U.S. Market Volatility

The housing market is stronger than it’s been in years. The U.S. economy grew an estimated 1.8% during the first quarter of 2013–not rip-roaring expansion, but an improvement over the previous quarter’s 0.4%. Employment isn’t where it needs to be, but companies are no longer shedding jobs in record numbers and the Federal Reserve thinks the unemployment rate will fall roughly another half-percent by the end of the year. Weeks and even months have gone by without headlines about a new European debt crisis.

And yet financial assets have been volatile recently. The benchmark 10-year Treasury yield has reached a level not seen since August 2011,* and since rising bond yields are typically accompanied by falling prices, bond markets have been hit across the board lately. The tidal wave of money that has gone into bond mutual funds over the last couple of years has slowed since yields began to rise, and has even begun to flow back out.** The S&P 500 has retreated recently from its string of record highs set in May. Prices for gold and oil also have seen weakness.

Paradoxically, relatively good news has made investors more anxious. Why has improving economic data somehow helped create turmoil in financial markets? The answer has to do in large part with the Federal Reserve and its monetary policy.

Good news, bad news
On June 19, the Federal Open Market Committee (FOMC) said that encouraging economic reports suggest that risks to the current moderate economic expansion have gone down. Assuming recovery continues, the Fed plans to begin reducing the economic support it has provided over the last couple of years. By the end of the year, the Fed could start reversing policies that have injected money into the economy through so-called “quantitative easing.” It will first cut back on the $85 billion a month it has been spending to buy Treasury and mortgage-related bonds. Once the unemployment rate falls to around 6.5%, it will consider raising its target Fed funds interest rate above 0.25% for the first time in more than 4 years.

Low interest rates have helped make it easier for businesses to buy equipment and for consumers to purchase a home or make credit card payments. When the Fed began buying mortgage-related securities in November 2008, those purchases increased demand for bonds generally, providing support for bond prices and keeping interest rates low (since bond prices move in the opposite direction from their yields). Fed bond purchases also have given banks money to lend for home mortgages and business expansion. Those “easy money” policies were intended to help stimulate hiring, the housing market, and economic growth.

Taking away the punch bowl
Former Federal Reserve Chairman William McChesney Martin is often credited with saying that the Federal Reserve’s job is to take away the punch bowl just as the party is getting good. The better the news about the economy, the more investors began to worry that a stronger economy would spell the end of easy money. Even before the Fed announced its blueprint for easing out of quantitative easing, markets were beginning to anticipate the potential implications for various financial assets.

Equities: Recent volatility has been sparked by worries that if the economy slows with less Fed support, corporate earnings could suffer. Also, dividend-paying stocks have been attractive to income-oriented investors seeking alternatives to rock-bottom interest rates; the Fed’s statement raised questions about whether that would still be true if and when bond yields rise high enough to be competitive with dividend yields. Foreign equities also have been hurt by concerns that if tighter U.S. monetary policy reduced American demand for their products, it could accelerate a global slowdown, especially in emerging markets whose economies depend on high prices for commodities such as metal ore.

Bonds: The Fed’s statement prompted fears that if its bond-buying helped bond prices, the reverse could also prove true. If the Fed buys less, or actually begins selling bonds it has already bought, that could lower overall demand for bonds or increase the supply of bonds on the market. And as any consumer knows, lower demand for something or too much supply can lower its market value. Bond prices also have been under pressure as investors worried that higher interest rates eventually might cut the value of bonds that pay today’s low interest rates.

U.S. dollar: The dollar has already gotten stronger, partly because of anticipation of eventual higher interest rates. A stronger dollar could hurt U.S. exports, which would become more expensive for customers who use a weaker currency. That could affect U.S. companies that derive a large portion of their profits overseas.

Commodities/metals: Concerns about the potential for a global slowdown as a result of the factors listed above have brought oil prices down in recent weeks. A stronger dollar, which is often accompanied by weaker global oil demand, tends to hamper oil prices. Gold, already in a slide since last October, also has suffered from a stronger dollar.

The Fed isn’t the only factor contributing to recent volatility, and it hasn’t been the only central bank to use quantitative easing to try to stimulate growth. Investors worry that whenever the United States does raise interest rates, other central banks might be forced to follow to make sure investors don’t take their cash elsewhere. Any monetary tightening overseas could prove problematic. Europe has been mired in a recession for months and continues to have debt issues, while China’s economic growth has shown signs of stalling and its financial system has been under pressure lately. Fears of the global impact of monetary policies are part of the reason equities also reacted poorly to the Bank of Japan’s recent refusal to inject additional economic stimulus.

