Opinion: This Ends Poorly

Investment Portfolio Diversification
August 9, 2017
Florida Retirement System Investment Plan
August 19, 2017

It seems that the time is nigh for individuals who will eventually depend on the assets that they have invested to seriously consider the potential near to intermediate-term outcomes if they maintain their current allocations.

The world is an exceptionally risky place right now, and domestic equities do not seem to fully reflect even front-page event risk.

I, for one, hope that any sort of conflict between the U.S. and North Korea can be averted. Regardless of how low the probability of a significant conflict is, it seems that the securities markets around the globe are taking the threat with an outsized grain of salt. Panic selling is hardly ever the best financial tactic, so why shouldn’t the world be commended for its steadfastness in the face of potential calamity?

Context is Everything

Were equities fairly valued for future growth, or even slightly overpriced, relative to historical prices, it might be more worthwhile to stretch for additional returns. This is because it might be assumed that equity prices can only revert back to some intrinsic value – like net current assets, for example – in the event of a negative catalyst emerging. In other words, the fall from a second story window might be more survivable than the fall from a third or fourth story window.

However, this is not the case now. As I mentioned in a previous article, Care About CAPE?, domestic equity valuations do seem to be getting rather stretched. As it stands, there is no shortage of fundamental metrics to indicate that domestic equities are expensive relative to historic valuations.

Like it or not, fundamental measures of relative historical valuation do still matter. No, they might not portend near-term shifts, but they should be folded in to a broader analysis which might shape opinions about the near-term.

Unlike investments in debt securities, where, as long as the debtor doesn’t default on its obligations, a timetable can be applied to being made whole, the value of assets invested in overvalued equities – even in comparatively solid companies, but with overpriced shares – can evaporate in short order with no promise of returning to its previous value, even if the company survives long into the future. This being the case, when equity valuations get stretched, it is arguably more important to survey the terrain for bumps in the road than when markets are trading at lower multiples of fundamental valuation.

So, yes, panic selling is bad, but a thoughtful assessment of the value  of what one owns or intends to own in the context of potential future value can hardly be criticized…and might actually prevent panic selling if inventory can be taken while cooler heads still prevail.

Recognize Risk

So, what if this very public bout of sabre rattling did escalate into something material? Who knows?

I have heard some say that if a war broke out, it would be good for the economy. Think of the profits for Boeing, Lockheed, and U.S. Steel, they might say. But what those in this camp aren’t considering are the effects of an attack on Seoul or Tokyo in a truly global economy. Any domestic profits derived from plane, ship, and warhead construction would likely be dwarfed by the immediate economic impact of disruption to major global centers of commerce.

I am concerned by the fact that even a slight misstep between flexing nuclear capable militaries, with nuclear capable allies has a huge number of incalculable and potentially disastrous economic variables.

I am not a stock broker, day trader, or speculator. The people that I work with on a day to day basis need the assets that they have invested to pay for some future obligation. I mention this because it makes sense for a speculator to make bets on a potentially volatile market because that’s where the prospect for making money is highest for the speculator. For the typical objective driven investor, however, real spikes in volatility are where life changing errors are made.

Risk can be boiled down to the unknown. With the known-unknowns presently facing the world, combined with historically high equity valuations, it seems that an acknowledgement of risk should be more evident in securities markets.

We can see from the chart below that the CBOE Put/Call ratio is elevated compared to a couple of weeks ago, but nowhere near high:

We can also see that shifts can often be abrupt and reactionary when the probability of an adverse event is seen as low. So, prior to the most recent U.S. Presidential Election and prior to Brexit, the ratio spiked, as investors decided to buy protection (or speculate) in advance of an impending and time constrained outcome. But in the event of unknowable events not constrained by a deadline, like the equity selloffs in August, 2015 and January, 2016, the purchase of such protection was largely reactionary and impactful.

Why does this matter? If something big were to happen, with equity valuations at these levels, and an apparent underutilization of typical hedging positions, the knock-on effects could be substantial.

Cascade of Concern

Over the last 10 months or so, selling volatility – being on the side of a transaction that makes money if volatility remains subdued – has been big business. Not only has it been big business, but it seems like it would have been an exceptionally profitable business, too. With the VIX remaining historically low through most of the Spring and Summer, those that have taken positions on the short side of volatility have had few opportunities to be priced into humility.

