Martello Headline: Martello Investments recently launched its investment management business. We focus on data-driven, diversified strategies that can participate in upside while protecting investor capital in downturns.
Negative Rates: 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.
Markets: After a brief pause in March, April saw a continuation to the rally in equity markets. Domestic markets flirted with all-time highs despite tepid economic growth, prospects of further Fed tightening, and seemingly endless chaos in Washington. International equities were bolstered by an as-expected result in the first round of voting in the French PM election. Bond markets rallied, with benchmark interest rates falling and credit spreads continuing to tighten.
Negative Rates
The concept of negative interest rates has gripped markets in recent months; there are now 14 countries with negative 2-year treasury yields. Switzerland currently has a negative rate on its 10-year bond while several other countries have 10-year treasury rates under 0.50%. To illustrate the mechanics of a negative interest rate, let’s consider a savings account with a negative rate. Instead of receiving interest on the saver’s balance at the bank, the saver must now pay interest for the privilege of holding their money at the bank. Indeed, the saver would be better off hiding their money under the proverbial mattress, though large corporations and pensions will undoubtedly never find one large enough to hoard all of their cash.
Setting aside the reality of negative interest rates as a market force, viewing them from the perspective of purposeful monetary policy shows the incredible desperation of many countries’ central banks. The purpose of setting benchmark interest rates, or deposit rates for that matter, below zero is to encourage current spending. From a capital outlays viewpoint, a company should use all available cash on any project or investment with a positive expected return in the face of negative interest rates; the opportunity cost is to forfeit money by paying a negative rate. Consumers face a similar choice, deciding whether to pay for deposits or spend their money by frontloading consumption. Furthermore, the negative interest rate should theoretically drive the cost to borrow money to incredibly low levels, further encouraging consumers and businesses to increase debt burdens to spend money today at the expense of future consumption.
A negative market rate, on a treasury bond for example, speaks to an entirely different situation. To be clear, a negative market interest rate is, at once, setting deflationary expectations while also stimulating asset prices. Expectationally, if an investor is willing to accept a negative interest rate, they are implicitly betting that prices will fall, and therefore that a dollar today is less valuable than a dollar tomorrow.
This phenomenon of future cash being more valuable than present cash has troubling consequences for equity valuation. If one views a stock as a claim on the perpetual earnings of a company, the present value of those earnings will ultimately drive what an investor is willing to pay for the stock. A present value calculation is incredibly sensitive to the assumed interest rate. For example, let’s evaluate a hypothetical example of an asset at different interest rates. Assume the asset pays $10 per year in cash flows, and that the terminal value of the asset at the end of 10 years is $100, for a total cash flow stream of $200 over 10 years. In a normal interest rate environment, an investor should be willing to buy that cash flow stream for less than $200 because the value of money in hand is higher than money expected in the future. Indeed, we can see that in the example below, the investor would be willing to pay $185.24 for this cash flow stream at a 1% discount rate. At a -1% discount rate, however, the investor would value the cash flows, totaling $200 over 10 years, at $216.30.
This clearly defies logic, but it is the reality in which a few countries currently reside, and many others could be heading. The problem here is that, if interest rates rise, the claim on these cash flows become significantly less valuable. If the trajectory of global interest rates eventually changes, the timing of which is of course impossible to know, equity markets could come under significant stress. We have seen this once before: in 1965-1975, U.S. bond yields rose significantly, which was accompanied by significant equity market volatility, including drawdowns of 21% (1965-1966), 36% (1968-1970), and 48% (1973-1974).
Markets
After a brief pause in March, domestic equity markets continued their steady upward trend, as the MSCI World Index returned 1.5% for the month. US Large Cap stocks, as measured by the S&P 500 Index, gained 1.0%. US mid-cap stocks, as measured by the S&P 400 returned 0.8% and the Russell 2000 small-cap index finished the month up 1.1%. The headline indices for Europe (STOXX 600) and the UK (FTSE 100) returned 2.0% and -1.3%, respectively. At the sector level, Technology (+2.5%) and Consumer Discretionary (+2.4%) led the way, while a large loss in crude oil sent the Energy sector down 2.9%. After rebounding from a weak 2015 with a strong return in 2016, Energy stocks are again under pressure so far this year, as the sector index has returned -9.4% year-to-date through April.
The S&P 500 wavered throughout the month, with U.S. air strikes in Syria and continued dysfunction in Washington sending the index lower by 1.4% through April 13th. An as-expected result in the first round of the French election calmed markets, though, as the S&P 500 rallied to post a 1.0% gain for the month. Market volatility, as measured by the CBOE Market Volatility Index (VIX), rallied into the mid-month but ultimately faded to close at 12.37, well below the long-run average of 20.
Despite the prospect of an additional rate hike by the Fed, bond market showed continued strength in April. The U.S. 10-year Treasury closed the month 10 bps lower at 2.29%, while the 30-year closed 6 bps lower at 2.95%. High yield credit spreads, as measured by the BofA Merrill Lynch US High Yield Option-Adjusted Spread, tightened by 17 bps to close April at 3.75%. The high-yield bond market has shown particular strength in recent months, as the index approaches recent lows.
The S&P GSCI Total Return Index returned -2.1% in April, dragged lower by Energy and Industrial Metals sub-indices, which returned -3.6% and -3.1%, respectively. The oil market continues to be a source of volatility in the commodity complex, driven by OPEC supply machinations and fluctuations in U.S. production and stockpiles. A mid-April report signaling an unexpected climb in gasoline inventories sent energy commodities sharply lower. Meanwhile, as OPEC attempts to extend its supply cut, the cartel seems unable to tame U.S. shale production, as U.S. oil output is anticipated to rise by more than 860,000 barrels per day in 2017.
Gold, on the other hand, continues to trade up on increased global socio-political risks and a weakening US Dollar. After rallying to over $1,294/oz. into the mid-month, gold faded to close April at $1,269.50/oz. The US Dollar Index traded lower throughout the month to close at 99.04, 1.5% lower than March’s close. The Euro rallied sharply against the USD following the first round of French elections, ultimately closing the month at 1.089 USD/EUR.
Company Update
Martello Investments launched effective May 1. We utilize an adaptive, data-driven approach with an eye towards risk. We build systematic investment strategies that use market data to position our portfolios. By focusing on market trends, volatility, and systemic analysis, we hope to eliminate the emotional pitfalls of investing. This approach can help investors take risk off the table when markets show signs of weakening, while participating in rising markets in the interim.
We are excited to announce that Mark Finn and Bill Grant have joined us as Advisory Board Members. Both Mark and Bill have been important mentors to us through the years and we are pleased to have them on the team. We greatly appreciate and are humbled by the support and encouragement we have received so far.
Sincerely,
Arthur Grizzle & Charles Culver Managing Partners Martello Investments
May 2017 - Markets in a Post-Volatility World
Market Volatility: 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.
Markets: Headline stock indices continued to rally in May. Since the November US election, the S&P 500 is up nearly 15%, and has posted gains in 6 of 7 months. Technology continues to lead the market higher, as the sector index has returned over 20% year-to-date. Bonds have rallied in recent months despite the Fed guiding interest rates higher, as intermediate and long-term treasury yields have fallen meaningfully in 2017. The flattening yield curve has impacted the Financials stocks, which initially received investor interest after the election but have faded in recent months as meaningful reform from Washington seems less likely.
Market Volatility
Structurally, investors can analyze market volatility in two distinct ways: realized volatility (how volatile something has been historically) and implied volatility (expectations for future volatility based on the price of derivatives). In both cases, US stocks have shown dramatically low levels of volatility in recent years. Implied volatility is easiest tracked using the CBOE Market Volatility Index (VIX), which derives its price from the implied volatility of options on the S&P 500 Index. In May, VIX broke under 10 for the first time since 2007. Indeed, there have been only two other periods since 1990 that the VIX reached a 9-handle; one was in late 1993 through early 1994, and the other in late 2006 through early 2007. In each case, the index ultimately re-rated to higher levels, though in only the more recent example of 2006-2007 was this eventually accompanied by lower equity prices.
In realized terms, equities have delivered volatility that ranks among the lowest in several decades. On a five-year basis, the S&P 500 has posted an annualized standard deviation of 9.6%, compared to a long run average of nearly 16%. By comparison, an index of long-term government bonds has produced a five-year standard deviation of 10.2%, which is roughly in-line with long-term averages. So, the headline US stock index has posted lower return volatility than an asset which is considered, at least on a credit risk basis, to be risk-free. The next chart shows rolling 5-year standard deviations for the S&P 500 and a long-term government bond index.
There are a few obvious takeaways here:
Equity markets have delivered realized volatility lower than that of Treasuries only three other times since 1980. Once, in the mid-1980s, was the result of a pronounced rise in interest rates and therefore a sharp increase in bond volatility compared to normal levels of equity volatility. The other two periods were late-2007 and relatively recently in mid-2015.
In absolute terms, recent equity volatility is the third lowest period on record, only exceeded by the bubble markets in the 90’s and 2007-2008.
The series tends to mean-reverting, meaning that low-levels of volatility are generally followed with more elevated volatility and vice-versa.
Since general volatility, as measured by standard deviation, is not a perfect proxy for risk, we also present a chart of realized downside volatility (using downside standard deviation, which only considers negative periods) below. Once again, you can see both the mean-reverting nature of this series, the extremely low levels compared to both history and bond volatility.
As evident in the first chart above, the VIX (implied volatility) can remain low for extended periods of time. The VIX simply reflects expectation about risk in the future, and the price investors are willing to pay to hedge that risk. Therefore, a low level of implied volatility simply reflects extremely bullish investor expectations and indifference towards risk. Similarly, there is nothing to say realized volatility can’t continue to trend lower. Over the last few years, and certainly over the last several months, the equity market has shown a tendency to ignore negative news and rally nevertheless. In fact, during the 15% rise in the S&P 500 following the US election, the market shook off increased dysfunction and potential scandal in Washington, rising geopolitical tensions and terrorist activity, potential political upheaval in developed Europe, the prospect of continued tightening by the Fed, and a very weak 0.7% first quarter GDP growth number out of the US. Even May 2017 delivered lower volatility, even with a 46% one-day gain in the VIX, which was erased in a matter of days.
There are endless potential reasons for the market’s resilience over the last few years, including easy monetary policy by the Fed, ZIRP/NIRP from global central banks pushing investors into riskier assets including stocks, and fund flows dominating the market due to the growing force of passive investors. Perhaps these forces can continue to support the market indefinitely, leading investors into a glorious post-volatility world. However, with the Fed recently announcing plans to unwind its enormous bond portfolio, the “central bank put” could be in question. In addition, flows from passive vehicles could prove a double-edged sword for markets, meaningfully impactful on the way down as on the way up, particularly for funds with significantly mismatched liquidity.
Low volatility does present inherent risks to portfolio construction, particularly for certain types of strategies that use backward-looking volatility metrics for position sizing and risk management. A well-known version of this is a metric known as Value-at-Risk (VaR); VaR’s role in the 1998 LTCM downfall and 2007-2008 credit crisis has been widely covered. Essentially, these types of models rely on, among other things, trailing historical volatility to infer how much a portfolio can lose in a given period. With such a prolonged period of benign markets, these strategies are susceptible to volatility shocks, as complacent investor behavior causes an undervaluation of the real potential losses of the portfolio. The real risk in the portfolio is only realized ex-post, when the volatility environment changes and a market shock occurs. Particularly for strategies with leverage, this could potentially lead to a cascade effect, whereby increased volatility causes further selling pressure, further raising volatility, and so on.
To be clear, we are not forecasting another 2007-2009 scenario, but we are mindful of the dangers from persistently low volatility on investor behavior and portfolio risk modeling, even more so when leverage is added to the equation. Whether this is the calm before the storm remains to be seen; bubbles are always easiest spotted with the benefit of hindsight. However, at a time when valuations are sky-high by most metrics, margin debt remains near all-time highs, and geopolitical risk is rising, we view the historically low market volatility as a potential sign of apathy, not an all-clear signal.
