Investing in Volatile Markets

Investing in Volatile Markets

Starting with 2009 into the first portion of 2020, investors enjoyed a constant ride with volatile markets under historical norms. As we advance, traders need to accommodate and find out how to invest in volatile markets. The procedure that fostered asset prices within the previous 11 years (low rates of interest and central bank buys) will not be as efficient going forward.

Most investors, being biased long their national equities markets, suffered through the coronavirus situation. Many were over-extended, basically betting on the market continuing to get better while it actually got worse.

It will take a while for them to return to their faith. Economic reopenings will be sluggish and limited, and before the second half of 2021, a vaccine will probably not be available.

The Way to Invest in Volatile Markets

Volatile markets are just another instance where you need to go contrary to your instincts to handle it well. It is the same notion as to how traders typically see assets based on what direction they are moving in.

For instance, once the cost of an asset goes up, the standard reaction is that it is a much better investment than a more expensive investment.

Our behavior that rules purchasing financial assets is generally against our behavior purchasing something else.

If an object that we like goes down in price (e.g., a discount), we consider it cheaper.

If a financial asset drop in size, we view it as a bad investment or a riskier one.

In some cases, one might say that we view financial assets as what economists call “Giffen goods” – that is, our demand for it rises the more the price goes up. This way, Bitcoin may theoretically also be thought of. Once people realized it was going up, they were more likely to buy it out of fear of losing out. When Tesla was going up before the collapse brought on by the coronavirus, the popularity of Robinhood increased. We learn of some form of product making a lot of money, and we are likely to hop on the bandwagon.

That is definitely not a smart idea. People buying to the tops of bubbles (e.g., Japan in the late-80s, tech in the period 1998-2000, US housing in 2007, Bitcoin in 2017) would continue to stay underwater for years, if not forever.

Chances are they don’t know it’s a trap, as they think it’s a new idea, although it is clear in retrospect. Besides, many investors want out of the investment when it drops either for cash flow. Or to eliminate the associated pain by holding a volatile investment that has terrible performance recently.

Low volatility regimes may also spur this form of behavior, where low volatility encourages buyers to underestimate their vulnerability massively, and high volatility leads traders to become excessively vigilant.

Applying the Concept to Volatility

The idea is analogous.

Yield is more important to investors when uncertainty is small, so they are more confident in taking risks. So, you bid down the price premiums.

Accordingly, both discretionary and mechanical plans tend to leverage up to magnify smaller premiums to the return on equity. More placid environments often lead to their downfall due to the buildup of this leverage. Reactions become amplified from the contrary direction.

Since beginning to calculate the coronavirus effects on the volatile markets, the return is not as significant relative to the threat. Capital preservation is then more significant, and money-flow-constrained investors sell to increase money. Thus, risk premiums collapse, folks deleverage, and resources become cheap.

Needless to say, many investors may wish to move their funds as risk premiums move and flow to find the very best return relative to their risk – i.e., move into assets that risk premiums are enlarging (asset prices taking a fall) and sell since the risk premiums contract (asset costs increasing).

The definition of returns in one asset class relative to another is a risk premium.

What is bond yield relative to cash?

What is stock yield relative to bonds?

There are different approaches to doing this. One explanation is below.

Asset returns graph

It’s among those large three market equilibriums that’s part of the mechanisms of how markets and economies operate.

This displays the latest yields and risk premiums (“RP”) for USD investments across different asset classes.

It shows that cash and short-term bonds deliver minimal yields. To enforce their policies, the Fed – like other existing central banks on the market – had to make cash and bonds unattractive to bring investors into the kinds of reserves that would help fund spendings.

Stocks do not have conventional returns like bonds and cash. In the latter two tools, those could be set by taking a look at their interest prices. Money pays a return approximately the same as all the short-term prices supplied by the central bank. Bonds pay a return based on their regular voucher payment relative to their current cost.

The “return” of stocks could be considered as the anticipated earnings relative to this price. Basically, it is the reciprocal of the forward P/E ratio.

If the forwards P/E ratio is 16, then stocks “return” the reciprocal of it, or a bit more than 6 percent. If you compare this to a secure bond of comparable length yielding just under 1%, this risk premium is 5-5.5%.

Usually, the excess yield of stocks within the 10-year Treasury has been nearly 3%, and the yield of stocks over money is roughly 5 percent.

Stocks generally cheapen when volatility is greater as people need more reimbursement to maintain them.

The graph above projects the forward yield of shares at 6.07 percent. It predicts that corporate earnings will snap back to normalcy levels in a year.

Is this overly optimistic? It might be, given just how much more we need to go to reopen the market.

Volatile Stock Markets: Comparing the big and small cap-gap

You can find divergences within asset categories.

