After living through the worst quarter (Q4 2018) since 2011, we just experienced the best start to a year since 2012, with the S&P 500 Index up +13.5% and international equities up +10.3% in Q1 2019. As recently as December 2018, the S&P 500 Index was down -20.2% (peak-to-trough, 9/20/19- 12/24/19), and the threat of moving into a global recession loomed large. In other words, the first quarter was almost a mirror image of the fourth quarter.
What triggered equities to drop to bear market levels then to abruptly – and I mean abruptly! – reverse? While explanations abound, the consensus is that the move was primarily driven by the “about face” in interest rate policy by Jerome Powell, the Chairman of the Federal Reserve – moving from threatening to continue to raise interest rates, to potentially cutting them in 2019. Another contributing factor was increased confidence in the U.S. and China coming to a favorable resolution on trade.
The remainder of this blog is dedicated to other factors that likely contributed to what has been one of the more violent swings (whipsaws) in the market, some of which I gleaned by attending the Ned Davis Research (NDR) conference last week.
This may get a bit wonky, so if you are just interested in the market outlook, you can skip down to the “Outlook” section.
The type of market volatility that we experienced during Q4 2018 and Q12019 is fairly unprecedented. Not that equity markets can’t selloff sharply, but to go straight back up is what’s unprecedented. What happened over the two quarters is called a “V-shaped” recovery. You can see this in the chart below, with the S&P 500 Index essentially forming a “V” during the period illustrated.
What’s more typical is for the market to get “confirmation of a bottom” – where the market hits a low, rallies, then sells off again. This second sell-off “confirms that a bottom may be in place,” and that it’s safe to re-enter equities. This is known as a “W-shaped” recovery, and again, is much more typical. A recent example of this type of bottoming process is illustrated below with the S&P 500 Index from 2/2/15 – 3/31/17.
As a result of the significant sell-off in Q4 2018, most of our models trigged a “high risk environment,” resulting in us reducing exposure to equities in January. We decided not to get more invested as the month and quarter progressed as this would have meant: 1) going against the discipline of our models, which we don’t do lightly; and 2) we were confident that we would get another sell-off and confirmation of a bottom (a W-shaped recovery). Instead, we got no confirmation, and the market marched ahead, ending with one of the one of the best-performing quarters in years.
This period was very challenging for me. Thankfully, I had the opportunity to attend the NDR conference last week, which provided even more context on these whipsaws. I say “thankfully,” because I learned that I was in very good company – that many, if not most, conference attendees, as well as the NDR folks, had been thrown off by these violent gyrations.
Why is this happening?
“Program trading” has been taking a bigger and bigger role in how buys and sells are executed in the institutional money management world. Program trading uses computer algorithms (“algos”) to buy and/or sell a basket of securities. Institutional investors, such as hedge fund managers, use program trading to execute large-volume trades. In the past couple of years, systems have become even smarter, with artificial intelligence and machine learning revolutionizing the world of investment management. Machine learning involves feeding an algorithm data samples, usually derived from historical prices. The data samples consist of variables called predictors, as well as a target variable, which is the expected outcome. The algorithm learns to use the predictor variables to predict the target variable.
This may sound like science fiction, but it’s happening. And it means that these types of big swings over shorter time frames may become more prevalent.
What are we doing about it?
While it was somewhat comforting to hear that other portfolio managers attending the NDR conference had a similar experience to ours in Q1, it didn’t change the fact that our portfolios’ performance lagged their benchmarks. And while we believe in assessing performance over the long-term, and that short-term gyrations can just be “noise,” we still felt very uncomfortable with the “how and why” of these whipsaws.
We are believers in active money management as a tool for being able to participate in strong-trending bull markets and mitigating losses in strong-trending bear markets. But it’s the “space in between” – these high volatility periods with big whipsaws – that are becoming increasingly challenging. We are addressing this by creating a couple of passive (“buy and hold”) portfolios. These portfolios will suffer more during significant bear markets, but will help investors better weather these volatile periods.
Unfortunately, there is no perfect investment approach – there is always the trade-off of risk versus reward. And now, to add to the complexity of an already complex business, we now have to adjust for the “algos!”
Fears that were prevalent when entering 2019 have all but dissipated. Jerome Powell, as mentioned, has indicated a “lower for longer” interest rate policy, which is supportive of equity markets. Additionally, this about-face in in U.S. interest rate policy has helped international markets stabilize, giving central banks around the world breathing room to keep their rates low.
One of the biggest concerns late last year was China, which appeared to be sliding into recession. The government has been taking constructive steps to revitalize its economy through fiscal and monetary stimulus, and it seems to be working.
So, recession fears have cooled – at least for now.
This doesn’t mean the risk has been squeezed out of the market. The S&P 500 Index is nearly back to the September 2018 all-time high. And we have a president who is a “tariff guy.” Trump is currently negotiating a trade deal with China, and has threatened to place tariffs on a long list of European goods. Tariffs are not market friendly as they fly in the face of free trade, which is deemed a key for long-term economic growth.
My guess is that equity markets are due for a period of consolidation or “cooling off” before continuing their march higher. However, a “cooling off” could turn into a more significant downturn if Trump insists in smacking tariffs on imports.