March 18, 2018
Long-term investors are making a large, implicit bet on market momentum as funds pile into market-capitalization weighted products. Each of the 10 largest ETFs, together over $1 trillion in AUM, use a market-cap weighting scheme, and at the same time, momentum as a trading strategy continues to gain popularity. This month, we examine the embedded momentum bet hidden in the market-cap indices and highlight a momentum-factor crash as a notable risk moving forward.
February 15, 2018
After a historically extended period of benevolent and comparatively placid markets, volatility finally reemerged in early February, with many pundits highlighting inflation fears as the primary driver. In this commentary, we explore the relationship between an inflation scare and equity/bond returns, and how the negative correlation between stocks and bonds, a foundation of modern portfolio management, could come under pressure in a prolonged inflationary environment.
February 7, 2018
Monday was a historic day in terms of equity market volatility. The S&P 500 saw a greater than 4% decline, and the over 115% daily move in the CBOE Volatility Index (VIX) was easily the largest one-day spike on record, surpassing the 64.2% move in February 2007. This caused a catastrophic loss in inverse VIX exchange-traded products (XIV, SVXY) with early estimates putting the daily loss on those securities at greater than 95%.
2017 Commentary Archive
Equity market volatility, or the absence of it, continues to dominate headlines, with the VIX hovering below 10 for extended periods and low realized volatility. In recent months, many market pundits forecasted an uptick in volatility, and that even a small increase will cause a wipeout for investors in the “short-vol” trade. In this commentary, we examine the state of the volatility market, particularly short-vol exchange-traded-products. While we highlight the increased fragility of the VIX and prevalence of vol-based strategies as definite risks, we show how short-volatility may be useful as an equity replacement strategy when sized appropriately as part of a whole-portfolio approach.
The most recent tax reform proposal from Republican leaders in Congress removed the proposed mandate for first-in-first-out (FIFO) accounting of stock transactions. The FIFO mandate, projected to add only $2-3 billion in revenue over 10 years in a bill that would add hundreds of billions to the deficit, would have disproportionately hurt long-term investors and those that add to their investments over time. We had been concerned that passage of such a mandate could cause temporary selling pressure in equity markets, as long-term owners of stock could seek to trim holdings under a more flexible tax structure.
The Federal Reserve continues its path of further interest rate increases, as several officials have cited an expectation of rising core inflation. For the last 20 years, investors have been able to rely on bond positions as a significant counterbalance to stock holdings, but periods of high/rising inflation and higher yields generally lead to less diversification benefit from bonds. Though we do expect rates to remain lower for longer due to macroeconomic and demographic forces, we identify the asymmetric risks developing in core fixed income funds and high yield bond markets in Europe and the United States as potential problem areas.
Behavioral economics and finance combine financial theory with psychology to challenge the assumptions of traditional models, and we applaud the recent recognition of the field with Dr. Thaler’s Nobel Prize. In today’s market environment, characterized by Fed-interpretation, passive fund flows, and geopolitical news, the arguments made by the behavioral camp are as important as ever. In this commentary, we analyze household ownership of equities as a proxy for herd behavior, and share analysis showing the relationship between household equity ownership and future returns.
The last several weeks has seen major Hurricanes Harvey and Irma bring incredible destruction to the people of Texas, Florida, and the Caribbean. In the aftermath of these catastrophes, it seems that Wall Street and the investment community at large is obsessed with prognosticating the ultimate impact of the storms on economic growth and the stock market. Not only do we find this type of analysis objectionable in the face of much personal disaster, we find the economic arguments on both sides of the debate lacking; in addition, historical data shows that the analysis is useless regarding the stock market.
Each year, July 31st marks the non-waiver trade deadline for Major League Baseball. For weeks, fans are overwhelmed with rumors about players on the move and teams’ strategies as the deadline approaches. In this commentary, we examine the use of the rumor mill in baseball (including the proverbial “Mystery Team”) and capital markets, particularly in their ability to drive increased value for the holder of the asset (players or stocks). We also discuss two “Market Mystery Teams” that have been prevalent in the headlines over the last few years: OPEC and global central banks.
The strong bull rally over the last 8 years continues to expose the inherent tension between valuation metrics flashing warning signs and technical or sentiment-driven factors leading the market higher. Though valuation is not a tradeable signal over the short-term, we acknowledge its important role in portfolio construction and risk analysis. This month, we delve into the Cyclically-Adjusted Price to Earnings Ratio (CAPE), analyzing its historical significance in forecasting long-term equity market returns, and what the current ratio value may tell us about the level of risk in the market and the opportunity set moving forward.
Global equity markets, and especially the US stock market, have shown remarkable resilience despite elevated valuations and an onslaught of negative news. The last few months have seen increased dysfunction in Washington, rising geopolitical tension particularly saber-rattling from North Korea and increased terrorism in Europe, weak economic growth, and the prospect of the Fed unwinding nearly a decade of stimulative monetary policy. Nevertheless, market volatility sits near historic lows on both an implied and realized basis.
Investors continue to deal with the prevalence of negative interest rates in global markets. Fourteen countries ended April with 2-year government bond rates below 0. The impact of low interest rates on equity valuation is well understood, but it remains to be seen how the push to negative rates will affect equity valuations moving forward.