When concluding industry cycles, many investors move from cyclical (e.g., autos, consumer discretionary, manufacturing, building homes, banks, transport) and to businesses with more steady earnings and revenues (e.g., consumer staples, health care, utilities).

The same goes for the magnitude of a business concerning investors’ preferences for small-cap and big caps. Larger, more diversified businesses tend to perform better toward the latter phases of the company cycle and during the violence of a downfall than smaller, not as many diversified businesses.

Concerning volatile stock markets, the dip in small caps has been particularly challenging.

The USA small caps, through the Russell 2000 index, dropped 43 percent in a couple of weeks peak to trough, deeper compared to 36 percent from the S&P 500, which is basically a big cap index. Additionally, small caps have not hit a fresh high since August 2018.

Little cap underperformance pre-dated that the coronavirus catastrophe. Here we see a Russell 2000/S&P 500 graph (mall cap indicator split by large-cap index):

Russell 2000 / S&P 500

Russell 2000 / S&P 500 - volatile markets
(Source: Trading View)

Small caps are usually defined as people have a market capitalization of $2 billion or beneath.

They tend to have less diversification, are somewhat less global (exposing them to fewer markets and diversification chances), have significantly fewer earnings, and are more leveraged. This makes them vulnerable to economic downfalls more than bigger businesses. They’re also less liquid to exchange when compared to large-cap companies.

They were falling behind in the previous 2 years since investors were uneasy over the way US-China trade pressures would affect their company. Moreover, investors thought that small caps are riskier to have later in the process because of these attributes. Thus they missed out on the S&P 500’s march to new records in 2019 and the first part of 2020.

The part of small caps that don’t earn money and have high debt levels has been climbing. March 2020 declared the worst month for smaller caps ever since October 1987. Almost 100 percent of stocks dropped, and more than 85 percent suffered declines of over 20 percent.

The fall was the fastest in the recorded history of the bear market territory, surpassing all other famous bear markets. In 2008 (subprime lending), 2000 (tech bubble), 1987 (heavily a 1-day happening), and market fluctuations from the 1929-1945 era of the Great Depression and WWII.

Given the character of an economic shutdown, excluding the most crucial services, the industry route has been wide and spanned across industries.

By the end of February, based on BofA Global Research and FactSet data, Russell 2000’s unprofitable firms stood at 29%. The highest since November 2009, when 31% had negative earnings. That certainly increased after the coronavirus effects shut down significant portions of the economy.

How Can Investors Win in the Markets

Actively trading based on which resources are expensive or cheap relative to one another according to their risk premiums isn’t simple since it takes a degree of timing.

Most investors need to have a well-balanced portfolio, which may extract risk premia through the cycle and avoid bias toward some environment.

Every asset category has an environmental prejudice.

Stocks fare nicely when growth surpasses anticipated results and when inflation is moderate or low.

Government bonds of the reserve currency states do best through deflationary recessions.

Gold does best when real interest rates are reduced or during intervals of geopolitical uncertainty.

The goods do their best through times of inflation.

Money does best when credit and money are tight (essentially periods when the higher-returning resources do badly because funds are insufficient to purchase them, resulting in many sellers comparative to buyers).

Environmentally biased portfolios necessarily have horrible drawdowns. They excel in a specific environment and always do badly as soon as the environment changes.

Mixing assets nicely enhance your yield per each risk unit and reduce expected drawdowns, shorten submerged intervals, and offer lower left-tail risk, among several additional advantages.

Limiting left-tail risk is fundamentally the concept of restricting how much you can shed. We tend to spread over various asset categories, currencies, and states. When done wisely, the risk moves from”How will the stock market in the US fare?” to “Will the shift outperform money?”

One thing that we can be fairly sure of over the years is that financial assets will outperform money. That is a risk you’ll be able to feel quite comfortable taking.

When this does not hold up (for a short period in late February and early March 2020 since the Covid-19 problems were raging), policymakers have large incentives to get the system going to get cash flowing back into assets. Central banks will do anything to conserve the machine – decreasing interest rates, purchasing financial assets of different kinds, and backstopping all kinds of collateral.

Here is a drawdown map of a basic portfolio of 25% stocks / 40% intermediate government bonds / 20% cash / 15% gold portfolio (blue line; diversified) versus a portfolio of 100% stocks (red line; non-diversified).

drawdown map of a basic portfolio of 25% stock - volatile markets

The bond shift is generally performed through bond futures, as it takes less capital outlay. Mixing assets nicely typically lets you acquire equity-like yields at 30-40% of the risk, or greater than equity returns in precisely the same risk or any permutation thereof, based upon your leverage. The quantity of leverage necessary to design a portfolio similar to this is quite low.

