See
also:
General Index
of all guest columns written by Dennis C. Butler,
CFA
"We're willing to sleep less, but perform better" —
brave-sounding but
dangerous words when coming from a fund manager aiming to enhance his
results marginally by departing from the narrow path of investment and
embracing the siren call of derivatives and other products of financial
"innovation." We have seen this before — AIG anyone? This time, big funds and
other investment institutions are hoping to profit from their trading
expertise and asset bases by selling protection against that bugbear of the
investment world, "volatility."�
Volatility, of course, refers to the tendency of
security prices to move up or down unpredictably and sometimes violently. We
have never really
understood Wall Street's obsession with the simple tendency of financial
asset prices to vary. As (the original) J.P. Morgan is purported to have
said, stocks "will fluctuate." Perhaps it is our idealism that leads us to
believe that genuine investing is not very concerned with short-term price
movements; in any case, their impact can be mitigated through simple
measures such as appropriate diversification and, importantly, not
over-paying.
In
the hyper-competitive fund management world in which "performance" is
monitored with equally hyper frequency, fluctuations can be damaging to
careers, not to mention to that critical figure, "AUM"� ("assets under
management"). Heaven forbid that a fund manager be caught in a downdraft at
quarter's end, just in time for those all-important performance reviews.
Hence, the desire arises for protection against the vicissitudes of the
market, and the demand for products that promise to reduce this "risk."
Naturally, Wall Street is always ready with services to meet these needs.
The
demand for volatility "insurance" comes at a time of unusual market calm in
both the equity and fixed-income realms. Economic recovery, low interest
rates, central bank monetary stimulus, and an abundance of cash in the
system are some factors that have contributed to a dampening of animal
spirits in the markets. While some traders, including hedge fund managers,
complain about the lack of opportunity for profits in an environment where
prices do not change very much, others have expressed alarm, seeing a "calm
before the storm" situation that could change without warning. Hence, there
is considerable demand for protection against turmoil at time when it
doesn't seem all that necessary.
The problem with selling insurance when the perceived
need is low is that it can be difficult to obtain a price, or "premium,"
that is commensurate with the risks being assumed. In fact, prices are
frequently depressed at such times. Further depressing the market for
volatility coverage is the growing supply, as big pension and mutual funds
show growing interest in the area. New exchange traded fund ("ETF")
products are also bringing on new "capacity," to employ a term used in the
traditional insurance business. Low returns from traditional investments
such as bonds are providing the incentive for these pools of capital to
enhance their results through non-traditional means, much as stockowners
might write options against their portfolios to generate additional income.
The risk facing the writers of volatility insurance is that they are pricing
their products too low, and when normal market volatility eventually
returns, they could potentially face big losses.
(As an aside, similar incentives explain why
so-called "catastrophe bonds" are a bad idea, at least for buyers.
"Cat bonds" are issued by insurance companies to spread their liability for
losses in case disasters occur. Such bonds are typically sold on the basis
of their relatively attractive yields, but their principle can be impaired
by an insurance liability. Cat bonds sell well at times when yields on
alternative investments are meager, and when the insurance industry hasn't
had a bad year for a while (i.e., "volatility"� has been low). Given a big
enough disaster, however, and catastrophe bonds can easily live up to their
name.)
It is unclear the extent to which funds are engaging
in these non-investment practices, or how much such undertakings have
influenced reported returns, but they could be sizable; the
Financial Times
reports one fund manager as saying that "bouts of underperformance"
could occur if the markets turned sour. In this light it is noteworthy that
financial regulators are currently debating whether big players in the asset
management business should be designated as "systemically important
financial institutions," a move fiercely opposed by the fund industry
because it would mean tighter oversight and more regulation. Given the
experience of recent years when banks and insurance companies strayed far
from the straight and narrow path, perhaps the new activities of the big
fund groups warrant this closer scrutiny.
