The Big Picture
“Listening to the wind of change.” -Klaus Meine
The song Wind of Change by Scorpions was written in 1990 and quickly became a global hit. It was about the restructuring going on in the former USSR led by Mikhail Gorbachev. The conflict between the communist Soviet Union and the desire of Easter Bloc nations of Europe for change that led to the ultimate collapse of the Soviet Union in 1991.
Recognizing change is critical in assessing economic and market environments.
While the economic data and fundamental data of individual companies are painting one picture, the markets themselves are painting a different picture altogether. How do investors respond and adapt to this scenario? A good question, and not one to be taken lightly. Given the market actions of the last several weeks: Are we on a precipice of a change that will effect how we assess, measure, and think about the market environment going forward? Or, are we witnessing an anomalous event that will be more temporary and pass in time. This isn’t a question of being bullish or bearish on the market. This is an analysis of the bigger picture factors that affect market pricing.
The rules of the game may be changing. I don’t like referring to the investment world as “a game”. However at times, such as the present, it seems to be treated as such. Should the policy actions being taken prove successful, this will be the first time in history that we have a recession with no reflection, or very little, in markets.
What does this say for risk today, and risk going forward?
Have a Plan and a Process!
From the Trenches
“I can not control the direction of the wind, but I can adjust my sails to always reach my destination.”
What is risk?
Just for some review (as I yammer about this quite a bit), the traditional definition of risk revolves around a relationship between volatility and expected returns. It is a very mathematical and academic approach to a thesis on the link between the two. Basically a specific expected return should be achieved per unit of risk. It looks good on paper, and in a classroom, however in the real world it doesn’t always work out. Most investors do not think of risk this way. We define risk in one primary way: What is the risk the investor will not meet their financial goals?
A risk we come in contact with frequently because of the behavioral aspects of investing is the risk of missing out? Or FOMO (Fear of missing out). This can be very dangerous when the risk of not meeting your goals and the risk of FOMO are not properly balanced.
So the next logical question would be, what is the current assessment of risk? Or more to the discussion, has risk itself been altered?
For the first time ever, and ever is a long time, it appears that the risks that come with a recessionary economy are being ignored. At least by market prices! Initially this may seem like a good thing. However, what does this imply for the future of risk and return?
While the policies and actions taken to assist Americans and the economy are welcome and needed; what we are witnessing in financial markets is somewhat alarming. Intervention, or stimulus, has been a consistent theme over the last ten years. Nothing new there! Another round of stimulus received. However, this time the sheer amount of stimulus being deployed is truly eye opening!
It took the Fed nearly ten years to expand their balance sheet by roughly $3 Trillion. In just a few short months, the Fed added another $3 Trillion.
The inference is that the “environment of risk” may be changing. If any negative economic event will be met with policy actions that mitigate market declines, then is risk no longer present? Furthermore, if investors accept that risk is nonexistent due to policy actions; could this have a contra effect of making the market ultimately riskier? Meaning, market prices rise to levels entirely disconnected from reality?
Bottom Line: By attempting to mitigate risks and create stability, does the potential for even more instability become inevitable?
“Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.” -Hyman Minsky
Hyman Minsky was an American economist and professor. He contributed to financial theory by studying the link between market fragility in economic cycles and the speculative bubbles that arise at later stages of the economic cycle.
Do we have recent evidence of stability leading to instability in the markets?
The declines witnessed in March were an example of how quickly stability can become rapidly unstable. Given the catalyst, one may easily justify this reaction. However, not too long prior, in late 2018, we also witnessed a very quick shift from stable market to an unstable one directly related to policy action. Or in that particular case, a desire for the cessation of actions. We have had other quick price declines from time to time, such as the “flash crash”. All of these events contributed to risks arising from policy efforts and goals to achieve stability.
It is clear that policy actions have regained some stability over the past few weeks. It is also clear however that there may be some speculative euphoria developing. There is a fairly clear disconnect between different areas and sectors of the markets.
The below chart shows the QQQ/SPY Ratio, or the NASDAQ 100 index performance divergence against the S&P 500 index. The NASDAQ is primarily made up of technology, social media, biotechnology, etc. companies. The S&P 500 is more representative of all economic sectors. The divergence between them is at extremes. Meaning the NASDAQ is vastly outperforming the S&P 500. In fact, it is the greatest margin since 2000.
While there is always some divergence between market sectors, at present, we are seeing fairly extreme readings. These readings are generally only witnessed under unusual circumstances. And, unfortunately, in periods where risk was elevated, and the environment for investors potentially unfavorable.
“Unless we understand what it is that leads to economic and financial instability, we cannot prescribe — make policy — to modify or eliminate it. Identifying a phenomenon is not enough; we need a theory that makes instability a normal result in our economy and gives us handles to control it.” – Hyman Minsky
Policy efforts to bring stability to economies and markets may have in effect brought increased instability.
Bottom Line: We are witnessing data points that are not relieving our concern on increased risk. They are pointing to the potential for even more risk going forward.
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