Markets
Domestic stock indices posted mixed returns in May, as political dysfunction and rising geopolitical tensions offset expectations for strong quarterly earnings. US Large Cap stocks, as measured by the S&P 500 Index, gained 1.4%. US mid-cap stocks, as measured by the S&P 400 returned -0.5% and the Russell 2000 small-cap index finished the month with a -2.0% return. International developed stocks, as measured by the MSCI EAFE Index, gained 3.8%, while the MSCI Emerging Markets Index rallied 3.0%. At the sector level, Technology posted a 4.4% gain for the month to bring year-to-date gains to 20.5%. Technology stocks have benefitted by heightened fund activity, with a recent Bank of America study indicating that active funds are overweight technology stocks at record-breaking levels on a relative basis. Energy continued to post weak returns, as year-to-date losses reached -12.5% after a -3.4% return in May. Despite rising US Production, Energy stocks have been weighed down by a falling oil price. Financials also lagged with a -1.2% return, as continued dysfunction in Washington has made investors skeptical that President Trump will be able to enact financial deregulation and tax reform.
The S&P 500 traded quietly for most of the month, with a brief drawdown and subsequent recovery in the mid-month providing the only volatility in May. The Index fell 1.82% on May 17 on reports of President Trump’s interference into an FBI investigation of ousted NSA Director Michael Flynn. The move sent the CBOE Market Volatility Index to 15.59, up over 46% for the day; the move in the VIX was the 7th largest one-day move since 1990, though market volatility ultimately retreated to its previous benign levels to close May at 10.41.
Fixed Income markets were generally positive, with the Bloomberg Barclays US Aggregate Index posting a 0.8% gain for May. After rising to 2.41 by May 9th, the US 10-year Treasury Yield fell sharply to close the month at 2.21%, 8 bps lower than April’s 2.29% close. Similarly, the 30-year closed the month 9 bps lower at 2.86%. High yield credit spreads, as measured by the BofA Merrill Lynch US High Yield Option-Adjusted Spread, were mostly flat for the month, tightening by 1 bp to close May at 3.74%. The Bloomberg Barclays High Yield Bond Index is now up 4.8% YTD, and has rallied over 13.6% over the last 12 months.
The S&P GSCI Total Return Index returned -1.5% in May, as the commodity complex was once again driven lower by the Energy sub-index, which returned -2.6%. After rising briefly on a new trade agreement between the US and China, Natural Gas fell sharply on milder than expected weather and bearish supply data. WTI Crude Oil opened the month at $49.33/bbl. and closed slightly lower at $48.32/bbl. The fall in oil came despite a nine-month extension of production cuts from OPEC, as the cartel attempts to stabilize the price of crude.
After rising to a 3-year high in the months following the election of President Trump, the US Dollar Index has declined steadily in recent months. The rally in the Index, driven by an expectation of Trump’s pro-growth economic agenda and a constrained fiscal policy by the Republican-led Congress, has faded as a string of political scandals has beset the administration and Congress has been as of yet unable to deliver on its promises of reform. The Index, which measures the US Dollar against a basket of 6 foreign currencies, fell 2.1% for the month and is down 5.1% year-to-date.
We’re thankful for the continued interest and feedback. Please feel free to contact us with questions or comments.
Sincerely,
Arthur Grizzle & Charles Culver Managing Partners Martello Investments
June 2017 - Market Valuation and its Discontents
Valuation: 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.
Markets: The equity markets capped off a strong first-half of the year with a solid return in June, though increased hawkishness from Fed and ECB officials caused a slight sell-off in the last two weeks of the month. Technology stocks, leading the market so far in 2017, sold off sharply in June, and volatility markets are showing a tick-up in investor fear regarding the tech sector. Central bankers’ comments were more impactful in the bond market, particularly in short-duration US Treasuries and across the curve in developed Europe, where yields rose significantly. Commodity prices continue to fall, weighed down by a weak oil market.
Market Valuation
I have a friend, whom we will call Jeff, who was (and still is) responsible for running a large family trust at the start of the millennium. It was certainly a different time back then. Stock markets were on an incredible run, screaming to all-time highs as valuations reached record levels. Unproven, unprofitable companies were going public. The idea that technology could change life as we know it was infectious, so much so, in fact, that it caused investors to incorporate new valuation techniques into market lexicon, casting aside mundane metrics such as profit and sales for “eyeball count” and “page visits.” Though the internet would certainly change life as we know it, many failures were left along the way, and the ultimate market crash left many investors’ capital permanently impaired. Jeff never saw it coming. He had invested so much in so many hyped technology stocks and, like so many others, nearly lost everything ignoring the warning signs in search of the next big thing.
It’s been a great market for stocks since the last financial crisis ended. Stock markets have made a string of all-time highs recently while valuations rise toward bubble levels, though not as lofty as during the height of the dot-com bubble. Technology is leading the market higher and investors have once again lost their taste for earnings and cash flow, instead favoring growth over profits, adjusted accounting metrics, and Fed-watching. The market’s resilience over the last few years is certainly astounding, particularly in the midst of continued dysfunction from Washington and increasing geopolitical tension across the world. At the same time, the elevated valuation over the last several years has stirred the perma-bears, those with the singular message that the overvalued market is primed for an imminent crash, from hibernation.
As we have highlighted in previous letters, bubbles and market tops are best spotted with the benefit of hindsight, and valuation is not a catalyst in and of itself. Still, we acknowledge that market valuation has an important role to play in risk analysis and portfolio construction. So, this month we want to explore the current valuations we see today, and what that may tell us about the opportunity set for the coming years.
An extremely bullish equity market exposes the inherent tension between trend/momentum trading and macroeconomic/valuation-driven investing. The recent bull run in the equity market over the past 8 years since the crisis trough in 2009 has been characterized as the most hated bull market ever, in part because the market has remained at elevated valuation levels compared to historical norms for a considerable length of time. Trend-following, valuation-agnostic by definition, is generally used for short-to-intermediate-term market analysis because valuation metrics are generally only useful over long time periods. Though under- or over-valuation may not be a tradeable signal, it can be useful to frame the level of market risk and strategically tilt asset class exposure.
There are many worthy long-term valuation metrics, but for the purposes of this commentary we will focus on the Cyclically-Adjusted Price to Earnings Ratio (CAPE), made famous by economist Robert Shiller in his book Irrational Exuberance. The CAPE ratio is a version of Price/Earnings which uses 10-year average inflation-adjusted earnings to smooth out the impact of cyclical earnings noise. The CAPE ratio has received a lot of press lately, most of which focuses on the level of the ratio relative to historical peaks. The current value (approximately 30) is higher than pre-crisis levels in 2007, and is surpassed only by valuations seen prior to the dot-com bust and the pre-Great Depression levels of the late 1920s.
Visually comparing the CAPE ratio to long-term equity returns shows that the valuation metric has some power at least directionally: high valuation generally leads to lower forward returns, while low valuation generally leads to higher forward returns.
Analyzing CAPE in ranges shows the impact of valuation on risk; lower CAPE valuation ranges tend to de-risk the portfolio in terms of worst observed outcome while higher valuation ranges have more negative worst outcomes. To be clear, these charts show CAPE against 10-year annualized forward returns for the equity market; the current CAPE ratio value (approximately 30) is historically followed by very low long-term returns, even negative in some cases. A 10-year annualized return near or below zero is obviously catastrophic for an investor’s ability to generate wealth.
A notable criticism of long-term ratio analysis is the idea that the market environment is different, meaning that it is not appropriate to compare current equity market valuations to valuations of the past for one reason or another. A common argument cites changes in economic development; the US now, as a leading global economy, certainly justifies a higher valuation compared to the early 1900s when the country was still an emerging market. To accommodate these criticisms in our analysis, we compared CAPE to a 50-year average (45-60 years is sometimes thought of as a super-cycle), which should account for long-term cyclical factors. Once again, it is clear that the average return to investors improves with lower CAPE valuations, but also that the worst observed outcome (Min Return) is more favorable in lower valuation environments. Note that the current CAPE level is about 1.2 standard deviations above the 50-year average, though its historical significance is likely clouded by the dot-com bubble, which was a 4+ standard deviation event at peak, pulling up the average and standard deviation of the series (the 50-year average of the series was around 15 in 1995, but it currently approaches 20).
Similarly, a ratio like CAPE does not incorporate the new low interest rate and accommodative central bank paradigm. Skeptics argue that historically unprecedented interventionist policy from global central banks means valuation should be higher on a relative value basis when compared to the low yields available in the bond market. Surely there is merit to this argument with the Fed and ECB keeping rates low, and the Bank of Japan going so far as to purchase equity funds as part of its quantitative easing program. A consequence of these low-rate policies is, of course, to push investors into riskier asset classes, such as equities, in the search for an adequate portfolio return.
To paraphrase an old saying…nobody rings a bell at peak valuation. As you can see from the previous charts, the market has spent the overwhelming majority of the last 30 years in overvalued territory despite several significant drawdowns during that period. Not only that, but the market has shown the capability to push the multiple to much higher levels in the relatively recent past. Whether the market will experience a valuation-driven drawdown is unclear; the ratio is not necessarily signaling a crash, but lower forward returns in general. In fact, CAPE could potentially fall despite a steadily rising equity market if corporate earnings continue to grow, inflation remains tame, and the impact of the 2007-2009 crisis begins to fall out of the ratio’s denominator (which, as explained previously, uses 10-year inflation-adjusted earnings). Indeed, valuation metrics have little ability to predict short-term market returns. The correlation between longer-term returns and valuation, however, is undeniable, as is the level of risk with the level of valuation.
As we stated previously, valuation in and of itself is not a catalyst. Ultimately, the market will likely only re-rate lower in a significant way with the presence of a negative catalyst. Benjamin Graham’s value investing principles utilize valuation as a margin of safety: lower valuation equals higher margin of safety and vice versa. We think this applies to the market at large as well; negative catalysts are softened in lower valuation regimes, while higher valuation regimes exacerbate them. And, in the world we live in, where potential negative catalysts abound, we advocate a cautious, vigilant approach.-A.G.
Markets
Domestic stock indices continued this year’s strength in June, though hawkish signals from central bank figures caused a slight sell-off in the second half of the month. US large-cap stocks, as measured by the S&P 500 Index, gained 0.6% to bring year-to-date gains to 9.3%. US mid-cap stocks, as measured by the S&P 400 and the Russell 2000 small-cap index gained 1.6% and 3.5% for the month, respectively. International developed stocks, as measured by the MSCI EAFE Index, posted a small loss of -0.1%. The MSCI Emerging Markets Index, which has gained over 18% in the first half of the year, rallied 1.1% in June. At the sector level, financials led the way with a 6.4% return in June, as Congressional leaders signaled a continued interest in pursuing deregulation, particularly a restructuring of capital requirements under Dodd-Frank. In addition, the Federal Reserve announced in late June that, for the first time in seven years, all 34 of the country’s largest banks passed the annual stress test mandated under Dodd-Frank. This led the way for approval of the banks’ plans to return capital to shareholders via dividends or share buybacks. The technology sector, which has led the market higher to start the year, was a laggard in June, posting a -2.7% return for the month.
The S&P 500 traded up over 1.8% through June 19th before selling off 1.2% through the month-end after the US Federal Reserve raised interest rates and outlined plans to reduce the size of its balance sheet and European Central Bank (ECB) head Mario Draghi signaled optimism about inflation in the Eurozone. Market volatility, as measured by the CBOE Volatility Index (VIX) trended higher throughout the month, closing at 11.18 after opening the month at 10.41. The VIX, which remains well below long term averages, has received increased interest in recent months as investors pile into exchange-traded products that attempt to track the index. Though headline volatility remains benign, elevated levels of volatility are appearing in other areas of the market, most notably in technology stocks. The VXN, which tracks volatility of the NASDAQ 100 Index, rose 36% in June after a 12% rise in May, signaling rising investor fear in the technology sector.