"Bull markets are born on pessimism, grown on skepticism, mature on optimism
and die on euphoria. The time of maximum pessimism is the best time to buy,
and the time of maximum optimism is the best time to sell." This
well-known remark by fund pioneer John Templeton epitomizes the contrarian approach
to investing: opportunities are most abundant when least wanted, and most
sought after when they are not really opportunities at all, but instead good
candidates for liquidation. In other words, you should zig when others zag.
There are at least a couple of problems with contrarian thinking, however.
Pessimism about the general market or a particular security does not
guarantee that a genuine bargain exists; contrarianism needs to be qualified
by analysis. Furthermore, periods of intense pessimism tend not to last very
long
— what happens during those not-too-hot and not-too-cold times
when money has to be invested? "Just right" doesn't count in this business.
Take the current state of affairs in the equity
markets, for example. Despite the steep rise from early 2009, the current
period is difficult to characterize, as the conflicting market commentary
one sees in the media confirms. Clearly the time of greatest pessimism is
long past, but neither do the markets appear engulfed in a surge of
euphoria, or even optimism
— stocks have advanced steadily, but they have also
"climbed a wall of worry"� in the process, overcoming many doubts. A few
sectors such as biotech have attracted intense interest, but overall
excitement appears tempered, perhaps due to geopolitical unrest and fears of
central banks' reigning in of monetary stimulus.
Beyond these considerations of market sentiment,
valuation measures also present a mixed picture of current conditions. The
so-called "CAPE" index (the "cyclically adjusted price-earnings ratio") has
drawn considerable attention, and at 26.5 it now stands at levels previously
associated with extreme market events. Yet the CAPE stood at similar heights
or higher in the late 1990s and early 2000s when, paradoxically, many
opportunities appeared for investors, despite the tech bubble. More
traditional valuation measures based on trailing or prospective earnings are
approaching 20, the higher end of a "normal"� range
— expensive, but not
outrageously so. Other broad market measures also tend to reinforce the
conclusion that stocks in general are "uninteresting"� at best.
Finally, valuations for individual companies based on their "normal" earning power
are not excessive in many cases, even if they are not attractive for
investment.
On the other hand, bond valuations remain
quite inflated. Average "junk"� bond yields fell below 5% for the second time
in history (the first being in May, 2013, just before last year's bond
market rout), reaching an all-time low of 4.9% in mid-June. A bond rally in
Europe has in a few cases brought about some of the lowest rates on
sovereign debt in
centuries.
Spain, whose borrowing costs sky-rocketed two years ago on fears of default
and exit from the Eurozone, now sells debt at yields less than those of
comparable U.S treasuries, a remarkable turnaround for a country whose
economy was devastated by a real estate collapse and which still suffers
from high unemployment. We believe, as we have for quite some time, that any
future financial market convulsion is likely to emanate from some corner of
the bond market.
The future has been proven wrong once again this
year. Six months ago investment "strategists"� predicted rising
interest rates and falling commodities during the first half of 2014.
Instead, rates dropped and long-term U.S. treasury bonds have produced a
"total return"
(income plus price change) of about 13%, more than double that of equities
at around 6%. Still, the year is far from being over and 6% isn't too shabby
for six months in the stock market. Commodities confounded expectations with
indexes gaining about 8% as oil prices rose in spite of rising U.S.
production, and gold rebounded after slumping in 2013. So much for the value
of investment strategy
— which is why we ignore it.
When it comes to the future the best
policy is to protect against it, not bet on it
— prediction is a very thin
basis for committing scarce funds. Only a proven record and demonstrable
value can provide the confidence that our capital is protected whatever
course events may take.
_____________
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 27 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at
www.businessforum.com/cscc.html.
"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the
Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of
NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of
Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or
"What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
Telephone: 617.441.9695
Email: [email protected]
URL: http://www.businessforum.com/cscc.html
Your comments and suggestions for these pages are most welcomed!
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