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A Tipping Point In The Market

This article is more than 6 years old.

If you haven’t noticed, the U.S. markets have been somewhat complacent recently.  The VIX (a gauge of stock market volatility) is at multi-decade lows while the MOVE index (the equivalent index for bond market volatility) is dormant as well.  I expect this will change in the near future.  For starters, the Federal Reserve is finally tightening and wants to put the Fed balance sheet in run-off mode later this year.  What large buyer will have the ability and the desire to pick up the slack and consume nearly $400 billion in Treasury debt?  What interest rate level will be enticing enough to provide such liquidity?  (I imagine much higher.)  I should add that any loosening in fiscal policy by the current administration, which will require even more debt issuance, would produce more supply in Treasuries at exactly the wrong time.

Meanwhile the market remains completely unperturbed as the prevailing thought appears to be that interest rates will remain lower for longer.  Economists are just as complacent about avoiding a recession, despite the flattening yield curve, which typically is a precursor to lower economic growth.  Dave Rosenberg notes that economists that were polled by the Wall Street Journal have actually “reduced their recession odds from 20% a year ago to a mere 15% now”, making this contrary indication even more pronounced.  Rosenberg goes on to state the facts – “Fed tightening cycles in the past have a track record” of leading to the majority of recessions.

Furthermore, liquidity appears to be drying up.  Just look at the options market, which seems increasingly more fragile.  Hanweck Associates, an analytics firm, analyzed that on an average day in March there was zero options activity on about 1,400 individual equities.  Zero.  Can you imagine that?  Inevitably, this lack of liquidity will have a significant negative impact on the equity market, particularly given Hanweck’s analysis also revealed that the bid-ask spread (a barometer for liquidity) has grown 30% wider over the past five years.

Liquidity in the bond market is at risk too.  In addition to the Fed and potential changes to fiscal policy, the bond market could be impacted negatively by other factors.  For example, there is one large tech company (based in Cupertino, California) which has managed to accumulate more bonds (nearly $150 billion in total) than the largest bond index fund in the world.  In essence, if its business for whatever reason were to deteriorate, this one company could negatively impact pricing and liquidity of many different bonds from many different companies if it were forced to sell its bond holdings.  Talk about a run on the house.

Finally, even the most tenured money managers are throwing in the towel.  As hedge fund managers have generated poor returns over the past few years, some of these experienced managers are now capitulating.  Many are abandoning their previously successful fundamental investment processes and strategies in favor of computer algorithms.  Given their career risk has become so acute, the decision to chase the performance and massive flow of funds to these “quantitative strategies”, which is largely foreign to these managers, marks an important inflection point for fundamental analysis.  As money manager Rich Bookstaber has written, “If you can model it, you’re wrong.”

Since the financial crisis, quantitative easing and artificially low rates have been the constant in the market.  That is now changing.  Fundamental investment strategies and processes that have worked for decades will once again prove essential to performing well in this market.  When the algorithms are in charge with their inherent circular reasoning, perniciously, selling begets selling.  We all know the havoc that computer models can reap on a market, whether it was Long-Term Capital Management in 1998, or the decline that was compounded from portfolio insurance in October 1987.

Fear is now low in stocks and bonds, which I expect will change for the reasons stated.  I believe we are at an inflection point as the Fed is moving from an easing to tightening phase where stock correlations break down and equities become valued based on their individual merit, much like I experienced in the early 2000s.  I have held hefty cash balances to maintain cushion and optionality in these markets, while any exposure to fixed income has been short in duration and high on the credit quality scale.  On the equity side, I recommend remaining largely defensive in stocks and sectors that are less sensitive to economic cycles.  It is also very important to remain disciplined on valuation and focused on cash-generating businesses with solid balance sheets, top tier management teams with a proven track record that are incentivized to meet meaningful value-enhancing goals.  Above all, this is a time to ignore mainstream opinion and focus on risk management.  Investing can be a lonely sport, but I have found it most rewarding exactly at these times.