Fixed income markets were generally weak in June, with the Bloomberg Barclays US Aggregate Index posting a -0.1% return for the month. Government bond interest rates generally rose in the US in Europe after hawkish comments from Fed and ECB officials. In the US, the 10-year Treasury yield rose 9 bps to close the month at 2.30%, though the 30-year yield closed the month 3 bps lower at 2.83%. The short-end of the curve rose sharply, with the 2-year Treasury yield rising from 1.28% to 1.38% in June. Mario Draghi’s comments were particularly impactful to government bonds in Europe, as the German and UK 10-year bond yield increased 16 bps and 21 bps to 0.46% and 1.26%, respectively, in June.
The S&P GSCI Total Return Index returned -1.9% in June, bringing year-to-date losses to 10.2%. The commodity complex continued to be weighed by falling energy prices. WTI crude oil opened the month at $48.63/bbl., and traded lower to $42.53/bbl. by June 21, before rallying sharply to close the month at $46.33/bbl. US drillers continue to increase production, Libya and Nigeria have increased production after war and terrorism related slowdowns, and OPEC struggles to find consensus on further production cuts. The precious metals sub-index also struggled to a -2.8% return in June as gold, which trended higher by over 7.7% to start the year, sold off in June to close the month at $1,241/oz.
The US dollar continued its slide against most major currencies in June, leading to a -1.4% return for the US Dollar Index, which measures the US dollar’s value against a basket of 6 foreign currencies. The only weaker currency was the Japanese yen, as Bank of Japan officials signaled a continued commitment to accommodative policy at its June meeting. After falling sharply in the wake of the US election, the Mexican peso has rallied over 13.8% against the US dollar in 2017, as the administration’s stance toward Mexico has softened in recent months.
We’re thankful for the continued interest and feedback. Please feel free to contact us with questions or comments.
Sincerely,
Arthur Grizzle & Charles Culver Managing Partners Martello Investments
July 2017 - The Market Mystery Team
Market Mystery Team: 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.
Markets: After a strong first half of 2017, headline equity market indices rallied across the board in July, led by continued strength in the Emerging Market Index, which has gained over 25% this year. Technology stocks continue to lead domestic markets higher, and after a significant move in recent months, implied volatility in the tech sector fell in July. Dissention in the Fed over the pace of rate hikes sent the US Dollar lower and steepened the US Treasury yield curve. Oil, after struggling for several months, rallied sharply on cooperation within OPEC, including export cuts by Saudi Arabia.
The Market Mystery Team
The end of July marks one of my favorite times of year, the non-waiver trade deadline for Major League Baseball. When I was a teenager, my dream job was to be a baseball general manager, the front office executive that basically controls the team’s roster, transactions, and minor league player development. The non-waiver trade deadline generally brings a flurry of activity, where contenders stock up for the playoff push while weaker teams look to stock their farm system with prospects for the future. For the weeks leading up to the deadline, I check the league news more often than I’d care to admit, awaiting news of a pending blockbuster that changes the shape of the league for years.
As I’m sure many of you can imagine, news around the trade deadline is dominated by the rumor mill. Each day brings reports of players that will certainly be traded or that a team is prepared to deplete their minor league system of all prospect talent in search of a player to help the team to a playoff berth this year. In many cases, not only does the rumor not come to fruition, but team executives claim there was no basis to the claims at all. In recent years, the rumors have taken on a more interesting shape with the creation of the “Mystery Team.” The “Mystery Team” is exactly what it sounds like, a team that is in on a trade or player that is unidentifiable for some reason. An example headline, unbelievable as it might be, would be “An unidentified team joins the Orioles and Pirates in pursuit of Charlie Culver, Pitcher for the Green Sox.” This obviously fake headline does highlight the winner in the Mystery Team report, though, as the Green Sox. Logically, the presence of a Mystery Team in this case only helps the Green Sox, who are seeking to drive up interest in their pitcher to improve their return. This incentive has led many baseball pundits to suggest that the concept of a Mystery Team has been invented by teams seeking to start a bidding war in trade discussions, or by agents looking to drive up the value of their players.
Markets seem to have their own Mystery Teams these days, and more and more market action seems to be dominated by the rumor mill. We have seen several clear examples of this over the last few years, particularly in stories surrounding central bank activity, OPEC’s plans, and the machinations of activist “investors.” Much like the Mystery Team in baseball, the nature of the rumors makes clear who stands to gain. Take the oil market, for example, which has taken some painful losses since the start of its most recent drawdown in 2014. Many factors have contributed to the collapse in crude prices: low global inflation, the strength of the U.S. dollar, the new dynamics of shale and hydraulic fracturing technologies, and significant production growth in the United States. Furthermore, the Organization of the Petroleum Exporting Countries (OPEC) has shown itself unable to stabilize oil prices, and splinters are forming in the cartel. With each jog lower, the rumor mill begins to spin, primarily around OPEC’s production and whether the cartel will further curtail output in effort to stabilize prices. It is clear that these types of rumors have a primary motivation: to change investor attitudes about oil, which might drive the price up in the short term. Who may have started the rumors, the ones that benefit OPEC member nations above anyone else? Analyzing it in the same incentive framework as the baseball Mystery Team above leads to only one conclusion: OPEC is the Mystery Team.
Like the crafty general manager using a Mystery Team to bid up the price of a trade, rumors in the market have a similar motivation. The greatest Mystery Team of them all is the global central banks. As the developed world continues to battle structural deflation caused by over-indebtedness, aging populations, the diminishing impact of stimulus, and the falling productivity of credit, leading global central banks continue to fight back with accommodative policies. Over the last few years, suggestions that the central banks (the Federal Reserve, particularly) might reduce their accommodative activity has been met with episodic bouts of volatility and modest sell-offs in the equity market. Even worse, for several years the US market was stuck in the “good news is bad news” paradigm, whereby good news about the economy was interpreted as poor news for the market, if only because it would encourage the Fed to taper. Inevitably, the Mystery Team stood ready to greet the market in the midst of these tantrums; each benign move lower was met with a rumor (or outright comment by a Fed official) that accommodative policies might persist.
In baseball, the ultimate consequence of the Mystery Team rumor is at least a partial disregard of it; as I stated earlier, it is generally accepted that at least some of the Mystery Team reporting is caused by the interested agent or team trying to create additional value in its player. In the market, however, the consequence of these rumors is a phenomenon known as the “central bank put”, the idea that central banks will intercede in any negative market event to stabilize investor sentiment and ultimately prices. This causes investors to bid up the price of equities and implied volatility to plummet (see our May commentary titled “Markets in a Post-Volatility World”). Recent months, however, have seen the Federal Reserve signal its intent to unwind its bond portfolio. How global markets might respond to this unwinding is unclear; on one hand, it signals at least some level of confidence in the economy, even though recent Fed minutes show tension about rate hikes given the benign level of inflation. On the other hand, the “central bank put” has at least somewhat helped support the market, meaning recent Fed actions could call that support into question. Put another way, when the Mystery Team is removed from the equation, what happens to the value its existence helped create?
Markets
Domestic stock indices rallied again in July, shaking off a jog lower at the end of June to continue this year’s strong run. US Large Cap stocks, as measured by the S&P 500 Index, gained 2.1% for the month, while the Russell 2000 small-cap index rallied 0.7%. Small cap has lagged large cap so far this year, with the Russell 2000 gaining 5.8% year-to-date compared to a 11.6% gain for the S&P 500. Emerging Markets led the way, with the MSCI Emerging Markets Index gaining 6.0% in July to bring year-to-date gains to 25.8%. At the sector level, each S&P 500 sector index posted gains for the month, though Technology continued to lead the market with a 4.3% gain in July. After rallying sharply in May and June, the NASDAQ 100 Volatility Index (VXN) fell nearly 10% in July, as recent fears of forthcoming volatility in the technology sector appears to have abated for now. Similarly, headline market volatility, as measured by the CBOE Volatility Index (VIX), fell 8.2% to close July at 10.26, near record lows.
Fixed Income markets rebounded from a weak June to post gains in July, with the Bloomberg Barclays US Aggregate Index rallying 0.4% for the month. The US Treasury yield curve steepened in July, with the 2-year Treasury yield falling 2 bps to 1.35%, the 10-year Treasury yield rising 2 bps to 2.29%, and the 30-year Treasury yield rising 9 bps to 2.90%. High yield credit spreads, as measured by the BofA Merrill Lynch US High Yield Option-Adjusted Spread, tightened 16 bps to close July at 3.61%, though the Index tested its 52-week low during the month. Bond yields in Europe were mixed, as June’s sharp rise in German yields continued in July, though yields in the UK fell modestly.
The S&P GSCI Total Return Index gained 4.6% in July, as a rebound in energy prices bolstered in the commodity index. The GSCI Energy sub-index gained 8.1% on strong rallies in Gasoline [+12.4%], Heating Oil [+12.2%], Gasoil [+11.8%], and Crude Oil [+8.6%]. WTI Crude Oil, which has fallen 14% year-to-date through June, gained nearly 9% in July to close the month at $50.17/bbl. The main driver of July’s crude bullishness were reports surrounding the OPEC meeting at the end of July. At the meeting, Saudi Arabia pledged to limit exports while Nigeria planned to cap production at 1.8 million barrels per day. Saudi Arabia’s export cuts are seen mostly as an attempt to offset increased production from Libya and Nigeria, which continue to ramp output after years of war and terrorism. Still, US crude production continues to trend higher, and several countries including Iraq, OPEC’s second largest producer, continue to violate the cartel’s agreement to reduce overall output. After a pause in June, the Precious Metals sub-index gained 1.9% in July, as investors flock to gold as a safe-haven asset. NYM Gold rallied $34/oz. in July to close the month at $1,275.40, nearly 11% higher on a year-to-date basis.
The US Dollar faced continued pressure in July, as the US Dollar Index fell 2.9% on the month. The Index, which measures the US Dollar’s value against a basket of 6 foreign currencies, has fallen over 9% year-to-date after posting gains in each of the previous 4 years. The USD has trended lower on continued political turmoil in Washington, with the GOP’s latest failure to pass healthcare reform sending the greenback lower. In addition, the most recent Fed minutes show dissention on the pace of rate hikes, as growth and inflation remain sluggish, which put further pressure on the currency.
We’re thankful for the continued interest and feedback. Please feel free to contact us with questions or comments.
Sincerely,
Arthur Grizzle & Charles Culver Managing Partners Martello Investments
August 2017 - Hurricanes and the Market: Who Cares?
Hurricanes: 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.
August Market Recap: Equity markets were mixed in August, with the S&P 500 posting a modest 0.3% gain. Emerging Markets and the Technology sector were leaders for the month, while Energy stocks and small cap lagged. The market also endured two significant VIX spikes in August, including the 9th largest one-day percentage move in the VIX since 1990. Fixed income market indices generally rallied, though high yield credit spread expanded on bearish reports from several banks and investment managers. Expectations for damage to Texas refineries sent oil prices lower and gas prices higher. The US Dollar continued to fall, and is down 9.3% year-to-date.
Hurricanes and the Market
As surely all of you know, this season has thus far brought two major hurricanes to the US. The first, Harvey, made landfall in southern Texas as a Category 4 and is widely considered to be the wettest Atlantic hurricane on record. The second, Irma, hit the Florida Keys as a Category 4 in mid-September, turning northward and raking the entire state of Florida. As of the time of this writing, the combined death toll from Harvey and Irma approached 100, and residents of Texas and Florida are assessing the damage before beginning the lengthy process of rebuilding. Still, typical for these types of disasters, the days following the hurricanes saw a barrage of reports from big banks and investment companies discussing the potential impact of the storms on the economy and the stock market. These reports are filled with statistics about the size of the Houston economy (fourth largest in the US) and estimates for how much the storm might drag down GDP in the short-term or, even worse, how natural disasters are a boon to the economy because of the stimulative impact of increased spending during the recovery period. These are the same clowns that argue that war is good for the economy because of increased defense spending (never mind the death and destruction). Putting aside the actual economic argument of the hurricanes for now, this is the type of cold, detached analysis that causes people to despise Wall Street and the investment industry in general. A line from the fictional Ben Rickert in the movie The Big Short rings true here:
“You know what I hate about…banking? It reduces people to numbers. Here's a number - every 1% unemployment goes up, 40,000 people die, did you know that?”
