeks and months. Your guess is as good as mine though. I’m opining for fun – nobody knows!
- High equity and bond valuations exacerbate all this, for many different reasons. But cheap equity valuations are no protection once the selling begins.
- It’s different for bonds, because the pension world needs to own them to match liabilities (and arguably there’s not enough around.) There’s a permanent bid, and at some point a yield will be found where bonds stabilize. Probably higher than here, across the world.
- Remember this is almost certainly a market correction, not an economic disruption. Growth is great everywhere apart from the UK, which is lagging because of the Brexit baloney (as it will likely now do for a decade, as even the government’s own forecasts have now admitted).
- Great growth does imply higher inflation, but also a good environment for companies to grow profits, hire more workers, increase wages, and so forth. These are ongoing ills that do need addressing. In the long-term this is a good problem to have.
- If you’re an active sort, you might want to make sure you own companies with exposure to bulk commodities. (Passive investors will have some exposure anyway in FTSE trackers etc). I’d consider owning some gold, too. (Don’t expect gold to go up the day markets go down, or anything so orderly. If share prices follow a random walk, gold follows the random walk of a drunk. But eventually he makes it home.)
- People will say “you have to be in equities because they will protect you against inflation”. But remember, we may have already had our inflation protection from shares. Pundits tend to miss this – global trackers have been going gangbusters for a decade, and they could not continue like that forever. You get your on-average higher returns from shares averaged over many years. i.e. High returns in recent years could have ‘borrowed’ some returns from the future.
- The best thing is a balanced portfolio that you set up for all-weathers [2]. Many Monevator readers – particular the passive-minded who find my co-blogger less distracted than old gadfly me – have such portfolios. Along the lines of our Slow and Steady model portfolio [3].
- Such passive investors should probably do nothing in the face of this return of volatility (and potential regime change towards higher yields). Continue with your plan, and rebalance when you’d planned to rebalance. Don’t panic!
- The exception is if you’ve now realized you really own too many equities as you’ve watched your portfolio oscillate this week. Be careful! Most people find it infinitely easier to see shares go up than down. Do nothing is a plan of action to stop you focusing and fussing, and selling when markets are down. But if you genuinely feel you own too many shares in retrospect, it’s probably better to get comfortable by reducing your allocation a little (I’d switch to cash not bonds for now) rather than risk selling everything if we have a bigger correction.
- Markets go down as well as up. That is not small print, it’s chalked into the walls of the stone Temple of Investing. We were bound to see falls again, and while this week has had some fun elements we will see far worse in terms of peak-to-trough declines in the future, some day.
- Volatility is a feature, not a bug!
Not (yet) all mod cons
Right, so I’m in a coffee shop. Why? Because my new flat has no Internet yet.
Yes, I’ve bought a property and moved this weekend!
Let’s discuss why, how, and whether it was a good idea in a future post. I hope to be back to normal in a fortnight or so – at least back with links by next weekend.
But for now my cup running empty. The millennials around me seem happy to occupy their tables all day with an espresso bought six hours ago, but I’m made of more self-conscious stuff.
Take care, don’t do anything silly with your investments – and look out for The Accumulator’s broker table [4] update on Tuesday!