If investors can look at leverage with no black-and-white preconceptions – “no leverage is great, and any leverage is poor” – they’ll observe a reasonably leveraged, highly diversified portfolio is less risky than an unleveraged, non-diversified one.

Volatile Markets Greater Than Normal Will Stay for Awhile

The coronavirus had a definite catastrophic impact on the US market. This came at precisely the same time US equity markets were at all-time highs. Many dealers were set for the market to continue its growth, which had lasted twenty-five years, the longest in the nation’s history.

A lot of economic indicators reported their biggest downturn ever. That covers retail prices, the index of general terms of business for the New York Fed, and the NAHB housing market index. The decline in industrial output in March was the worst in 70+ years.

The market will recover, but it is going to take some time. It has affected incomes and balance sheets. For instance, many entities, assets, and savings are struck while liabilities have stayed the same or gotten worse.

Those pockets of fiscal destruction have to be full of cash and credit. Unlike in 2008, as the banks had the leveraging problems, policymakers needed to find out which banks they desired to save and which ones they could afford to go bust. In 2020, nearly all companies are taking a hit since large swaths of the market have been closed down.

Nominal US retail sales dropped 8.7% in March. This was the biggest drop since the information collection started.

Motor vehicle and parts sales dropped 25.6 percentage, which induced total retail revenue to fall 4.2 percentage points. Excluding the impact of autos, retail earnings were down 4.5% in March.

The effects of retail shop closures and social distancing hit retail sales in March and last in April plus a few months afterward.

Manufacturing information can also be dreadful. A 5.4% decline in March was recorded in industrial production. That is the biggest drop since 1946. As motor vehicles and components dropped 28%, industrial production dropped 6.3% in the third month of 2020. Excluding autos, industrial production fell 4.5% in March (it’d fallen in the first and second month, too).

The general business conditions index for the Empire State manufacturing survey plunged to -78.2 in April, from -21.5 in March. This was the biggest monthly fall and the lowest amount since the dataset’s beginning in 2001.

the biggest monthly fall and lowest amount since the dataset's beginning in 2001
(Source: New York Federal Reserve)

The Philadelphia Fed manufacturing survey’s overall business conditions index dropped in the fourth month down to -56.6 compared to -12.7 in the third month of 2020.

The outlook for business investment is also bad. Prospective spending by customers is expected to become reduced as coronavirus uncertainty lingers, causing companies to fall back (e.g., capital expenditure programs).

Both industry confidence surveys and measures of economic policy doubt affect producers’ capital spending plans. Company confidence has dropped drastically, and financial policy uncertainty has risen.

Home buying can also be a part of it. Housing starts have fallen to their lowest since the year 1984.

Housing starts have fallen to their lowest since the year of 1984.
(Source: US Census Bureau)

The NAHB housing market index dropped from 72 in March to 30 in April.

Initial claims for unemployment insurance benefits surged by 5.245 million in the week ended April 11. Claims over the last couple of weeks would set the unemployment rate at 20+%. That is over double the speed which stemmed from the 2008 catastrophe and near the rate seen throughout the Great Depression in the 1930s.

Fred: Initial claims graph
(Source: U.S. Employment and Training Administration)

Some businesses have dried up entirely. Sit-in restaurants are down nearly 100% across the country. Box office revenue is nearly non-existent. Traveling by airline companies through TSA checkpoints plunged by 96% at a year-to-year level.

In Conclusion

Markets in the US have climbed 32% in only a couple of weeks following the Fed-based swap lines, lending centers. While Fed has also agreed to purchase nearly anything (Treasuries, mortgage-backed securities, municipal bonds, corporate credit, and ETFs) to fix up the market while large pieces of it’s shut down.

The markets might be hurrying up since it will take some time for earnings to achieve their former summit. Volatile markets will stay elevated for quite a while, and any financial re-opening will be attentive and spasmodic. Folks need to accommodate in the best way they can.

Any investors seeking to create a longer-term strategy in character ought to consider diversifying any plan to not be too imbalanced in their own approach. Each asset class has a specific environment where it will fair best.

Ever since economies came out from the fiscal meltdown, stock markets transferring 3-4% in a day could have been news. Now, they do so naturally, and it appears uneventful. Rumors of re-openings and advancement toward a vaccine or treatment will be an integral catalyst of markets. Besides, we need to contend with ongoing credit risk.

Many suppose that central banks will keep their “infinite stimulation” programs moving forward. But obviously, many policymakers have doubts about this and what it can do to risk-taking and the longer-term effects over bonuses and what it implies to currency.

With markets pretty much predicted to be inconsistent in the near future, balancing and being in the know while being shielded has never been more significant.