This is more personal for me than most; I grew up in the Florida Keys, where dealing with hurricanes is an annual ritual, and where Hurricane Irma made landfall last weekend. I appreciate the good wishes I received from many of you over the last week. My family was fortunate this time, as everyone is safe and property damage was minimal. Others were not so lucky, particularly the Middle and Upper Keys not to mention the people of the worse-hit Caribbean islands. In the wake of these events, I wish analysts on Wall Street and the financial advisory community could show some restraint. I would be willing to bet that not a single person in Texas or Florida that has lost a loved one, a home, or a business due to Harvey or Irma cares about the impact of the storm on GDP growth and the stock market.
There are many reasons to not trust disaster-focused economic or market analyses, not the least of which is that the theories underpinning them are debatable at best, and more likely unknowable. The arguments on both sides are clear. The “pro-natural disaster for growth” camp argues that the economy will receive a short-term boost caused by the stimulative impact of increased spending as communities rebuild and, funded by insurance payouts, the injection of funds into the real economy will increase the velocity of money, further improving economic growth and boosting inflation. The “anti-natural disaster for growth” camp points out that increased spending caused by hurricane recovery efforts, while providing a short-term boost to growth, is just robbing future spending and growth, washing out the overall impact (pun not intended). In addition, the reduction in income and discretionary consumption at least partially offsets the “positive” impact of recovery-related spending. As I said, these theories are debatable at best and ultimately matter little; economies are highly complex adaptive systems, making it essentially impossible to evaluate the impact of any specific underlying factor at any specific point in time.
Not only that, but regarding the stock market, the analysis is, in fact, completely useless. The truth is that the costliness of hurricane damage and its estimated impact on GDP (either positive or negative) have zero effect on the market. Below find a table of the costliest US hurricanes since 1979 and the returns of the S&P 500 in the months following the end of the storm. The most glaring conclusion to draw from this data is that the market, on average, delivers returns roughly in line with historical averages following the landfall of an extremely destructive hurricane.
The point, however, is not to search for meaning in the movements of the stock market following a natural disaster; it is, in fact, to do the exact opposite. There is much to be done in the aftermath of such catastrophes. The destruction in Texas from Harvey is saddening, and early reports from the Keys are grim. FEMA estimates that a quarter of the homes in the Keys are destroyed, and full recovery will likely take months, if not years. I know several organizational efforts underway throughout the state to collect, ship, and distribute supplies to people in need in the Keys. I will participate in these, and am happy to pass on information for others looking to help as well.
-A.G.
Markets
Domestic stock indices were mixed in August, and this year’s trend of large cap stocks outperforming small cap continued. US Large Cap stocks, as measured by the S&P 500 Index, gained 0.3% for the month, while the Russell 2000 small-cap index returned -1.3%. Year to date, the S&P 500 has gained 11.9% compared to a 4.4% gain for the Russell 2000; on a rolling 8-month basis, small cap is underperforming at the worst rate since April 2016, when the market was rebounding from correction levels. International developed stocks were flat, while Emerging Markets, as measured by the MSCI Emerging Markets Index, rallied 2.3% for the month to bring year-to-date gains to 28.6%. At the sector level, Technology stocks led the market with a 3.5% gain, bringing year-to-date gains to 26.6%. Energy lagged the market with a -5.2% return, as a weak oil market continues to weight on the sector. Market volatility, as measured by the CBOE Market Volatility Index (VIX) finished the month only slightly higher, closing August at 10.59 after closing July at 10.26. The market, however, endured two significant volatility spikes intra-month, a 44% spike on August 10th and a 32% spike on August 17th. The August 10th spike was the 9th largest in the VIX on record, which is significant given the equity market’s return for the day (-1.45%) was relatively benign compared to returns in similarly dramatic VIX spikes.
Fixed Income markets delivered solid returns in August, with the Bloomberg Barclays US Aggregate Index rallying 0.9% for the month. The US Treasury yield curve flattened in August, with the 2-year Treasury yield falling 4 bps to 1.32%, the 10-year Treasury yield declining 17 bps to 2.12%, and the 30-year Treasury yield falling 17 bps to 2.72%. High yield credit spreads, as measured by the BofA Merrill Lynch US High Yield Option-Adjusted Spread, rose 24 bps off of historically low levels to close August at 3.85%. High yield spreads were impacted by bearish reports from several large banks and investment managers citing significant compression in yield on low credit-quality companies. Recently, Bank of America highlighted European High Yield bonds in particular, which now trade at similar yields to US Treasury bonds.
The S&P GSCI Total Return Index returned -0.8% in August, as falling prices of oil and agricultural commodities weighed on the index for the month. Hurricane Harvey significantly impacted the energy market in August, as the anticipated damage to refineries in Texas caused refined products to rally, with Gasoline [+12.7%], Heating Oil [+4.4%], and Gasoil [+3.2%], each posting gains on the month. At the same time, Crude Oil prices fell for the month, as damage to refineries could impact demand for oil in the short-term. West Texas Intermediate (WTI) Crude Oil opened the month at $50.17/bbl. and traded down through August to close the month at $47.09/bbl. Agricultural commodities Soybeans [-6.1%], Corn [-7.0%] and Wheat [-13.3%] fell sharply following a report by the US Department of Agriculture (USDA), which forecasted supply higher than expectations. Geopolitical tension and uncertainty about the timing of Fed tightening was a tailwind for Gold and Silver, which posted monthly gains of 3.9% and 4.3%, respectively.
The US Dollar continued to weaken in August, with the US Dollar Index falling 0.2% in August. The Index, which measures the US Dollar’s value against a basket of 6 foreign currencies, is now down 9.3% year-to-date, as expectations of spending cuts by the new Republican regime have faded and investors question the pace of tightening by the Fed.
The US Dollar continued to weaken in August, with the US Dollar Index falling 0.2% in August. The Index, which measures the US Dollar’s value against a basket of 6 foreign currencies, is now down 9.3% year-to-date, as expectations of spending cuts by the new Republican regime have faded and investors question the pace of tightening by the Fed.
Sincerely,
Arthur Grizzle & Charles Culver Managing Partners Martello Investments
September 2017 - Greed, Fear, and Fallacy
Greed, Fear, and Fallacy: 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.
September Market Recap: The S&P 500 capped off a strong third quarter with a 2.1% gain in September. The quarterly gain of 3.96% was the index’s eighth consecutive quarterly gain, the fifth longest streak on record. Energy stocks benefitted from rebounding oil prices, while Utilities struggled. The Federal Reserve announced plans to begin unwinding its bond portfolio, which sent interest rates higher in the US and Europe. The Fed’s announcement caused the US Dollar to strengthen against most currencies and weighed on inflation-sensitive metals, including Gold, which traded down 3.3% for the month.
Greed, Fear, and Fallacy
Earlier this month, Richard Thaler received the Nobel Prize in Economics, and his recognition was long overdue. In a world where conventional economics is driven by simplifying assumptions — assumptions like “markets are efficient” and “investors are rational” — Thaler’s contributions to the field as one of the founding fathers of behavioral finance bring a realistic perspective. The underlying principles of behavioral finance, blending financial theory with psychology, accept the emotional and cognitive biases of most investors. Instead of assuming investors are rational, Thaler and others acknowledge that, on the contrary, most investors are irrational, emotional creatures that are driven by a combination of greed, fear, and fallacy, and that it is these behavioral issues that can cause bubbles and overreactions.
Despite tidy econometric models that peg investors as rational creatures, we value the contributions of the behavioral camp; we believe that emotions and irrational decision-making tend to govern investor behavior, oftentimes to the detriment of the investor. There are numerous behavioral biases prevalent in investing; some of the more notable include loss aversion (losses are generally 2-3X more painful than the positive feelings associated with similarly sized gains), confirmation bias (only pay attention to opinions that agree with you), and endowment bias (what we own is more valuable than what we don’t). Ultimately, these behavioral fallacies can result in investors buying high (chasing) and selling low (out of frustration and fear), the consequences of which are long-term wealth destruction.
One of the key concepts in behavioral finance is called herding, which is the tendency of individual investors to follow the actions of a larger group. Herd behavior happens because people implicitly trust the collective wisdom, and because of the pressure to conform. Think of the 1990s technology stock bust or the 2007-2008 housing crisis; part of the driving force of the bubbles preceding those crises was a fallacy that suggested “everyone is doing it, so it must be right, and I should do it too.” I saw some charts recently that brought herd behavior to mind; in a post titled “Two Key Indicators Show the S&P 500 Becoming the New ‘Cash’”, FF Wiley (ffwiley.com) highlighted that investors hold more equities as a percentage of total assets than any other time since 1946 except during the height of the dotcom bubble in 1998-2000. Wiley takes his analysis a step further by showing that high equity ownership is generally followed by low 6-10-year future returns, while low equity ownership is generally followed by higher returns. Some of this growth is certainly caused by the price of the market itself; household ownership of equities will rise organically as markets rise, as equity ownership percentage will fall as stock prices fall. The fact remains that, if history is any guide, the current level of equity ownership by households is associated with very low future returns.
Part of the reason this relationship may exist is due to valuation; high equity ownership periods are generally associated with high valuation periods. Another reason it may exist is a related construct from the fields of sociology and behavioral finance: thresholds. Sociologist Mark Granovetter, in his paper Threshold Models of Collective Behavior, identifies that group outcomes are dependent upon the various thresholds of the members. In this case, a threshold for an individual is based on how many other individuals are engaged in the behavior. In financial markets we can think of a low-threshold actor as a contrarian, meaning they favor of non-consensus ideas. Similarly, we can think of high-threshold investors as “herd,” meaning they only participate after a large amount of reassurance. The problem is that by the time high-threshold entrants are sufficiently convinced to enter the market, the majority of the trend is over and there are few new entrants (with seemingly even higher thresholds) to push the market to new heights. This would mean the highest-threshold entrants generally enjoy the lowest returns. Using the chart above as a guide, any investor currently jumping into stocks after such a prolonged bull run (which we could call a high-threshold actor) should expect below average returns over a long holding period.
Though the threshold model may not be a pure comparable to the equity ownership charts above, we think it is fair to wonder, with household ownership approaching record levels, who is the marginal buyer of equities these days? One question that always comes up in these analyses is to wonder if “this time is different,” particularly given low interest rates globally, which push investors out on the risk curve and could theoretically cause a new higher stock ownership paradigm. Another potential answer is trend-following strategies and quasi-trend, vol-driven strategies like risk-parity, which some estimates put at $8 trillion globally in aggregate, and are natural buyers of equity markets in a stable up-trend with low volatility. Then there are the indiscriminate buyers, such as corporate buybacks, which have fallen to only $500 billion on a rolling 12-month basis. Let’s not forget the Bank of Japan, which owns an alarming proportion of Japanese ETF issuance.
As with most of our commentaries, which to date have mostly focused on historical abnormalities present in today’s markets, we present this analysis with a word of caution. The charts above say nothing about near-term market returns, and we are not forecasting an imminent crash. As we constantly stress to investors, there is nothing to say that, despite these historical anomalies, the market can’t continue to grind higher in the short-term. Indeed, the analyst community is bullish on third quarter corporate earnings, projecting earnings and revenue growth in the 4-4.5% range. At the same time, the Fed is signaling a general comfort with the state of the economy by beginning to shrink its bond portfolio in October. As we continue to point out, we do not take these data points as gospel, nor do we use them to drastically shift our portfolios. In practice, long-term metrics play an important role in our view of risk; current readings show us that risk is elevated, and long-term returns are likely to be below average.
