Via Guy Haselmann of Scotiabank,
A comment I posted on a Bloomberg Chat this morning says it all, “herd trading, policy pivots, and terrible market liquidity are a bad combination.”
This week, markets have been driven by position squaring and P&L management. There have been extraordinary price movements in various commodities and currencies due to extreme weather, the decline in the Chinese Renminbi, capital flight, Fed taper, and geo-politics. Such P&L volatility is causing decisions to be made in other, seemingly uncorrelated markets, due to the need to manage P&L risk.
These movements are of elevated concern because the investment climate of recent years has created a herd mentality. Now that global stimulus is being withdrawn, those trades are under attack and a mini-contagion is unfolding (see my March 24th Commentary note)
Adding to recent concerns of increased volatility are the price declines, and loss of momentum, in many high-flying stocks, such as Twitter, Pandora, Tesla, Netflix, Solar City, Priceline, Facebook, Gilead, and Biogen, to name just a few.
Given how this is unfolding, it is worth revisiting a few points I made in my “2014 and Beyond” outlook paper (from January 3rd).
“…..investors and speculators receive ever-lower returns for ever-higher levels of risks. Over time, the ability of an investor to assess an asset’s fundamental value becomes ever-increasingly impaired. It should be a warning sign to portfolio managers’ fiduciary responsibility to maximize return per unit of risk.
“In 2014, investors have asymmetric risk distributions that are skewed to the downside. Risk-seeking investors are playing a high-stakes ‘game of chicken’ because the door to exit will be narrow. When risk needs to be pared, market liquidity will be challenging due to fewer market- makers, and potentially fewer new marginal buyers.”
“Investor behavior is partially being driven by fear of missing the upside: they feel pressure to ‘not earn zero’, to beat inflation and benchmarks, or to simply outperform their peers. This herd mentality is a powerful, yet dangerous force. It should be a warning of the markets’ downside potential when markets are confronted with the next “risk-off” catalyst.
“Regulations and uncertain rules of trading have thoroughly compromised market liquidity. It is the ‘Greater Fool Theory’ for investors believe they will be able to monetize profits in aggregate.”
“The FOMC wants markets to believe that they can navigate a soft landing through micro-managing the unwind process. However, investors and traders care more about the “final destination than the journey”, to quote from Mohamed El-Erian, so there will become a time when the Fed tips investors from yield-seeking toward getting ‘ahead of the curve’. This point will occur during the process of the Fed lowering the accommodation needle.
“The apt analogy is a playground see-saw where investors (and Fed) have a seat firmly on the ground and risk assets dangling in the air. The Fed has started the process of tossing 10 pounds (billions of Treasuries) onto the seat in the air. Every six weeks after each meeting, another 10 pounds will be tossed on the ‘high-side’. At some point, a few heavy investors will decide to jump-off the seat that they have been sharing with the Fed, causing the high-seat (risk assets) to come crashing down from its high perch. The Fed would like to balance the see-saw, but history suggests the chances are infinitesimal.”
The trades that have worked well during the Fed’s ‘pedal to the metal’ accommodation policies are now showing signs of strain as QE is being unwound. As the calendar advances closer toward QE’s end, market volatility will edge higher and positions will adapt accordingly. Investors will soon learn whether the QE policy (specifically designed to lift asset prices) was actually a pressure cooker that ultimately had to blow once the QE spigot was turned off. Is this trade beginning now or could it pause until later in the fall?
Financial asset prices and positions will have to adjust and recalibrate to levels that properly reflect the asset’s fundamental value. More importantly, expected returns will have to begin to more accurately reflect the true level of the risk of the asset. After all, the implicit Fed put that has placed a floor under the market, and powered it forward, is gradually being removed.
I expect portfolio re-balancing to put a floor (this time) in Treasuries over the next several months. This is one of several reasons, I remain a bond bull. If you are not in yet, I would at least wait until after PCE (8:30 am), but I would not wait too long.
“A lot of people are afraid of heights. Not me, I’m afraid of widths.” –Steven Wright