So what does all this mean for my portfolio?
Markets already on edge for weeks about what the Fed might do reacted strongly to its blueprint for an exit from quantitative easing. However, it’s worth remembering that one of the reasons for any monetary tightening is that the Fed’s outlook for the economy is more encouraging. The Fed also has left itself plenty of room to maintain its support if economic conditions don’t continue to improve in the coming months; in 2010, it halted bond purchases because the economy was growing, only to renew them a couple of months later. Fed Chairman Ben Bernanke has said that when the Fed does begin to reverse course, it will be more like a driver easing off the gas pedal rather than slamming on the brakes.

If you hold individual bonds, remember that even if a bond’s market value declines, the principal will be repaid in full if you hold it to maturity (as long as the issuer doesn’t default). The closer a bond is to its maturity date, the closer its market value is likely to be to the amount of the principal; pay close attention to both a bond’s maturity date and to the price you pay for it. Also, higher yields could provide some relief to those whose incomes from their hard-earned savings have suffered from rock-bottom interest rates.

Market risk based on monetary policy tends to have a broad-based impact, which can make it more challenging to try to protect your portfolio through diversification. And diversification alone can’t guarantee a profit or protect against potential loss. However, it might be worth exploring how various asset classes in your portfolio could be affected by possible future Fed actions, and whether there are ways to hedge your exposure to possible market volatility. If you’ve been keeping a substantial cash position, volatility also may present buying opportunities.

It’s important to maintain perspective in the face of market turbulence. While you should monitor the situation, don’t let every twist and turn derail a carefully constructed investment game plan.

*U.S. Treasury Department Resource Center, Daily Treasury Yield Curve Rates, retrieved from www.treasury.gov on June 21, 2013.

**Investment Company Institute historical flow data as of June 19, 2013.

Don’t get whipsawed by Risk Management!

Back in February of 2012, I recall a prominent CFO departing a global insurance company.  This particular individual was labelled “the highly regarded architect of a hedging strategy that proved key in rebuilding investor confidence in the wake of the financial crisis.”  The company had suffered financially during the prior market meltdown because of a huge exposure to equity-linked products;  pre-crisis the company had introduced investment products that guaranteed to return a substantial (if not all) amount of the investor’s initial investment.  The money was invested in the company’s funds which in turn invested in stock markets.  During the financial crisis, the value of these assets (stocks) held in the funds declined below the amount that was guaranteed spelling serious trouble for the company.  In response a stricter approach to risk management was adopted after-the-fact.

Sounds sensible doesn’t it?  But it just isn’t!  I’ve watched this pattern time and again over decades.  The fundamental flaw is a complete misunderstanding of what constitutes risk.

Risk is almost always equated to volatility.  For example, stocks move up and down rapidly with much magnitude so they are deemed more risky than bonds.  But are we really as averse to upside risk as downside risk?  Strangely people become more averse to volatility when they’ve suffered downside risk (and come to adore volatility when upside risk has rewarded them).  Because our internal model of risk is so much more complex than mathematics can reckon with, our efforts to ‘manage’ volatility can actually subject us to less volatility but more risk.  When we reduce risk (hedging strategies usually reduce volatility – both up and down) at the wrong times, we miss the chance to be rewarded by the kind of volatility we adore.  We are our own worst enemies.

The President and CEO of a completely different insurance company was quoted as saying this, also in February of 2012:

“We are maintaining our equity hedges as we remain very concerned about the economic outlook over the next few years. We continue to be soundly financed with year-end cash and marketable securities at the holding company of about $1 billion.”


This statement followed the company’s earnings release, having reported substantially increased losses from its investments – management had hedged the company’s equity position in 2010 (again, after-the-fact) and suffered investment losses in that year’s fourth-quarter because stock markets rose (instead of declining).  The actions designed to protect the company against volatility lost money.  Risk aversion after-the-fact caused the company to lose money and avoid potential returns from upside volatility.