-A.G.
Markets
Domestic stock indices rallied strongly in September, adding to already solid year-to-date performance, as investors’ expectations for a strong earnings season and the Republican tax reform plan sent indices higher. US Large Cap stocks, as measured by the S&P 500 Index, gained 2.1% for the month, while the Russell 2000 small-cap index returned 6.2%. The MSCI EAFE Index, an index of international developed stocks, rallied 2.5%, while emerging markets posted a modest loss. A strong September return capped off a solid third quarter for the market, with the S&P 500 gaining 3.96% for the quarter. The S&P 500 has now posted gains in 8 consecutive quarters, the 5th longest streak on record.
At the sector level, a rebound in crude prices sent the Energy sector up 9.9% on the month, though the sector remains in negative territory on a year-to-date basis. The Energy sector continues to grapple with a weak oil market and depressed earnings since the 2014-2016 oil slump, causing the sector to carry the highest sector valuation on estimated 2017 and 2018 earnings. The move in energy in September, as well as rising interest rates, impacted the Utilities sector, which returned -2.7% for the month. Market volatility, as measured by the CBOE Market Volatility Index (VIX) spiked in the first days of September, but trended lower throughout the remainder of the month to close at 9.51. The 9.51 September close is the lowest monthly closing price for the VIX since the index’s 1990 inception.
Fixed Income markets posted losses in September, as hawkish statements from the Federal Reserve sent interest rates higher. In mid-September, the Fed announced that it would begin to unwind its $4.5 trillion balance sheet, which was built up with purchases of Treasuries and mortgage-backed bonds following the Great Recession. The Fed signaled that it won’t actively sell bonds, but instead will choose not to reinvest a portion of bonds as they mature, starting at approximately $10 billion per month and growing to $50 billion per month over the next several quarters. Despite the Fed’s relatively modest pace, interest rates rose sharply in the United States; the 2-year Treasury rose 15 bps to 1.47%, the 10-year Treasury rose 21 bps to 2.33%, and the 30-year Treasury rose 14 bps to 2.86%. The steep rise in interest rates, coupled with a rally in risk assets, tightened high yield spreads significantly, with the BofA Merrill Lynch US High Yield Option-Adjusted Spread contracting 29 bps to close the month at 3.56%. The rally in US interest rates also impacted European bond yields, as did hawkish statements from ECB head Mario Draghi and an inflation surprise in the UK; the 10-year treasury bond for the UK rose 36 bps to close the month at 1.36%, while the German bund yield closed the month at 0.46%, 10 bps higher than its August close.
The S&P GSCI Total Return Index returned 3.3% in September, as rebounding energy prices overwhelmed weakness from Metals sub-indices. The Energy sub-index returned 5.9% for the month, though the index is down 7.4% on a year-to-date basis. The index was led by a strong rally in Crude Oil, which rallied sharply after falling in August in the aftermath of Hurricane Harvey. After closing August at $47.09/bbl, West Texas Intermediate (WTI) Crude Oil traded up throughout the month to close September at $51.64/bbl. US refinery utilization hit a 7-year low following Hurricane Harvey, but forecasters expect demand to rise as these refiners come back on line. The Federal Reserve announcement signaling its intent to unwind its balance sheet put pressure on inflationary Industrial Metals and flight-to-quality Precious Metals; in September, the S&P GSCI Industrial Metals sub-index returned -2.7%, while the Precious Metals sub-index returned -3.0%. Gold opened the month at $1,326.60/oz. and sold off steadily throughout the month to close September 3.3% lower at $1,282.50/oz.
The US Dollar Index rose modestly in September, posting a 0.44% gain to close the month at 93.076. The Index, which measures the US Dollar’s value against a basket of 6 foreign currencies, benefitted from a hawkish Federal Reserve and investor expectations about pro-business tax reform from the Republican-led Congress and White House. The Dollar rallied against most major foreign currencies, with a notable exception of the British Pound (GBP); the Pound rallied sharply following higher than expected inflation in the UK, which caused speculation that the Bank of England would face pressure to raise interest rates.
We’re thankful for the continued interest and feedback. As always, please feel free to contact us with questions or comments.
Sincerely,
Arthur Grizzle & Charles Culver Managing Partners Martello Investments
October 2017 - Ode to Bonds – Walking the Tightrope
Walking the Tightrope: 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.
October Market Recap: The S&P 500 continued to rally with a solid gain in October, led by better than expected earnings from several technology bellwethers. Continued hawkishness from the Federal Reserve caused further flattening in the US Treasury yield curve, with the 10/2 spread approaching 10-year lows. Commodities were led higher by gains across the energy complex, particularly gasoline, which saw declining inventories and worries about short-term supply due to Hurricane Nate. The US Dollar appreciated against most major currencies, and the Euro weakened following unexpected dovishness from ECB President Mario Draghi.
Walking the Tightrope
Throughout October, much airtime was given to the 30th anniversary of Black Monday; on October 19, 1987, the Dow dropped nearly 22%, resulting in the worst single-day market performance in modern financial history. Several financial writers have focused on the potential similarities between the current market environment and the market in 1987, leading many to believe a similar crash is imminent. Pundits use the structural selling pressure caused by the “portfolio insurance” craze in the 1980s as a template for the next liquidity-induced crisis, which they claim will be caused by herds of passive investors, trend-followers, and short-volatility strategies simultaneously heading for the exit. For several months, we have discussed the dangers to portfolio construction presented by persistently low volatility and herd behavior. Though the prospect of pounding the table on an overvalued, complacent equity market is tempting, we also attempt to not say the same things month after month. So, in the interest of keeping our readers awake, we focus on a markedly different anniversary and draw a parallel to the current market environment.
By October 1802, Ludwig van Beethoven was becoming increasingly deaf. In the depths of his suicidal despair, he penned a letter intended for his brothers. The letter, known as the Heiligenstadt Testament, outlines his depression and embarrassment over his hearing loss. The letter is worth a read, if for no other reason than to get inside the mind of one of the most famous musicians the world has ever known. In his Testament, Beethoven identifies that as a master composer, the one thing he had taken for granted above all else, his ability to hear, was now slipping from his grasp:
…Ah how could I possibly admit such an infirmity in the one sense which should have been more perfect in me than in others, a sense which I once possessed in highest perfection, a perfection such as few surely in my profession enjoy or have enjoyed…
We all know how the story ends; ultimately, Beethoven pulled himself from despair and in fact persevered, composing many masterpieces (including 7 symphonies) after the Heiligenstadt Testament. His 9th symphony, arguably his most famous work, came over 20 years later. By which time he was nearly completely deaf.
An interesting component of the human condition is our unique ability to take for granted such important things; be it running water, food, our families, or, in Beethoven’s case, the ability of the musician to hear. Financial market participants are not immune to this behavior. At Martello, we spend a lot of time thinking about which assumptions the financial community takes for granted and how those are likely to change over time. For example, in May we discussed the assumptions underpinning portfolio risk metrics like Value-at-Risk (VAR) and how those cause potential problems when the volatility landscape changes. That mindset has also meant focusing significant energy on the role of bonds in a portfolio. For over 20 years, the financial advisory community has been able to rely on bonds as a reliable hedge to equity markets while interest rates have fallen steadily since the early 1980s. So, for what amounts to the entirety of most advisors’ careers (including our own), bonds have been the Holy Grail of investments: an equity market hedge with positive carry. However, recent months have seen the Fed note signs of rising core inflation and a healthy economic environment, leading to its acceleration off the zero bound. Several ancillary signs appear to indicate fixed income risk is rising and investors should proceed with caution.
Though investors have enjoyed a mostly reliable negative stock-bond correlation for the better part of two decades, the long-term correlation between the two asset classes is volatile and regime-dependent. As the chart below shows, there have been several periods in history with strong positive correlations between equities and bonds.
Though this is tautological, it bears repeating—in market regimes characterized by negative stock-bond correlation, bonds are a hedge in an equity market drawdown. In market regimes with positive stock-bond correlation, bonds do not provide as much of a diversification benefit. These periods of positive stock-bond correlation are generally categorized by high or rising inflation and real yields. Rising yields impact both stock and bond prices negatively as equity valuations rely on a discount factor which is tied to the risk-free rate. And as we all know, the Fed is committed to raising rates. Whether or not they will be able to fully follow through is yet to be seen, but it would be a mistake to ignore that fact considering this correlation data. How much does this positive correlation affect fixed income returns? As you can see from the chart below, past positive correlation regimes led to more frequent drawdowns for both stocks and bonds at the same time.
Meanwhile, core fixed income investors are faced with the unenviable proposition of taking greater interest rate risk for less yield. A recent Guggenheim study shows an interesting metric called Yield per Unit of Duration, shown in the next graph, which measures “value” available in a fixed income index. If the Yield per Unit of Duration is high, investors are well compensated for taking interest rate risk, while low values mean the opposite – investors are poorly compensated for taking interest rate risk.
Several factors have caused this value to fall over time, including the general downward trajectory of interest rates and the massive increase in Treasury debt over the last 10 years, which tilts core fixed income indices toward higher government debt allocations. This creates asymmetric risks for core fixed income investors. Let’s ask ourselves what happens to fixed income portfolios during periods of rising rates. Assuming the investor is positioned in a mix that matches the Bloomberg Barclays US Aggregate or is invested in the ETF AGG, we can use the current level of the graph above to determine that the capital losses incurred in a 42 basis point parallel upward shift in interest rates would erase any income gains generated from yield.
Similarly, junk bond markets currently offer maddeningly low yields, so much so that it is difficult to refer to them by the politically correct “high yield” moniker. In particular, Europe has reached levels that can only be described as silly. In our August market review, we briefly discussed the yield available in BB-rated European “high yield” bonds as it neared the yield on offer from US Treasuries. Since that time, investors have pushed yields lower in European credit, to the point that the Euro High Yield index trades at a lower yield than the US Treasury index.
Part of this is explained by the higher duration in the US Treasury index and the negative interest rate environment in Europe. Still, we view this complacency towards credit risk as unsustainable, particularly as covenant-lite market share in the European leveraged loan market has reached alarming levels.
The US High Yield market, yielding 5.56%, looks attractive by comparison – even as the BofA Merrill Lynch US High Yield index flirts with historically low yield levels.
The overall picture for fixed income looks mixed; the flattening yield curve in the wake of Fed interest rate hikes generally signals investor caution about the future economy, while historically low high yield rates signal optimism. Also, several macroeconomic forces – the disinflationary impact of high global debt, tightening monetary policy in the US, and aging demographics in the developed world – all point to tame inflation, persistently low interest rates, and, therefore, a mostly reliable negative correlation between stocks and bonds in diversified portfolios for the near future. That doesn’t mean that bonds will be as strong of a diversifier in the next equity bear market. Indeed, the already low level of interest rates may give yields less room to fall in the next crisis, even if the Fed quickly returns to zero interest rate policy. Overall, we view bonds as having an important role in a diversified portfolio, but investors may want to consider incorporating other diversifying assets (such as gold) or alternative strategies that can help protect the portfolio in times of market uncertainty.
Markets
Domestic stock indices continued this year’s trend of positive performance as a strong start to earnings season, expectations for growth, and signals of a forthcoming tax reform plan sent equity markets higher. US Large Cap stocks, as measured by the S&P 500 Index, gained 2.3% for the month, while the Russell 2000 small-cap index returned 0.9%. The S&P 500 has now posted gains in 12 consecutive months, which is tied for the longest streak on record; since March 2016, the S&P has generated positive returned in 19 of 20 months, with a -1.82% loss in October 2016 the lone exception. The MSCI EAFE Index, an index of international developed stocks, gained 1.5%, while the MSCI Emerging Markets Index rallied 3.5% for the month to bring year-to-date gains over 32%.
