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Skerritts View - June 2017
Low Volatility Does Not Equal Lower Risk:
There has been quite a lot of discussion recently regarding the low volatility that exists in equity markets at present. We have highlighted previously in this publication how the complacency index is at a historic low, and how we consider that to be a warning sign rather than a consoling one. We view low volatility in a similar vein. The chart below shows that volatility at the moment is at or around the lowest levels that we have seen in the past 45-50 years. What does this actually tell us?
We referred last month to the growth of passive funds being a reflection of a mature bull market, performing well against a backdrop of equities steadily rising over a prolonged period. This is not a criticism of passives at all – we use them extensively within our portfolios – but it pays to bear in mind why one type of investment is performing better than another.
Volatility is similar. A low volatility level such as the one that we are experiencing now is simply a reflection of an equity market that has been rising steadily over a long time period, for as the equity market rises, so volatility declines. Thinking of it another way, you never see a headline proclaiming that “billions have been wiped on” the stockmarket. We are very familiar with the “billions wiped off” version. This is because stockmarkets tend to rise gradually and steadily whereas falls tend to occur sharply and dramatically. This, of course, raises the volatility measure.
And this is why it is very dangerous to associate low volatility with low risk. As the chart indicates, every period of low volatility that we have experienced in the past has been followed by exactly the opposite. Periods of “no more boom and bust” proclamations are invariably followed by boom and bust. Politicians and others become carried away with periods of steady growth, failing to recognise that most are fuelled by an expansion of credit, which normally leads to over-extending lending and borrowing to reckless levels which then precipitate the bust. A period of head-scratching usually follows this.
Today’s complacency therefore should be heeded. We are not trying to forecast when a correction will occur – such forecasts are normally lucky guesses if they are correct – but we should not be surprised if we get one. Trying to time events is notoriously difficult. Many fund managers claim to have been too early in making a move. We prefer to call being too early “being wrong”. We repeat the mantra as well, that it is easy to overestimate what will happen within two years, yet underestimate what will happen in ten. But any investors who regard the current low volatility as being a period of low risk will, in our opinion, be scratching their heads a couple of years from now unless they keep a sharp eye that their exit routes are clear.
So What Can We Be “Too Early” About Next?:
We were right so far about the European elections being a red herring this year, and we’re sticking to that view even though the Tories’ lead has been reduced significantly on the lead in to June 8th. Of course, the polls got it wrong on both Brexit and Trump, but we did not share their complacency and we invite readers to check back on our previous editions to see that it is not just hindsight that is talking. We would be surprised if Europe allowed the small matter of a 6 billion Euro repayment due from Greece at the end of the month to rock the boat. With the German elections the safest call to be made on the continent for the coming months it will not be until the prickly Italian election that alarm bells will ring again across the Channel.
There has been talk of impeachment in Washington. This may be more than a low risk possibility, but is it going to happen in the short term (if at all)? President Trump’s trip abroad has poured some oil on fairly troubled waters at home, but there is surely someone or something standing by ready to ignite it again. In the meantime, however, Trump needs a victory and we think that the Republicans will try their utmost to see tax reforms passed well before mid term elections are due in 2018, even though they have not been as forthcoming as many predicted straight after the election. If reforms are passed either later this year or early next, the Republicans can campaign on how they kept their promises.
Whether it is Donald Trump that is leading the campaign may be irrelevant. Peter Berezin of BCA Research (who correctly predicted a Trump victory) has repeatedly said that “American voters voted for “Trumpism”, not Trump”. If he was to be impeached, it may increase volatility (that word again), but it wouldn’t necessarily cause a run on the market. Bill Clinton’s hardly caused a reaction. In the case of Richard Nixon, the market fell dramatically, but was that because the US was in the midst of a financial crisis of its own between 1973 and 1974 of devaluation of the Dollar and ultra-high inflation?
So, to go too defensive too early just because volatility is low may indeed be equated with being wrong. There is undoubtedly a bit of uncertainty in the markets, but as we said last month, when was anything certain? The more certain that things appear to be, the more likelihood that we’ve become too relaxed and dropped our guard. Having said this though, we can’t see anything insurmountable happening between now and the end of the year, but the hurdles appear to be getting higher the further into 2018 we progress.
Now, is that prediction too early? Time will tell.
Sources BCA Research-May 2017