A robust investment process needs to accept that higher volatility in equity markets is normal, and unlikely to disappear anytime soon.
When the nineteenth-century American banker, John Pierpont Morgan, was asked what the stock market would do next, he is reputed to have drily replied, “It will fluctuate”. The riposte (which may as a matter of historical fact never have been uttered by the famous financier) is witty because it states the obvious. It is in the nature of equity markets to fluctuate, sometimes for good reason, but at other times perhaps for no good reason at all.
Though equities have been quieter over recent months than they were during the last quarter of 2018, recent market instability is unlikely to have run its course, in my view. To paraphrase Morgan, fluctuations lie ahead. To be more specific, I believe that volatility will be more characteristic of its average over the longer term, than of the two unnaturally calm years, 2016 and 2017.
Volatility is back
The Vix Index (a measure of volatility based on S&P 500 index options) has averaged 19.2 since January 1990. The Vix’s average during 2016 and 2017 was much lower, at just 13.5; so this two-year period of low volatility was anomalous.
A false sense of security? Volatility in 2016 and 2017 was anomalously low
Although higher volatility than in 2016 and 2017 is perfectly normal and to be expected, that does not mean that all market fluctuations are or will be rational. Investors can be prone to overreaction, and markets driven by fear and greed as much as by macroeconomic perception. Over recent months, central bank policy (and other macroeconomic data) has become more difficult for the market to interpret; and when clarity is absent, markets can run on behavioural biases as much as on information.
An example of behavioural overreaction was in the fourth quarter of 2018. Between 20 September 2018 and 24 December 2018, the S&P 500 Index fell by 19.8% and the MSCI World Index by 17.9%.The Vix spiked to 36.1 on 24 December 2018. This market upset went beyond the macroeconomic evidence that the US Federal Reserve (Fed) would continue to tighten into a period of economic weakness. As it happened, the Fed changed its mind, flip flopped from hawkish to dovish, and during the next four months the market clawed its way back. By the end of April 2019 the MSCI World had regained most of its ground, while the S&P 500 had reached a new all-time high.
In May 2019, something similar happened. The S&P 500 suffered its worst May return since 2010 and the second worst since 1962. Both the MSCI World and the S&P 500 lost more than 6% during May. This time the trigger of the market upset was the escalation of the trade war between the US and China. But in June the S&P 500 recovered, reaching a new all-time high. Towards the end of July it reached another new all-time high. August began very weakly. Time will tell whether some of the June-July upswing may have been over-optimism.
The rallies between 24 December 2018 and 3 May 2019, and between 3 June 2019 and 26 July 2019, were both cautious in tone. During these climbs, investors preferred stocks of defensive character. Quality (shares in companies with strong balance sheets) outperformed value (shares that are relatively cheaper in relation to company book value or earnings). Value tends to work well in risk-on environments. In risk-off environments, it is often better to buy quality.
Investor appetite for risk does not always correlate with the direction of equity markets. Equities may sometimes be described as ‘risk assets’ but this is an oversimplification. It is far from always the case that when investors desire more risk, then equities rise.
A risk-averse rally: MSCI World Quality has beaten MSCI World Value in 2019 YTD
Understanding the market in terms of factors, such as quality and value, but also including growth (shares in companies with faster-growing revenues or profits) and momentum (shares that have outperformed), has become recognised as important. In John Pierpont Morgan’s day, most equity investors probably thought of the market as one-dimensional – up or down – whereas today we see it through the prism of factors. The market is multidimensional. Most investors today appreciate that their returns – while they may include alpha – are in part due to their capturing factors.
That said, there are dangers in an overly simplistic approach to factor investing, for example by the use of factor ETFs. Although factor investing is powerful, and can predict returns, there are downsides to it. Factor returns are cyclical, and do not work all the time. Individual factors can have negative periods. The behaviour of factors can overlap, reducing diversification, if the investor is not careful how they are implemented.
Objectivity and diversification
What of the future? Risks abound that could easily stir up more volatility, in my view. Here is a partial list of potential risks: global trade war, an economic downturn in China, a new cold war between the US and China, armed conflict with Iran, a spike in oil prices, North Korean aggression, a disorderly no-deal Brexit, a banking crisis in Italy… This list could easily be extended, but it is also possible that the trigger for the next major market fluctuation is not on anyone’s list, and will come as a complete surprise.
How should investors face this uncertain environment? Another saying attributed to John Pierpont Morgan is: “No problem can be solved until it is reduced to some simple form. The changing of a vague difficulty into a specific, concrete form is a very essential element in thinking.”
When facing the problems of the volatility of markets, the variety of potential risks, and the unknowability of the future, it is essential to adopt an objective, bias-free approach, based on thorough and objective research. Central to our philosophy on the global equities team is a continuous and disciplined research effort, testing hypotheses against specific, concrete data.
We base our stockpicking on systematic methods using five diverse components. These five are not vanilla factors, but are proprietary, having been developed over years of research. Our five components are designed to be quite different from each other, in order to increase diversification. We call our five proprietary components: dynamic valuation, sustainable growth, company management, analyst sentiment, and market dynamics.
Secondly, we include hedging even within single components. Our dynamic valuation component, for example, contains a quality sub-component designed to protect returns against risk-off periods in which value falls. Our momentum component includes mean reversion.
Thirdly, our weightings to the five components are flexed in accordance with the market environment, which we measure carefully, tracking changes in investor sentiment and risk appetite. The weighting of each component is dynamic, tilting the portfolio towards those most likely to be effective at the time.
That is why, although fluctuations lie ahead, we believe we are well-prepared for them. We are confident that over the long-term, across varied market conditions, and despite volatility, our funds will continue to produce uncorrelated returns.