At the sector level, a host of strong earnings reports from technology bellwethers sent the S&P 500 Technology Sector Index higher by 7.8% for the month, adding to an already strong year of outperformance. Several technology companies, including Amazon, Microsoft, and Alphabet (parent company of Google) reported better than expected earnings. Despite the positive announcements, the CBOE NASDAQ Volatility Index (VXN) traded up 8.7% for the month. The VXN, which tracks the implied volatility of index options on the NASDAQ 100 Index, had traded down in recent months. As you can see from the chart below, the VXN is trading at a significant premium to the VIX, which tracks implied volatility on index options for the S&P 500. The high premium of VXN relative to VIX, to pre-financial crisis levels, signals investors are either increasingly concerned with technology positions or increasingly complacent with respect to the market at large. The VIX also trended higher throughout October, closing the month 7.05% higher at 10.18.
Fixed Income markets posted modest gains in October, as expectations for a December rate hike tempered a continued contraction in credit spreads. The US Treasury yield curve has flattened significantly in recent months, as investors push up short-term rates in anticipation of more rate hikes by the Federal Reserve. In October, the 2-year Treasury rose 12 bps to 1.59%, the 10-year Treasury rose 5 bps to 2.38%, and the 30-year Treasury rose 2 bps to 2.88%. Despite the flattening yield curve, which is generally associated with cautious investor sentiment, the high yield market continued to show strength in October. High yield credit spreads, as measured by the BofA Merrill Lynch US High Yield Option-Adjusted Spread, tightened by 5 bps to close October at 3.51%, though the first weeks of November saw spreads trend up to 3.76% by November 10th. After a significant spike in September, benchmark treasury yields in Europe fell in October, as the 10-year German treasury fell 10 bps to close the month at 0.36%, while the 10-year UK treasury bond closed October at 1.33%, 3 bps lower than its September close.
The S&P GSCI Total Return Index rallied 3.8% in October, as a continued rebound in energy and growth-sensitive metals fueled the rally. The Energy sub-index returned 4.9% for the month, led by a more than 10% gain in Gasoline. The Unleaded Gasoline index traded up throughout October, as Tropical Storm Nate caused concerns about supply and the EIA reported a significant reduction in inventories. West Texas Intermediate (WTI) Crude Oil also traded higher in October, closing the month at $54.64/bbl., $3 higher than September’s $51.64/bbl. close. Bullish global growth expectation sent the industrial metals complex higher. The GSCI Industrial Metals sub-index was led by Nickel [+17.2%] and Copper [+5.5%] in October as investors expected solid demand out of China in the wake of the country’s Communist Party congress meeting.
The US Dollar Index continued to rise with a 1.6% gain in October to close the month at 94.552. The Index, which measures the US Dollar’s value against a basket of 6 foreign currencies, continues to benefit from hawkish statements from the Federal Reserve, while recent dovish statements from the European Central Bank (ECB) provided an additional tailwind for the greenback. In October, the ECB extended its bond purchases to September 2018 and pushed any potential rate hikes to 2019 or beyond. After strengthening against the dollar for much of the year, the Mexican Peso weakened by nearly 5.1% in October, as President Trump has signaled a willingness to dismantle NAFTA in favor of bilateral trade deals with Mexico and Canada.
We’re thankful for the continued interest and feedback. As always, please feel free to contact us with questions or comments. We wish everyone a happy first half of the holiday season here in the United States.
Sincerely,
Arthur Grizzle & Charles Culver Managing Partners Martello Investments
December 2017 - Volatility: Tempest or Tool?
Volatility: 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.
December Market Recap: The S&P 500 posted a 1.1% gain in December, capping off the first year of positive returns in each of the 12 calendar months. The index has now posted gains in 9 consecutive years. Bullish news from OPEC benefitted crude oil and energy stocks, while disruptive weather and rising interest rates dragged utility stocks lower. Fixed income indices posted modest gains, as credit spreads were flat, and the yield curve flattened. Congress’ deal on comprehensive tax reform, which is expected to add to the deficit, was bullish for gold and bearish for the US Dollar.
Volatility: Tempest or Tool?
In early January, the snow-pocalypse came to Virginia Beach. While stuck inside as the city was blanketed in 6 inches of snow (blizzard conditions that shut down transportation for many days and left our office’s water pipes frozen), I found myself perusing the free documentaries available on YouTube. I love documentaries, but as any frequent YouTube user knows, the recommendation algorithms are sometimes bizarre. A few clicks later, I found myself watching a 1960 made-for-TV version of Shakespeare’s The Tempest. I’m sure the majority of you at least read the play in high school English class. For those that need a quick refresher (SPOILER ALERT!), The Tempest is about a marooned magician/duke that conjures a storm to shipwreck his enemies, who had previously exiled him to a deserted island, in an effort to exact revenge and reclaim his rightful place in the kingdom. The story is about vengeance, power, forgiveness, and ultimately, redemption. I won’t bore you with the rest, but I found it oddly poetic to watch the play in the midst of the worst snowstorm I had ever encountered. Some of you northerners may be laughing at that, but remember that I am originally from Florida.
As we reflect on 2017 in the markets, the major theme of the year was not a storm but an eerie calm, demonstrated by the continued strength of global equities and the near complete absence of volatility. Notably, this is the first year ever characterized by positive S&P 500 returns in each calendar month as well as the first time the equity volatility index, VIX, broke down through the 9-handle, though the index never closed below 9 until early 2018. There are many factors driving the health of the market — the election of a business-friendly US president, earnings growth, investor confidence, etc. — but we must take note of the unusual resilience nevertheless. For example, the S&P 500 Index’s worst pullback for the year was a meager 2.8%, the second lowest since 1928.
Many market pundits see a tempest brewing, with an inevitable uptick in equity market volatility at the proverbial eye of the storm. Recent months have seen the VIX and VIX-related products widely covered in various news outlets. These reports focus particularly on the historically low level of volatility, the large and increasing net short position of non-commercial futures traders, and the impressive performance of inverse VIX-linked ETPs in recent periods of low volatility. These factors and more lead many to believe that a volatility-induced wipeout is around the corner. In this analysis, we highlight some areas of the volatility market that concern us as well as other areas that we think are being overblown. Though the volatility complex is large and includes multiple instruments and strategy types, we will focus on ETPs that are tied directly to VIX futures.
Let me state emphatically that this note is not an attempt for us to “talk our book”, as we are agnostic to the direction of volatility. Though some of our strategies trade VIX-linked ETPs (VXX, XIV, ZIV), the strategies can go long or short volatility depending on market conditions. While this is certainly not to be taken as an investment recommendation, we would only say that if one were to participate in the volatility market, he or she do so with only a small portion of his or her portfolio, as an alternative or equity-replacement strategy, and with frequent rebalancing. In addition to some of our own commentaries, this analysis draws from Valentine Ventures’ white paper entitled Is Short Volatility A “Crowded Trade?” I would encourage you to read it if you are interested in the volatility space.
Just because the short-vol trade is getting more attention does not mean, on its face, that its recent returns are abnormal. In 2017, VelocityShares Daily Inverse VIX Short-Term ETN (XIV), which tracks short VIX futures positions at the front of the curve, returned approximately 187%. Looking at a rolling 12-month return since the ETN’s inception in 2011 shows that, while extremely volatile, prolonged periods of high returns have happened previously – with no immediate corresponding crash.
Let’s touch on the underlying drivers of VIX futures and VIX-linked exchange-traded products (ETPs). The VIX Index is derived from the implied volatility of S&P 500 index options. The VIX index itself is not tradable and is not replicable in real life due to the prohibitively expensive cost of trading the numerous options that would be required to construct the VIX’s return stream. The major way to use the VIX index to hedge or otherwise express an opinion is using futures on the VIX index or options. VIX futures are based on investor expectations about the future value of spot VIX, not the S&P 500. In addition, a few investment companies have released exchange traded products that track indexes of VIX futures. There are a number of VIX-based ETPs – both long and short – and the total combined asset value of the VIX ETP group is almost $5.25 billion as of November 2017. It is important to note that of the total assets under management in the VIX-based ETP space, it is approximately evenly split between long and short exposure when accounting for the underlying leverage in several funds.
The next chart has been making the rounds on investment websites. The point this chart attempts to make is that non-commercial traders (which includes institutional investors and hedge funds) are short volatility through VIX futures in historic proportions. The presumption is that these non-commercial traders are creating a short squeeze that when unwound will be the undoing of investors in short VIX ETPs.
It is true that there is more non-commercial short exposure than ever before, but this graph fails to account for the explosion of the volatility asset class (both long and short) since VIX futures were introduced in 2004. Valentine’s paper charts the non-commercial VIX futures position as a percentage of total open interest. With proper scaling, the “huge” net short position looks relatively normal.
Similarly, if there was abnormally high selling pressure in VIX futures, we would expect to see suppression of premium along the curve, leading to a flatter curve. On the contrary, the % premium available along the curve is high by historical standards. This may be a VIX-specific phenomenon; other volatility markets and strategies are less liquid and more difficult to access, making the VIX complex the preferred method of hedging for many investors, and therefore leading to more volatility buying concentrated in this index’s derivatives.
To be clear, we are merely claiming that the volatility market appears to be functioning normally given current market conditions; the term structure (futures curve slope) is within normal bands, the ETP market remains balanced between long-vol exposure (likely for hedging long equity exposure or short-term speculation on a downturn) and short-vol exposure, and the large net short position for non-commercial traders is at least partially muted when set to a proper scale. We are not claiming that the short-vol trade will be profitable or that short-vol products are safe for most investors. In fact, we acknowledge that the volatility market has shown increasing fragility to moves in the S&P 500, which generally happens in low volatility environments. This may or may not be a temporary phenomenon; increases in VIX-sensitivity in previous low-volatility regimes have subsided before as volatility normalizes (sometimes accompanied by significant market losses, sometimes not). In any event, it does present increased risk to short-vol ETP investors, but whether that risk rises to calamitous levels is not as clear. The August 10, 2017 VIX spike (44.4%) was the 9th largest on record. Equally significant is the equity market’s relatively benign return for the day (-1.45%) compared to returns in similarly large VIX spikes. The average daily return for the S&P 500 during the other VIX spikes in the chart below was -3.37%. The low level of spot VIX may create a scenario where smaller equity market moves create larger moves in spot VIX, causing magnified moves in VIX-linked ETPs. However, the August 10th spike in VIX caused XIV to lose 13.5% for the day, and a continuation of the selloff caused a loss of 4.6% on August 11th. A significant move, yes, but not a wipeout event for most investors, particularly in diversified portfolios.
In addition, we have discussed in other commentaries the reflexive nature of low equity volatility, meaning that falling volatility is a positive feedback loop that begets even lower volatility. Strategies that use volatility as a portfolio weighting mechanism — some examples include risk-parity, trend-based strategies, and VAR-focused approaches — continue to add to positions as volatility falls, further lowering volatility. This reflexive nature of volatility increases shock risk, particularly with the amount of leverage in the system, because rising volatility forces selling to decrease risk, which potentially begets even higher volatility, causing more selling, and so on. The violent move in VIX in August 2015 gives us a look at the magnitude of losses over a brief period in short-vol ETPs caused by a huge move in spot VIX. Over a 5-day period in August 2015, spot VIX increased by more than 200% from 13 to over 40, though it hit an intraday high of over 53 on August 24th. This caused the short-vol ETP group to post significant losses; XIV lost 54% in a 2-week timeframe and continued to lose value into early 2016, where peak losses hit over 66%. A massive loss, but a bearable one for investors with appropriately sized positions in a diversified portfolio with reasonable rebalancing, particularly considering the gains in XIV before that event and since.
