Not here. Our little-faith-in-central-bank-interventions tendencies aren’t getting much love despite hard data that are warning of clouds on the horizon. We could have done better over the last few months by following the dictum of continuing to dance while the central bank music is still playing.
What’s going on? I’m not really sure, but I do have guesses. First, it’s true that the high-yield, low-beta (low-volatility) names we’ve favored greatly outperformed in the first half of the year, making them overextended. What does that mean? Not much to me – I’d rather stick to following the data instead of worrying about short trends (while acknowledging that reflexivity can exacerbate (or extend) those trends, particularly when people are nervous and machines have increasingly taken over). But perhaps the recent risk-off trend could have been considered an opening for plentiful credit that is seeking somewhere to go. Whatever the case, that’s historically a pretty ephemeral reason for us to change our path (admittedly of late it’s been less ephemeral than usual). What else? There’s been some chatter about ECB QE tapering and Fed rate increases. Honestly, I don’t see what there is to get worked up about with those market narratives. If the Fed raises rates or the ECB tapers their QE program that would just slow the economy further and help guarantee the wisdom of our positioning, though perhaps with a lag.
The point that I find the most interesting is noises that risk-parity funds are struggling. To keep it simple, the idea in risk parity is to focus on risk. Generally you do that by being leveraged long lower-risk assets like Treasuries and utilities stocks and having a lower weight (or even short, depending on style) in high-beta areas like tech stocks. That tends to work well most of the time, except for those times when it doesn’t work, in which case it looks like another example of financial engineering gone horribly awry. I’ve heard chatter about problems in risk parity for a while now, and more of late. While I don’t really know what’s going on, the idea makes sense to me given the market action we’ve seen of late. That would explain why slow-growth oriented names have done so poorly of late despite data supporting their favorable performance and why lack of market liquidity suddenly seems like more of an issue.
If risk-parity is the big issue, what do we do? What we’re describing isn’t really a fundamental issue, it’s a liquidity issue. Imagine a lot of water trying to get out of a small drain. I’m not really equipped to know exactly when things will calm down. What I do know is that eventually liquidity issues get fixed. The drain clears, and you revert to normal pricing.
The way I look at it is this – I don’t know what happens for sure over the next week, or maybe even month – that’s liquidity. Over the next several months, value should reassert, rather than lack of liquidity. In that case, what worked in the first half of 2016 should continue to work – as long as the data stays the same (and every indication we can find is that it will actually get worse). We can spend a lot of time and energy trying to guess at what happens over the next week, but that’s not really how we’re geared. We’re built to deal with quarterly and annual change, and in that case the liquidity issues should mean revert before too long.
The last thing I’d note is that I acknowledge some people think that my view of the economy is way too bearish. I’m happy to debate that, but one thing I’d note is we have a repeatable process that doesn’t need to hang its hat on the bullish topic du jour. Who was focused on ISM Services until today (10/5/16) when it posted a bullish number? (To be clear, the ISM Services number was a short term improvement, but it is in a longer-term downtrend.) Here’s the way the economy tends to work. You have leading indicators like manufacturing output, corporate earnings, and new orders. Those all peaked a while ago. Then you have more lagging numbers like employment and services. Those have been on a downward trend, but not as bad as the leading numbers. That’s how the economy generally works. There is often something bullish to hang your hat on, but as the indicators get more lagging and esoteric you probably shouldn’t join the herd.
I finally watched The Big Short last night. Good movie, though it does help the misanthropy (mistrust of human nature) develop a bit more. Events today remind me a bit of The Big Short problems (housing bubble leading to a crash in 2008.) Even when it was obvious to a neutral observer that there were clear problems (New Century Financial, for instance, a mortgage lender that went bankrupt in 2007) people denied it and bulls generally thought they were on top of the world. The view looks pretty great from the top – good place for a party. It can take a while to go from ignored problems to the shock of broad recognition of the problems. In the case of The Big Short, the problems were pretty clear in 2006 (full disclosure- I didn’t really notice personally until early2007), but the broad recognition didn’t really hit until 2008. In today’s case, I think we could see clear signs of trouble beginning in 2013 (earnings growth and GDP peaking,) and things have been trending negative ever since. People want to talk about a hockey stick in earnings? That’s what they always look like – eventually. I’m happy to look for a real improvement in trends, and I just don’t see it. Economic cycles take a while to play out, despite people’s desires to call a bottom practically before a top has even happened. People can dance at the top like they always do, but from my risk/reward standpoint I’d rather leave the party when the clear warning signs are there.