Rudi's View | Feb 14 2018
In this week's Weekly Insights (published in two separate parts):
-Panic Not Invited
-Buy Restructuring Stories
-Conviction Calls: Wilsons, Macquarie, FNArena's Sentiment Indicator
-RBA Dilemma Between Tight Labour And Debt
-The Next Index Rebalancing
[Note the non-highlighted items appear in part two on the website on Thursday]
By Rudi Filapek-Vandyck, Editor FNArena
Panic Not Invited
Last week I learned about a 23 year-old gung ho trader based in Singapore who turned a mere US$50,000 into US$4m in about three years, including by raising an additional US$1.5m from friends, family and investors.
His secret? Volatility in reverse. One of such products out there generated 180% between January and December last year.
Of course, we can all imagine how much of a genius this young gun must have felt. And his enthusiasm, supported by a firm belief he had single handedly found the holy grail for making spectacular investment returns, must have been the decisive factor that pulled the additional US$1.5m over the line.
Now all those gains are gone, evaporated instantaneously as the XIV, a tradable product underwritten by Credit Suisse and designed to mimic the VIX, or "fear gauge", in opposite direction, lost 96% of its value in a brief moment of extreme market turmoil.
How/when best to tell family, friends and clients they will never see their money ever again?
Of course, there are lots of lessons to be learned from this. For example: what on earth was this guy thinking after three years of declining volatility? That it could reach zero, and then move into negative territory at a time when central banks are looking to unwind their extreme stimulus?
Clearly, the world looks a lot different when one's on a high and the account update says US$4m, well done!
The real message here is this is not an isolated example. Products like the XIV have been massively popular among hedge funds, wealth managers, and others. It's anyone's guess how much forced selling is still out there. Credit Suisse, being the guarantor of the product (and of any gains/losses) is the one buying futures over equity indices when volatility drops and investors who own the product are making gains, but Credit Suisse has been selling since most gains have disappeared.
Guess what? Now volatility has spiked, and the XIV has been smashed, millions of dollars are flowing back into the Credit Suisse product. One simply cannot teach Wall Street any new tricks. And yes, Donald Trump would like to see financial markets less regulated (not that any regulator can fully take away the risk of financial product failure). Credit Suisse has already announced it is closing down this particular product before the end of the month.
The problem with the above is that yesterday's heroes, like our devastated young man in Singapore, are not just losing their own shirt and trousers, including funds trusted upon them by others, but their tendency to stick with the winning trade until time's up is now causing share prices to drop amidst wild market swings - worldwide.
At a time of leveraged strategies, stop losses, robots and algorithms, trend followers, theme investing, and other failing strategies such as lesser known "risk parity" set-ups (Google it), it is not difficult to see how/why the current spike in volatility is likely to last a lot longer than most investors would like it to. And that doesn't even take into account the impact on global sentiment among investors who are suddenly confronted with a lot more up- and downswings than they have seen in a long while.
As was the case in early 2016 and throughout 2008, Wall Street specific factors are not the only bombshell depressing global equities this month. There is still the niggling question whether the US is about to witness an outbreak in inflation, or not.
Since late January investors are fearing inflation might be going for a run higher this year. This is pushing up US bond yields at a rate that is way too rapid to not make investors elsewhere highly uncomfortable with US bond moves.
For those fears to settle, US bonds must stop falling (yields stop rising). Thus far, the only way seems to be up, up, up. Three percent is the logical rounded up target US bonds seemingly have set their eyes upon. This also happens to be the level many bond market experts had set for year-end, with a slight possibility of yields temporarily overshooting (to, say, 3.20-3.30%).
At this point the US bond market is acting in the same manner as crude oil has done many times over in the past. Remember 2008? Crude oil futures quickly went from US$70 to US$157/bbl in a little over six months. That's too fast for governments and consumers to adjust, hence the world came to a standstill at around the same time as the financial sector froze up as Lehman Brothers defaulted.
This time around, oil prices have doubled over two years, and they already are retreating fast. Plus they've doubled from a beaten down US$30/bbl, not from an already elevated US$70/bbl.
The same principle should apply to US bonds. Assuming a mere normalisation in US inflation, rather than an upward break-out, US ten year bonds might find they've quickly traveled all there is for the time being, or else they might start choking off the oxygen from a humming global economy. This might provide investors with a much improved proposition, also with lower prices for equities.
The US ten year bond is currently yielding circa 2.86%.
Most share market experts, both here as well as overseas, retain a positive outlook for markets on the basis of robust synchronised global economic momentum. Apart from the fact that history shows a patchy relationship at best between economic growth and share market performances, if there is one message to take away from the opening weeks of the new calendar year it is that the year ahead might not revolve as much around economies, as it did 2017, but more around inflation, central bank policies, currencies and bond yields.
And around unintended consequences and hidden weaknesses inside the system. Which is one reason as to why I shall be worried when the RBA cash rate starts moving higher.
Always good to remember back in early 2008 very few understood what was causing global equities to sell off, and the same situation was apparent in early 2016. Only later on investors came to realise sovereign wealth funds from oil producing countries had become forced sellers of equities, on top of emerging fractures in the high yield US corporate bonds market; both were a direct consequence of sharply weakening oil.
What saved the world's bacon two years ago was the US Federal Reserve quickly realising its ambition to tighten relatively steadily was strangling the fragile global recovery that was taking place. This time around, there is less fragility, but thus also less anxiety at the Fed.
On a more positive note, all signs are pointing towards tax relief for Australian households from the current sitting government in Canberra, and that might temporarily spruce up the animal spirits locally.
Nevertheless, countering the view that equity markets will end the year on a positive note, once this bond market mayhem has been dealt with, is the minority view that global equity markets in 2018 have peaked already. Without any insight into how long financial markets will be disrupted by forced selling, or what exactly this year's trajectory looks like for bond markets, I think it would be rather foolish to dismiss the minority view off cuff.
On my own observation and assessment, the local share market is trying to not get sucked in too deeply with the anti-volatility driven correction on Wall Street, also taking into account Australian equities already posted a negative return in January when US equities were going berserk to the upside.
Don't get too focused on the index either. Many stocks on the All-Weather Performers list are holding up well. REA Group ((REA)), for example, is now back in the mid-$70s after releasing yet another solid financial performance. I'll happily repeat it again: a high Price-Earnings (PE) multiple does not mean a given stock is "expensive".
[Disclosure: the All-Weather Model Porfolio added to its REA exposure before the results release].
To all of you out there: stay level-headed and vigilant. Make sure you sleep well at night.
P.S. If you feel like all of the above has grabbed you by surprise, and you should have done a better job, consider the mindset of the newsletter writer who on Friday reported one of his funds manager mates was in a state of depression given several large casualties in the portfolio. The newsletter writer's own portfolio is now down -25%, but he's still sticking with an upbeat outlook.