The role of short-volatility strategies as a portion of a total portfolio must be properly framed. We think about short-vol exposure as equity-replacement; as the VIX is based primarily on the price of S&P put options, short-VIX exposure is inherently equity-sensitive. From 2011-2017, XIV’s beta to the S&P was over 4.5. This means that you can potentially use a 1% position in XIV to replicate a 4.5% equity position. Using this logic, a small portion of XIV in the equity portion of a portfolio (5% or so) can impact the total portfolio similarly to a 22.5% position in a stock index. Using short-vol as an equity-replacement strategy, then, would allow investors to free up additional capital and invest more defensively, putting less capital at risk and potentially limiting total portfolio risk and drawdown, while keeping the same return potential as a higher equity portfolio. For example, an investor could replicate a 60% equity position with 5% XIV (assuming 4.5 Beta), and 37.5% S&P 500, freeing up an additional 17.5% of capital to invest more defensively. We can test this theory to the inception of VIX futures in 2004 using VIX ETP Extension Data from SixFigureInvesting.com*. Below we present the results of a simple simulation using two portfolios, both rebalanced monthly:
“Traditional” Portfolio: 60% S&P 500, 40% Barclays US Aggregate Bond Index
“Equity Replacement” Portfolio: 5% XIV, 37.5% S&P 500, 57.5% Barclays US Aggregate Bond Index
As you can see from the simulation above, the inclusion of a short-VIX position as an equity-replacement strategy can increase returns, while reducing portfolio volatility and drawdown. The equity meltdown of 2007-2009 provides an interesting case-study in the benefits of equity-replacement strategies; despite the massive drawdowns in stocks and short-VIX positions (SixFigureInvesting.com data estimates XIV would have lost over 90% in the downturn), the equity replacement portfolio simulation posted better returns (by losing less) than the traditional portfolio. This is due to the increased bond position afforded by the equity replacement portfolio.
We do agree with the bears on one crucial point: it is a question of when, not if, short-VIX products will incur another large drawdown. This means that investors that choose to enter the short-vol trade through inverse VIX-linked ETPs should be prepared for significant bouts of interim volatility, including potentially large drawdowns on those positions. For those already interested in the space, we would advocate sizing exposure prudently (possibly incorporating short-vol exposure as part of an equity replacement strategy) and utilizing a rules-based, risk-managed approach that can participate in the large upside returns available in the short-vol trade, while potentially limiting drawdown.
Markets
Most domestic stock indices capped off a strong year with gains in December, as Congress boosted investor confidence by passing a tax reform bill. US Large Cap stocks, as measured by the S&P 500 Index, gained 1.1% for the month to bring year-to-date returns to 21.8%. The annual gain for the S&P 500 marks the best return since 2013 and the 9th consecutive positive year, which is the longest streak since 1928. Small cap stocks, measured by the Russell 2000 index, posted a modest 0.4% loss for the month to close the year up 14.6%. The MSCI EAFE Index, an index of international developed stocks, gained 1.6%; international stocks outperformed US indices in 2017, with EAFE returning 25.6% for the year. Emerging Markets lead headline indices for the year with a 37.8% gain after a 3.6% return in December.
At the sector level, Energy led the market higher with a 4.9% gain in December, though the sector lagged for the year with a -1.0% return. Energy stocks were boosted by supply disruptions and OPEC’s December meeting, during which the cartel agreed to extend their production limit agreement through the end of 2018. The story for the year, though, was Technology stocks, which posted a 38.8% return in 2017 despite a flat December. Utilities were the laggard for the month, returning -6.1%, as many regions experienced colder than expected weather, wildfires impacted west coast operators, and short-term treasury rates rose. Market volatility, as measured by the CBOE Market Volatility Index (VIX), trended lower through the first half of the month, bottoming at 9.34 on December 11th. The VIX ultimately touched 8.9 intra-day on the December 20th, the first time the VIX broke through the 9-handle. The index ultimately drifted higher to close the month at 11.04, 2.13% lower than November’s 11.28 close.
Headline Fixed Income market indices delivered gains in December to cap off modest 2017 returns. The Bloomberg Barclays US Aggregate Bond index returned 0.5% for the month to bring year-to-date returns to 3.5%. The US Treasury curve flattened significantly in December, driven by rising short-term rates, and falling 30-year treasury yields. In December, the 2-year Treasury rose 10 bps to 1.88%, the 10-year Treasury fell 1 bp to 2.74%, and the 30-year Treasury fell 9 bps to 2.83%. The 2/10 spread closed the year at 0.86%, 0.72% lower than 1.24% spread at the end of 2016. High yield credit spreads, as measured by the BofA Merrill Lynch US High Yield Option-Adjusted Spread, rose 2 bps to close the month at 3.63%. Despite rising in each of the last two months, high-yield spreads finished the year 59 bps lower, after closing 2016 at 4.22%.
The S&P GSCI Total Return Index gained 4.4% in December, bringing 2017 returns to 5.8%. The Index was led by Energy and Industrial Metals sub-indices, which returned 5.9% and 8.0% for the month, respectively. Energy was boosted by the previously mentioned OPEC deal and supply disruptions; West Texas Intermediate (WTI) Crude Oil trended higher for the second straight month, closing December at $60.40/bbl. after closing November at $57.42/bbl. Crude gained $6.51/bbl. in 2017, a gain of over 12%, and WTI’s December close was its highest monthly close since November 2014. Still, crude remains well below its post-2009 high of approximately $114/bbl. The tax reform package, which is expected to add meaningfully to the deficit, sent Precious Metals higher, with gold gaining 2.7% for the month. Gold had a particularly strong year, after closing 2016 at $1,152/oz., gold rallied throughout the year, and ultimately closed at $1,305/oz., a gain of over 13%.
The US Dollar Index, which measures the US Dollar’s value against a basket of 6 foreign currencies, returned -0.99%. The Index posted losses in 9 of the 12 months this year, returning -9.9% on a year-to-date basis, its worst year since 2003. The losses in December came despite an additional rate hike from the Federal Reserve and Fed guidance to three more rate hikes next year. Much of the USD weakness is explained by loose fiscal policy, as President Trump’s administration pursues deficit expansion, and the strength of the Euro, which rallied 12.4% against the Dollar for the year.
We’re thankful for your continued interest and feedback. As we reflect on 2017, it was certainly a year of firsts for us: we launched Martello in April, took on our first clients in May, and most importantly, Charlie and his wife Sheridan welcomed their first child into the world in November. There is much to be thankful for, and we wish you all health, success, and prosperity in the year ahead!
Sincerely,
Arthur Grizzle & Charles Culver Managing Partners Martello Investments
February 2018 - Special Report on 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%. As many of you know, we run a volatility trading strategy that utilizes short-VIX ETPs at times. This trading strategy is incorporated as a portion of our systematic multi-strategy programs as well.
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%. As many of you know, we run a volatility trading strategy that utilizes short-VIX ETPs at times. This trading strategy is incorporated as a portion of our systematic multi-strategy programs as well.
VIX ETP Mechanics and XIV
XIV is an exchange-traded note that tracks a short position in the front two months of the VIX futures curve. Its counterpart, VXX, tracks a long position in the front two months of the VIX futures curve. The VIX-linked ETPs have two main sources of return: the move in the VIX futures they hold and the embedded roll yield in the mechanics of the ETPs. To understand the impact of changes in market volatility and the VIX index on XIV and other VIX-based ETPs, you must first analyze the VIX futures curve. The VIX futures curve is positively sloped (in contango) over 80% of the time. Each day, the VIX ETPs roll a portion of their respective positions to the next month. For example, VXX, which is “long-VIX,” must sell a portion of its exposure in the first month and buy a small position in the second month (at a theoretically higher price). This causes a “decay” whereby the long-VIX ETPs lose value every day that the market is stable because they are, in effect, selling low and buying higher. The inverse VIX-linked ETPs (such as XIV) do the opposite; as XIV is short the front futures contract, each day it must cover (buy) a position in the front month and sell (short) a position in the second month. Also, as VIX futures slide down the curve, converging on the lower spot prices in contango, long VIX positions pay time premium (lose), while short VIX positions capture this premium in a stable market environment. This “positive roll yield” is generally what leads to the extraordinary returns of the short-VIX ETPs in stable market environments.
The obvious risk to XIV holders is a rapid increase in spot VIX, which causes not only a loss on the underlying futures positions but also causes the futures curve to slope negatively (that is, the curve is in backwardation). This turns the positive roll yield dynamics of XIV and the negative roll yield dynamics of VXX upside down.
In addition, XIV's underlying holdings are short positions in VIX futures and rebalanced daily, forcing it to cover its position into a VIX spike, which is what happened Monday. This is obvious but bears noting nevertheless... A VIX spike of over 100% in a single day effectively causes a margin call for products that are short futures at the front of the curve (XIV/SVXY). This is similar to being short a stock with 100% of your portfolio, and seeing it double in a day.
How Martello Uses These ETPs
As we discussed in our December market commentary, the inverse VIX-linked ETP space provides opportunities but also significant risks. Therefore, we discussed sizing the position appropriately as well as, in our case, using a rules-based methodology to potentially reduce risk. From our commentary:
We do agree with the bears on one crucial point: it is a question of when, not if, short-VIX products will incur another large drawdown. This means that investors that choose to enter the short-vol trade through inverse VIX-linked ETPs should be prepared for significant bouts of interim volatility, including potentially large drawdowns on those positions. For those already interested in the space, we would advocate sizing exposure prudently (possibly incorporating short-vol exposure as part of an equity replacement strategy) and utilizing a rules-based, risk-managed approach that can participate in the large upside returns available in the short-vol trade, while potentially limiting drawdown.
Our volatility strategy has the mandate to invest in VIX-linked ETPs (long or inverse) depending on market environment, or a group of “risk-off” assets in the absence of an opportunity in the VIX ETP complex. Our tactical approach to the VIX ETP complex is value-oriented and utilizes a number of different inputs. As the strong equity bull run accelerated in the first weeks of January, the “value” that we had seen in the inverse ETPs in the fourth quarter had significantly eroded, and as the VIX drifted from 9 to 12 in the middle weeks of January, our model generated a “risk paring” signal. This caused us to de-risk on January 22nd by moving from XIV to ZIV, which is short further out on the futures curve and generally has less beta to a spike in VIX. On January 30th, 8 days later, we exited ZIV after our model’s signals for that security similarly eroded. Little did we know that such a historic event would take place soon after.
Takeaways from Monday’s Move:
1. We take some comfort in the fact that our tactical approach got us out of the trade. Monday was a classic panic. Those that tried to “buy the dip” without understanding the impact the move had on the underlying futures and the mechanics of the ETPs have likely experienced unrecoverable catastrophic losses in their positions. Our approach caught levels of increasing risk in the weeks leading up to Monday’s move. We feel this illustrates the benefit of using a data-driven, value-focused methodology to help manage risk, especially in these extremely risky securities.
2. The move on Monday drives home the idea that sizing positions appropriately is critical, appropriately reflecting the risk in the trade. Investors that utilized a static allocation to XIV in their portfolios without active trading may now, in retrospect, know fully why position sizing was crucial to limiting the damage from this violent move. Paraphrasing our December commentary:
The role of short-volatility strategies as a portion of a total portfolio must be properly framed. We think about short-vol exposure as equity-replacement; as the VIX is based primarily on the price of S&P put options, short-VIX exposure is inherently equity-sensitive. From 2011-2017, the XIV’s beta to the S&P was over 4.5. This means that you can potentially use a 1% position in XIV to replicate a 4.5% equity position. Using this logic, a small portion of XIV in the equity portion of a portfolio (5% or so) can impact the total portfolio similarly to a 22.5% position in a stock index. Using short-vol as an equity-replacement strategy, then, would allow investors to free up additional capital and invest more defensively, putting less capital at risk and potentially limiting total portfolio risk and drawdown, while keeping the same return potential as a higher equity portfolio. For example, an investor could replicate a 60% equity position with 5% XIV (assuming 4.5 Beta), and 37.5% S&P 500, freeing up an additional 17.5% of capital to invest more defensively. We can test this theory to the inception of VIX futures in 2004 using VIX ETP Extension Data from SixFigureInvesting.com*. Below we present the results of a simple simulation, for illustrative use only, using two asset allocations, both rebalanced monthly:
“Traditional” Asset Allocation: 60% S&P 500, 40% Barclays US Aggregate Bond Index
“Equity Replacement” Asset Allocation: 5% XIV, 37.5% S&P 500, 57.5% Barclays US Aggregate Bond Index
The “Equity Replacement” Asset Allocation would have returned between -5.5% and -6% on Monday (based on estimates, data available upon request), depending on your rebalancing rules and the estimated losses for XIV of 95%-100%. Paraphrasing our December commentary…A massive loss, but a bearable one for investors with appropriately sized positions in a diversified portfolio with reasonable rebalancing, particularly considering the previous gains in XIV.
