Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

July 2014

“We’re willing to sleep less, but perform better”—brave-sounding but dangerous words when coming from a fund manager aiming to enhance his results marginally by departing from the narrow path of investment and embracing the siren call of derivatives and other products of financial “innovation.” We have seen this before—AIG anyone? This time, big funds and other investment institutions are hoping to profit from their trading expertise and asset bases by selling protection against that bugbear of the investment world, “volatility.”

Volatility, of course, refers to the tendency of security prices to move up or down unpredictably and sometimes violently. We have never really understood Wall Street’s obsession with the simple tendency of financial asset prices to vary. As (the original) J.P. Morgan is purported to have said, stocks “will fluctuate.” Perhaps it is our idealism that leads us to believe that genuine investing is not very concerned with short-term price movements; in any case, their impact can be mitigated through simple measures such as appropriate diversification and, importantly, not over-paying.

In the hyper-competitive fund management world in which “performance” is monitored with equally hyper frequency, fluctuations can be damaging to careers, not to mention to that critical figure, “AUM” (“assets under management”). Heaven forbid that a fund manager be caught in a downdraft at quarter’s end, just in time for those all-important performance reviews. Hence, the desire arises for protection against the vicissitudes of the market, and the demand for products that promise to reduce this “risk.” Naturally, Wall Street is always ready with services to meet these needs.

The demand for volatility “insurance” comes at a time of unusual market calm in both the equity and fixed-income realms. Economic recovery, low interest rates, central bank monetary stimulus, and an abundance of cash in the system are some factors that have contributed to a dampening of animal spirits in the markets. While some traders, including hedge fund managers, complain about the lack of opportunity for profits in an environment where prices do not change very much, others have expressed alarm, seeing a “calm before the storm” situation that could change without warning. Hence, there is considerable demand for protection against turmoil at time when it doesn’t seem all that necessary.

The problem with selling insurance when the perceived need is low is that it can be difficult to obtain a price, or “premium,” that is commensurate with the risks being assumed. In fact, prices are frequently depressed at such times. Further depressing the market for volatility coverage is the growing supply, as big pension and mutual funds show growing interest in the area. New exchange traded fund (“ETF”) products are also bringing on new “capacity,” to employ a term used in the traditional insurance business. Low returns from traditional investments such as bonds are providing the incentive for these pools of capital to enhance their results through non-traditional means, much as stockowners might write options against their portfolios to generate additional income. The risk facing the writers of volatility insurance is that they are pricing their products too low, and when normal market volatility eventually returns, they could potentially face big losses.

(As an aside, similar incentives explain why so-called “catastrophe bonds” are a bad idea, at least for buyers. “Cat bonds” are issued by insurance companies to spread their liability for losses in case disasters occur. Such bonds are typically sold on the basis of their relatively attractive yields, but their principle can be impaired by an insurance liability. Cat bonds sell well at times when yields on alternative investments are meager, and when the insurance industry hasn’t had a bad year for a while (i.e., “volatility” has been low). Given a big enough disaster, however, and catastrophe bonds can easily live up to their name.)

It is unclear the extent to which funds are engaging in these non-investment practices, or how much such undertakings have influenced reported returns, but they could be sizable; the Financial Times reports one fund manager as saying that “bouts of underperformance” could occur if the markets turned sour. In this light it is noteworthy that financial regulators are currently debating whether big players in the asset management business should be designated as “systemically important financial institutions,” a move fiercely opposed by the fund industry because it would mean tighter oversight and more regulation. Given the experience of recent years when banks and insurance companies strayed far from the straight and narrow path, perhaps the new activities of the big fund groups warrant this closer scrutiny.

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“Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.” This well-known remark by fund pioneer John Templeton epitomizes the “contrarian” approach to investing: opportunities are most abundant when least wanted, and most sought after when they are not really opportunities at all, but instead good candidates for liquidation. In other words, you should zig when others zag. There are at least a couple of problems with contrarian thinking, however. Pessimism about the general market or a particular security does not guarantee that a genuine bargain exists; contrarianism needs to be qualified by analysis. Furthermore, periods of intense pessimism tend not to last very long—what happens during those not-too-hot and not-too-cold times when money has to be invested? “Just right” doesn’t count in this business.

Take the current state of affairs in the equity markets, for example. Despite the steep rise from early 2009, the current period is difficult to characterize, as the conflicting market commentary one sees in the media confirms. Clearly the time of greatest pessimism is long past, but neither do the markets appear engulfed in a surge of euphoria, or even optimism—stocks have advanced steadily, but they have also “climbed a wall of worry” in the process, overcoming many doubts. A few sectors such as biotech have attracted intense interest, but overall excitement appears tempered, perhaps due to geopolitical unrest and fears of central banks’ reigning in of monetary stimulus.

Beyond these considerations of market sentiment, valuation measures also present a mixed picture of current conditions. The so-called “CAPE” index (the “cyclically adjusted price-earnings ratio”) has drawn considerable attention, and at 26.5 it now stands at levels previously associated with extreme market events. Yet the CAPE stood at similar heights or higher in the late 1990s and early 2000s when, paradoxically, many opportunities appeared for investors, despite the tech bubble. More traditional valuation measures based on trailing or prospective earnings are approaching 20, the higher end of a “normal” range—expensive, but not outrageously so. Other broad market measures also tend to reinforce the conclusion that stocks in general are “uninteresting” at best. Finally, valuations for individual companies based on their “normal” earning power are not excessive in many cases, even if they are not attractive for investment.

On the other hand, bond valuations remain quite inflated. Average “junk” bond yields fell below 5% for the second time in history (the first being in May, 2013, just before last year’s bond market rout), reaching an all-time low of 4.9% in mid-June. A bond rally in Europe has in a few cases brought about some of the lowest rates on sovereign debt in centuries. Spain, whose borrowing costs sky-rocketed two years ago on fears of default and exit from the Eurozone, now sells debt at yields less than those of comparable U.S treasuries, a remarkable turnaround for a country whose economy was devastated by a real estate collapse and which still suffers from high unemployment. We believe, as we have for quite some time, that any future financial market convulsion is likely to emanate from some corner of the bond market.

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The future has been proven wrong once again this year. Six months ago investment “strategists” predicted rising interest rates and falling commodities during the first half of 2014. Instead, rates dropped and long-term U.S. treasury bonds have produced a “total return” (income plus price change) of about 13%, more than double that of equities at around 6%. Still, the year is far from being over and 6% isn’t too shabby for six months in the stock market. Commodities confounded expectations with indexes gaining about 8% as oil prices rose in spite of rising U.S. production, and gold rebounded after slumping in 2013. So much for the value of investment strategy—which is why we ignore it.

When it comes to the future the best policy is to protect against it, not bet on it—prediction is a very thin basis for committing scarce funds. Only a proven record and demonstrable value can provide the confidence that our capital is protected whatever course events may take.

 

Dennis Butler, MBA, CFA