Because the pain caused by the downside volatility suffered previously was still fairly recent, aversion remained at a high level causing the company to stick to its hedging strategy (in denial?) despite these huge losses, and it continued to lose money as the market continued to go higher and higher still.

The financial crisis is behind us and now that markets are hitting all-time highs, record amounts of dollars are scrambling to get some upside volatility action. Too late?  It’s hard to put a pin in it, but intuitively might one conclude that if managing risk (or ‘risk off’ as they say on business television) was a bad idea during and immediately after the financial crisis, then perhaps chasing volatility (‘risk on’) might not be such a good idea at present?

It might seem as if I was picking on insurance companies earlier, but many pension funds, other financial services companies, portfolio managers and everyday investors follow the same destructive pattern.  Adoring upside risk but loathing downside risk – always at the wrong times – has ruined careers and put a serious dent in the life-savings of families.  More experienced money managers (there are fewer of us nowadays) increase risk when others are most averse to the idea, and begin to manage risk (hedging, raising cash balances) during periods of ‘irrational exuberance.’  They’ve learned the hard way that it’s easier to keep all the hair on your head if you avoid circumstances that make you want to pull it all out.

Mal Spooner

Are You Listening to Signal Or Static??

When I was in high school, I listened to baseball on the radio.  Joe Chrysdale and Hal Kelly on AM 580  CKEY told the story of the Toronto Maple Leafs baseball team.  Sparky Anderson played there in the early ‘60’s.  Who could forget Rocky Nelson?  He was a very good hitter but the story was that he kept his glove in oil lest it get rusty.  Clang!

If there was no Leaf game, you could catch Harry Caray with the Cardinals on KMOX.  You could hear Gibson versus Koufax or Drysdale or Marichal, and follow Stan Musial at the end of his brilliant career.  You had to pay attention though, because listening to KMOX required that you ignore the static.

Sort of like the stock market.

AM radio stations send a strong clear signal and the vagaries of the atmosphere and the receiver’s location interfere with it.  That is what static is.

In the stock market there is a clear underlying value driver (the signal) obscured by short term variability (static)

The signal for a given security is a combination of things.  The national and global economy, the business and its management, population growth, demographics, competitors, technology, brand.  The static is political comment, pundits, new and unproven connections, newspaper and TV stories, short term dominated thinking.

If you track values of the S&P 500 since the early 1920’s, you will find the signal is almost exactly 10%.  The values tend to run in a trough between 9.8% and 10.2%.  It is moderately clear.  Values do not stay far away for very long.  Year over year variations are seldom more than 3 times the size of the signal.  Most years lie between minus 20% and plus 40%

For 250 trading days a year, 10% annually is roughly .04% daily.  When you look at daily returns, the signal cannot be seen at all.  Static dominates.  There are days when the change has been more than 100 times the expected .04%.  There is one day when it was more than 500 times.  Yet, at the end of several years, the static all cancels and the underlying signal remains.

What does that mean?

  1. Most of the intense investors are trading on noise not signal.  Day trading does not use investment rules for success even though it sometimes looks like they do.  Day traders are trading the static.
  2. You will usually be upset with the stock market if you follow it too closely.  How so?  I should have less risk if I pay attention.

True if you are a robot.  Not so much for humans.

According to Nobel Prize winner Daniel Kahneman, people are about twice as upset over a given loss as they are happy for an equal sized gain.  To give yourself a chance you should look at intervals where you are about twice as likely to see a gain as a win.  If you look at the market every day, the odds are about equal that you will see a loss or a gain.  Emotionally though, that is plus one and minus two.  Emotion leads to weaker decisions.

I am sorry to say that I am not as fluent with math as I once was, and my awareness of the Central Limit Theorem is vague at best, but I think if you look about once every 42 months you should expect to see positive results twice as often as negative results.  This will not, and probably should not, change your behavior, but at least you can console yourself that the market is working as it should, just not today or this month, or however often you look.

When you buy shares, you buy part of a business.  Thinking business instead of stock will help you see the day-to-day variances in context.  When instead, you think share price, it is easy to fall into the volatility trap.

Warren Buffet buys businesses not stocks.  The difference from you is that he buys the whole or most of the business rather than a minute fraction of it.  He has said that he would not care if they close the stock exchange for 10 years after he buys.  He is seeking management, market position, products, techniques and people, and time does not change that.

You might want to do the same.


Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.  don.s@protectorsgroup.com