3. XIV has been terminated. We reached out to VelocityShares (the company behind XIV) to gauge the probability that they would relaunch the strategy in the future. So far, we have not heard back from them, as we’d imagine they are dealing with a lot over there. As of the time of this writing, ProShares has signaled its intent to keep SVXY open.
4. The move Monday is a reminder of the power of the reflexivity of volatility, the impact of leverage in the system, and the prevalence of vol-based strategies in the market. It is probably not coincidental that this move took place after one of the worst weeks for risk parity strategies in the last several years. From our December commentary:
In addition, we have discussed in other commentaries the reflexive nature of low equity volatility, meaning that falling volatility is a positive feedback loop that begets even lower volatility. Strategies that use volatility as a portfolio weighting mechanism — some examples include risk-parity, trend-based strategies, and VAR-focused approaches — continue to add to positions as volatility falls, further lowering volatility. This reflexive nature of volatility increases shock risk, particularly with the amount of leverage in the system, because rising volatility forces selling to decrease risk, which potentially begets even higher volatility, causing more selling, and so on.
And our May 2017 Commentary:
Low volatility does present inherent risks to portfolio construction, particularly for certain types of strategies that use backward-looking volatility metrics for position sizing and risk management. A well-known version of this is a metric known as Value-at-Risk (VaR); VaR’s role in the 1998 LTCM downfall and 2007-2008 credit crisis has been widely covered. Essentially, these types of models rely on, among other things, trailing historical volatility to infer how much a portfolio can lose in a given period. With such a prolonged period of benign markets, these strategies are susceptible to volatility shocks, as complacent investor behavior causes an undervaluation of the real potential losses of the portfolio. The real risk in the portfolio is only realized ex-post, when the volatility environment changes and a market shock occurs. Particularly for strategies with leverage, this could potentially lead to a cascade effect, whereby increased volatility causes further selling pressure, further raising volatility, and so on.
Thank you to everyone for your feedback. Please feel free to reach out at any time with questions or comments.
Sincerely,
Arthur Grizzle & Charles Culver Managing Partners Martello Investments
January 2018 Market Review - Inflation and the Short Correlation Trade
The S&P 500 fell over 10% in the 10 trading days following the index’s all-time high on January 26th, with many speculators pointing to the short-volatility trade blowup and oncoming inflation fears as primary causes for the selloff. Many articles also pointed a finger at risk-parity strategies for exacerbating the downturn, which was met with scathing responses by the leading strategists in the risk-parity space (including AQR’s Cliff Asness and Bridgewater’s Ray Dalio). Though I am not interested in debating investing titans, we had highlighted risk-parity as one example of investment strategies that use backward-looking volatility metrics as a portfolio weighting mechanism. We’ve also discussed that these types of strategies could be forced to de-lever into a significant volatility spike. Whether these strategies are large or reactive enough to intensify a relatively modest equity market drawdown—the S&P 500 is still positive on the year as of February 15th—is probably not knowable. With that said, this 10% short-term move in the equity market is likely not enough to cause a cascade of selling by risk-parity strategies. A prolonged and deeper equity market drawdown, however, could produce a re-calibration of these strategies, forcing them to materially lower their equity allocations.
The recent market selloff did, however, test a fundamental assumption underpinning not only risk-parity strategies but also widespread portfolio construction principles. Embedded in the risk-parity portfolio, as well as most asset allocation strategies, is a “short-correlation” trade, meaning the portfolio relies on certain assets offsetting risks from others. This is an assumption we all hold at some level, and it is the underlying rationale for most disciplined asset allocations including a mix of stocks and bonds. The simplest example of the short-correlation assumption is indeed a traditional stock and bond portfolio; the portfolio manager relies on bonds at least partially offsetting the risk of the stock portfolio. For the last 20 years or so, this assumption has been, for the most part, dependable, with stock-bond correlation reliably low or negative as evidenced in the chart below.
An inflation scare, however, challenges a portfolio built on reliable correlation assumptions because upside inflation surprise is a headwind for both stocks and bonds. Recent months have seen inflation fears surface as the economy reaches full employment, wages grow, rates rise, and the budget proposal out of Washington is expected to result in a $1 trillion budget deficit. Now, I understand that the “rising wages and full employment are bad for the market” argument sounds like one of the painfully obtuse things that dispassionate Wall Street folks say. However, understanding the impact of inflation surprise on stock and bond prices is important to understanding why a strong payroll or wage growth number can send the market into a tailspin.
The impact that rising inflation expectations have on bonds is relatively understandable and straightforward. If you are a debtholder, per the Fisher equation, the real interest rate you receive on the bond becomes less attractive as the aggregate price for goods and services rises. This erosion of purchasing power of the bond’s future cash flows causes yields to rise to recoup losses in real interest rates (causing bond prices to fall). Put another way, bonds are repriced to reflect this increased inflation risk.
The impact of inflation on stocks is more nuanced and is linked to the relationship between corporate profits and interest rates, and thus inflation, much like one views the relationship between bond payments and interest rates (inflation). As we’ve already established, an inflationary environment generally causes interest rates to rise. If one views a stock as a claim on the perpetual earnings of a company, the present value of those earnings will ultimately drive what an investor is willing to pay for the stock. We’re going to delve into Time Value of Money 101 for a moment. A present value calculation is very sensitive to the assumed discount rate, regardless of whether the cash-flowing asset is a stock or bond. For example, let’s evaluate a hypothetical example of two assets at different interest rates. The first asset is a 5% coupon 10-year bond, and the second is an equity-like cash flow stream, with 5% embedded earnings growth and a terminal value of $100. The table below shows the present value of those cash flows at discount rates of 1% and 2%. You can see that the increase in discount rate from 1% to 2% results in a more than 7% reduction in the present value of both assets. Note that this example borrows from our April 2017 commentary entitled “Negative Interest Rates: Go to the Mattresses,” in which we discussed the impact of negative interest rates on equity valuation.
It would be fair to say that corporations are different than bonds regarding the variability of profits; it’s possible for a company to offset surprise upside inflation’s impact by raising its prices in kind, preserving the profitability it had prior to its increase in input costs due to inflation. However, reality is a bit different: supply and demand as well as contracts to provide services at a predetermined price preclude companies from quickly raising prices across the board to offset inflation-related input price increases. As a result, the company’s profits fall and the stock is less valuable.
As may be clear by now, unexpected inflation can potentially drive a wedge in the negative correlation relationship between stocks and bonds by decreasing both at the same time in an inflationary environment. If one depends on stocks and bonds to hedge each other, it may be time to shift your thinking; not only are we are in the midst of an environment that is seeing elevated stock valuations, low yields, and historically tight credit spreads, we are also starting to see signs of inflation that could potentially reduce the effectiveness of the diversification benefit relied upon by most investors and portfolio managers these days.
It is clear that inflation fears are beginning to surface among investors and these concerns are likely at least partially responsible for the recent uptick in equity market volatility and the spike in interest rates. We also think the short-volatility meltdown and general deleveraging played a role; the weak response from commodity markets during the equity correction certainly counters the inflationary scare narrative. Still, investors should take note of the relationship between inflation and stock/bond valuation. With rising inflation fears in the United States fueled by continued fiscal stimulus (deficit spending) and other factors, investors would be wise to explore assets that can protect portfolios in a prolonged inflationary environment.
-A.G.
January Market Review
Markets started 2018 by continuing last year’s strong trend, as expectations for global growth remain solid and the recent US tax reform bill led to forecasts of higher corporate earnings. US Large Cap stocks, as measured by the S&P 500 index, gained 5.7% for the month, the strongest January return since the 6.25% return in January 1997. The S&P 400 Mid Cap index gained 2.9% while small cap stocks, measured by the Russell 2000 index, rallied 2.6% in January. The MSCI EAFE Index, an index of international developed stocks, gained 5.0% for the month. Emerging markets continued to outperform the developed headline indices, with the MSCI Emerging Markets index gaining 8.3% in January.
The S&P 500 started out the year on a tear, gaining nearly 7.6% through January 26th, before fading in the final days of the month, as rising interest rates and hawkish Fed comments stirred inflation fears. Market volatility, as measured by the CBOE Market Volatility Index (VIX), rallied over 22% in January, closing the month at 13.54 after closing 2017 at 11.04. The VIX spiked 24.9% to 14.79 on January 29th, as the US 10-year Treasury yield broke through the psychologically important 2.7% level, further stoking inflation fears. At the sector level, the income-sensitive sectors Utilities [-3.1%] and Consumer Staples [+1.6%] lagged the market, while Consumer Discretionary [+9.3%] and Technology [+7.6%] led markets higher. Despite the continued market leadership of Technology stocks—the S&P 500 Technology sector index has gained over 43% in the last 12 months—the CBOE NASDAQ Volatility Index (VXN), which tracks the implied volatility of options on the NASDAQ 100 Index, rose 25.3% in January. The VXN is linked to technology stocks because its underlying index, the NASDAQ 100, is approximately 60% tech, compared to the 25% technology sector weighting of the S&P 500.
Headline Fixed Income market indices struggled across the board in January, as rising interest rates offset continued tightening in credit spreads. The Bloomberg Barclays US Aggregate Bond index returned -1.2% for the month to bring its rolling 12 month returns to 2.1%. US Treasury rates rose sharply in January, as the 2-year Treasury rose 26 bps to 2.14%, the 10-year Treasury rose 31 bps to 2.72%, and the 30-year Treasury rose 20 bps to 2.94%. High yield credit spreads, as measured by the BofA Merrill Lynch US High Yield Option-Adjusted Spread, contracted 34 bps to close January at 3.29%, the index’s lowest monthly close since June 2007. Global interest rates also rallied sharply; the 10-year bonds for the UK, Germany, and Japan rose 32 bps, 27 bps, and 4 bps to close the month at 1.51%, 0.69%, and 0.08%, respectively.
The S&P GSCI Total Return index gained 3.4% in January, led by a 5.0% gain in the Energy sub-index. West Texas Intermediate (WTI) Crude Oil led the Energy complex higher, closing the month at $64.77/bbl., up over $4 from December’s $60.40/bbl. close. The oil markets received many bullish headlines throughout the month, including continued solidarity between OPEC and Russia, upside demand surprises, and unexpected inventory draws. Gold also rallied on inflation fears, though hawkish signals from the Federal Reserve sent Gold futures prices lower at the end of the month. After closing December at $1,305/oz., Gold rallied over 4% to $1,357.80/oz. on January 24th. However, during the Fed’s policy meeting—the last of the Janet Yellen era—officials highlighted signs of inflation growing and hinted at additional rate hikes this year. The Softs commodity index, which includes non-livestock agricultural commodities, fell 6% on the month, led lower by a -12.6% return in Sugar, which fell on higher than expected output and weak demand.
The US Dollar Index, which measures the US Dollar’s value against a basket of 6 foreign currencies, returned -3.25% in January, continuing last year’s trend of poor returns. The USD depreciated against all major currencies, led by its 5.3% depreciation against the Mexican Peso. The greenback’s slump accelerated in mid-January on comments by Treasury Secretary Mnuchin at the World Economic Forum in Davos, Switzerland. In Davos, Mr. Mnuchin signaled his comfort with a weaker US Dollar, which he expected to benefit trade.
We’re thankful for your continued interest and feedback. As always, please reach out any time with your questions and feedback.
Sincerely,
Arthur Grizzle & Charles Culver Managing Partners Martello Investments