Volatility has returned to stock markets following the unexpected escalation in US-China trade tensions. The blue-chip Dow Jones Industrial Average suffered its biggest one-day fall since early January last Tuesday while the Vix, or fear index, is on track to record its biggest monthly increase since stocks tumbled last October.
It’s reasonable to assume things could get worse before they get better, given volatility has been extraordinarily low in 2019 thus far. Pension Partners’ Charlie Bilello notes that prior to last week’s declines, the S&P 500 had not experienced a drawdown greater than 2.48 per cent in 2019 – lower than in any year in history. That’s “abnormally low”, Bilello cautioning that investors should “expect higher volatility and larger drawdowns through the remainder of the year”.
The same point is made by Fat Pitch blogger Urban Carmel. Stocks have fallen at least 5 per cent in all but two of the last 40 years and this has been one of the least volatile starts to a year in the past 90 years, so a “meatier reaction is odds on in the weeks and months ahead”.
This doesn’t mean investors should fret. Carmel remains bullish and expects stocks to ultimately hit higher prices this year, but stocks don’t go up in a straight line. A little volatility is perfectly normal.
Tech stocks gobble up market gains
Microsoft and the five FAANGs – Facebook, Amazon, Apple, Netflix and Google – are dominating the global stock market. If the six tech stocks are excluded, then the MSCI World Index would actually be slightly lower over the past 16 months, according to a recent Bianco Research note.
Now, Stocktake has previously noted that it’s not unusual for a small number of stocks to account for the bulk of stock market gains. However, today’s dominance is different in one key respect. Bianco notes that in the past, these large stocks would come from different sectors and be relatively unrelated to each other. In contrast, the aforementioned six stocks are all disruptive technology stocks – an “unprecedented” situation.
Does this mean global markets are too dependent on a few names? Will markets tumble if the mega-cap tech stocks run into trouble? Not necessarily. Apple "took" its market capitalisation from companies like Nokia and Blackberry, notes Bianco, and it could be argued the other disruptors have also taken away value from the rest of the stock market. "This makes sense," says Bianco, given the way Microsoft and the FAANGs "are soaring while the other stocks are not."
Trump still at war with the Fed
Financial markets have run into trouble lately but the news hasn't been all bad, with Donald Trump failing in his bid to appoint two patently unqualified candidates – his chief economist Stephen Moore and former pizza executive Herman Cain – to the Federal Reserve. As befitting the world's most important central bank, the norm is for Fed members to be serious, independent economists rather than partisan political hacks, so the fact that Republican senators were unwilling to do Trump's bidding in this instance is very welcome.
Still, one suspects they felt they had little choice, given the controversy generated by Moore’s offensive comments about women in the past as well as legal troubles following his failure to make spousal and child support payments. What if Trump manages to find an equally unsuitable hack without Moore’s personal baggage? Would Republican senators acquiesce in such an instance? “Congress did its job, but that was just one battle,” as Grant Thornton chief economist Diane Swonk put it. “There is still a war on the Fed’s independence.”
Hedge funds slacken off to protect bonuses
Hedge fund managers habitually slacken off in the latter part of the year. That’s according to research conducted by hedge fund managers KC Hamann and Parag Pande, who examined the returns of some 1,000 funds. The typical fund reduces its risk appetite by 17 per cent in the second half of the year, they found, with managers most aggressive in the first quarter and least aggressive in the fourth quarter “nearly every year”. The idea that there are fewer investment opportunities in the second half of the year makes little sense, so the likely explanation is that there is “an epidemic of seasonal effort” among hedge fund managers. Why? Incentive fees motivate managers to work hard in the first half and play it safe in the second half, protecting their gains to ensure a year-end bonus.
There may be other explanations, of course, although previous academic research has found profitable funds were more likely to “lock in” their gains later in the year. It’s not ideal for clients, of course, who pay the same hefty management fee in the second half of the year as the first, but the reality seems to be that managers don’t “strive to do their best at all times”; rather, “they strive to do just well enough”.