What is really frightening about the chart above is that while the VIX did jump from 10 to over 16 at one point over the course of the last few days, this occurred parallel to a drop of less than 2% in the S&P 500. On a historical basis, a 2% drop is little more than a blip. But investors have grown so accustomed to a low volatility environment, that I shudder to think about the self-feeding cycle of a drop of even 5% in the S&P 500 and the response in the VIX.

But the VIX, in and of itself, shouldn’t have any direct impact on equity prices, other than to alert investors about the sentiment of other investors, which is where the negative information loop comes in. What might be of larger issue are the factors that can directly move markets.

As some are aware, margin debt is on the rise. Although the actual amount of margin debt is a spectacle to behold, little can be gleaned from this number alone. What I believe is more important to consider is the ratio between margin debt and credit balances in margin accounts:

Data Source: NYSE

The current ratio would not be alarming compared to the standards of the Roaring Nineties, but we are at the top end of a range that began just as the Dot Com Bubble was bursting.

Margin debt has the potential to move markets. If a shock were to occur, with the current debt to credit ratio where it is, it is not unreasonable to assume that – depending on the size and duration of the shock – margin calls could eventually begin to force unanticipated selling to a degree that has the potential of triggering more selling for a variety of reasons. Due to the apparent lack of typical hedges, it might not take much downside variance in prices to create some panicky sales to fan the flames of uncertainty.

But What if Nothing Happens?

I hope nothing happens. I hope that markets continue on as usual without any kind of exogenous shock.

However, even in the absence of some specific event, I believe that the apparent complacency of market participants with regard to the treatment of potential event risk compared to the potential reward offered up by equities might indicate that there are systemic issues in general.

That is, what I’m really saying is that the market is exhibiting signs of exhaustion and complacency. So even without a specific event driven catalyst, it might be time for investors to consider the real nature of the risks they are taking, because the actual risk to reward ratio might not be what they imagined over the next several years.

Most retail, and many professional, investors only hear what they are told. When someone hears that markets have reached all-time highs enough times, it begins to affect the way they view markets. When someone hears that corporate earnings are outstanding enough times, they begin to believe that corporate earnings are outstanding.

It’s true that equity markets have been ticking off all-time highs recently, but the earnings haven’t necessarily warranted such heights. Although most earning of the S&P 500 have beaten expectations, expectations are just that. What has seemed to occur over the last several years in the major domestic equities markets is akin to me being expecting to, on average, arrive at work on time, but receiving no dock in pay if I reduce the expectation of when I will arrive at work from 8 AM to 9 AM and meet that expectation; but being rewarded if I am able to make it to work, on average, 10 minutes prior to my diminished expectation.

In reality, 12 Month As Reported Earnings Per Share of the S&P 500 are just now approaching the same levels last seen in September of 2014. Since September of 2014, however, the price of the S&P 500 is up over 25%. So, earnings are less than they were almost three years ago, but the price to purchase the companies generating those earnings has increased by 25%. This seems like something that investors, as opposed to speculators, might want to maintain measured exposure to.

Aren’t You Talking About Market Timing?

I suppose, to some, it looks that way. I believe that what I am talking about, though, is a matter of valuation and risk that happens to be brought up at this moment in time. There are, perhaps, times when we should all consider the value of what we own or buy or sell. At this moment, my plea is really just to those that might not fully understand the risks that they are exposed to, even if the threat of war, or the U.S. debt ceiling, or the next big event passes. With relative valuations high and expanding, event risk is terrifying, but regular old market risk should not be ignored either.

To be clear, my real fear is not imminent war. I am optimistic that the current threat will pass. My real fear is how equity markets are responding – or not responding – to various risks as they appear on the horizon. Investors seem to be too complacent. Investors also seem to have been guided into progressively higher risk investments due to a prolonged low interest rate environment with limited volatility. This is a potentially bad mix.

Unless you believe that you have a firm grasp on the consequences of what even a healthy correction of valuations might look like, you might want to get a handle on what you own and/or what you are buying, or, at the very least, what your eventual intentions are for the assets utilized to own and purchase investments. It is not always safe to assume that the dollars you use to purchase investments today will be there when you need them tomorrow. It is only prudent to be aware of your needs, expectations, and exposure to risk.

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