Wednesday, January 6th, 2016

Crossing the Median

We spent the Christmas period reading all the usual previews from all the usual people, and noticed an interesting phenomenon. Most of the bears think it necessary to lay out very specific scenarios as to what will go wrong and what the effect will be on their chosen asset class. By contrast the bulls tend to be much less specific and rely on concepts such as continued economic growth, multiple expansion, and gradual stabilisation in emerging markets/currencies /energy prices. To us, this is an important psychological indicator of where we are in the cycle. Back in 2009 and 2010, bulls had to explain in detail, why they thought the TARP would work, why they thought that the UK’s budget deficit was sustainable or how China was going to launch its stimulus package. All the bears had to do was pontificate about the threat from deflation (or hyper-inflation) and another banking crisis.

We make no secret that we are on the side of the bears at the moment, and find much of what they write to be better thought-out and more actionable, but we don’t want to be pinned down to a particular scenario. Part of this is our usual aversion to forecasts. But we think there is a better and more observable reason to be bearish: markets are more vulnerable now, than they have been for the last two years. This week we have added a new set of charts to our US Asset Allocation reports. These track the rolling 26-week volatility of eleven asset classes (5 equity indices, 4 fixed income, and 2 alternatives) over the last 20 years. To avoid the distortions caused by comparing different levels of intrinsic volatility we plot each asset class relative to its own median and then take the simple average, which is rebased to 100%. The current reading of 101% is therefore almost exactly in line with historical norms – which doesn’t sound too threatening.

If only it worked like that. Crossing the median is nearly always a signal that risk conditions are going to deteriorate significantly. Examples are October 1998 during the LTCM crisis, March 2000 as the Tech bubble burst, and August 2007 as the first money market funds “broke the buck” at the onset of the global financial crisis. Over the 20-year history we can find no examples of false positives, but not every crisis was as bad as these three. So the current reading is a warning, not a reason for complacency – especially when you understand that the index has increased from an all-time low of 63 in July 2014 in virtually a straight line. Our conclusion is that financial markets have little capacity to absorb any incremental risk, and that they are closer to a tipping point than many investors think.

If our index was being led up by asset classes such as commodities or EM bonds, bulls could argue that the rise reflected specific rather than general risks, and was therefore less important. But the big increases over the last quarter are in high yield bonds, US equities and EM equities. Every equity region and alternative asset class has seen volatility rise over the last quarter and only Japanese and Eurozone equities are significantly below their historical median. If this analysis is correct, it doesn’t matter which of the bearish scenarios eventually comes true. The impact on prices and returns will be much greater than it would have been one or two years ago.

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