From ConvergEx' Nicholas Colas
Financial asset price volatility gets a bum rap. Everything in moderation, yes… But the unusually quiescent capital market behavior of the last few years isn’t really doing anyone any favors over the long run. Today’s note reviews the benefits of a more volatile bond and stock market: everything from the possibility for truly skilled fund managers to make outsized returns to a very necessary reset of investor and corporate behavior. As bond and stock markets get twitchier - and that process is already underway – just remember that there are many silver linings in the storm clouds that are gathering.
For much of the history of modern medicine, the function of the human appendix has been a bit of a mystery and common wisdom held that it was essentially useless. About the only thing doctors knew was that it could become infected and that its removal caused no adverse health consequences. Medical professionals have been performing appendectomies since the 1730s, and one brave Soviet doctor managed to remove his own infected appendix in the 1960s while stranded on a scientific outpost in Antarctica. Don’t try that one at home, kids.
More recently, the appendix has gotten a reprieve and some researchers believe it may have several useful functions after all. As it turns out, that little sac in your abdomen acts as a back-up supply for the bacteria your body needs to stay healthy. It also serves a function in prenatal development, helping to balance hormone levels. Clever surgeons now use the appendix to reconstruct internal organs damaged by cancer or infection. In short, the appendix does have its uses – plenty of them, actually.
For capital markets, asset price volatility is much like the human appendix. The rally in both stock and bond markets – especially in the U.S. – has come with little in the way of wayward price action. It has been a “Set it and forget it” move for stocks for three years, with little in the way of classic 10% pullbacks to shake out weaker hands. The rally in bonds, thought unlikely at the beginning of the year, has been similarly uneventful. It is as if investors have extracted the seemingly unnecessary appendix of volatility and, with the market seemingly unaffected, decided it has no real function.
The problem is that volatility is actually important to the proper functioning of capital markets. In fact, it is critical to both effective societal asset allocation and as a way to judge the skill of managers on Wall Street and Main Street alike. It isn’t just price levels that define capitalism; it is the correlated spectrums of risk and return from sure bets to highly speculative ventures that keeps the machine running smoothly. The journey really is just as important as the destination.
That may come as an unwelcome message to those accustomed to steadily positive returns over the last 5 years. For many investors, the 90% advance in the S&P 500 or the 86% return in the Russell 2000 have been a welcome salve after the burns of 2007-2008. All that has come with very low levels of both actual and expected price volatility, as expressed by measures like the CBOE VIX Index. Since rising volatility tends to drive asset prices lower, what will the harvest be when stocks finally do start to act more like their crankier old selves?
Spoiler alert (sort of): stock price volatility is rising, and October is historically a seasonal high water mark for zippy price movements. Hundred-plus point moves in the Dow now come regularly, and the CBOE VIX Index is up from 12 to 15 in the last month. In short, stock volatility is back and it wants to know why we changed the locks and threw all its clothes on the front lawn.
And yet… There are several silver linings shot through those incoming storm clouds. Consider the following points:
- Imagine you are a public company Chief Financial Officer and you must explain your cost of capital to the rest of the organization and your Board of Directors. This is a tough concept for non-financial professionals, and they tend to look at the stock price as a way to shortcut the tedious math behind the calculation. High stock price equals “Things are going great! Expand the business. Buy other companies. Grow, baby, grow.”
Price volatility is what keeps those animal spirits in check and forces corporate Main Street to watch their pennies. Now, the last five years haven’t exactly been a rapper’s birthday party of corporate spending, so incremental stock price volatility isn’t just about keeping the lid on profligacy. Rather, it will be a warning shot to keep corporate America focused on the very best expansion projects and overall asset mix. And that’s always a good thing for investors and society as a whole.
- Then there’s the Wall Street side of the volatility equation. The last five years have been a boon to passive investing – why buy the active manager cow when you can get the milk of high returns for (almost) free? The recent news that the California Public Employees Retirement System plans to scale back their exposure to hedge funds is just one touchstone in that trend. So is the persistent move of capital from actively managed mutual funds to overwhelmingly passive exchange traded products.
It’s all funds (sic) and games until someone loses an eye, as every parent warns. Price volatility will allow active managers to feel some sunlight after the long eclipse of the last half decade. Truly skillful managers – long only or hedge fund, it matters not – welcome volatility since it allows them to find the babies mixed in with the bathwater.
- Economic volatility, to the degree it comes with asset price moves, also plays a productive if short-term painful role in capitalism. Consider that the times when the CBOE VIX Index ran consistently below its long run average of 20 (14.9 as of Friday) are all periods of bad capital allocation. The mid-1990s sewed the seeds of the dot com bubble. A decade later, the same VIX levels travelled hand in hand with the housing bubble and the setup for the Financial Crisis. Low volatility and poor societal capital investment share a room in the orphanage of failure.
The key question now is “Can the U.S./global economy handle a meaningful downturn in financial asset prices?” The short answer is that it may not have a choice. The Federal Reserve has done what it can to juice the American economy and has the balance sheet to prove it. Central banks, for all their power, do not control long term capital allocation or corporate hiring practices. Fed Funds have been below 2% for six years. If the U.S. economy can’t continue to grow in 2015 as the Federal Reserve inches rates higher, there are clearly larger issues at play. And those private sector problems will need private sector solutions.
In short, higher asset price volatility from current levels isn’t something to fear if you consider its function over the long run. A little pain now will save a lot of trouble later.