"Insanity: doing the same thing over and over again and expecting different results." - Albert Einstein
About that rising rate environment thing…
Last week, markets served a humbling reminder to traders and investors of something we continuously stress - magnitude of being right matters far more than frequency of being right. Seemingly out of nowhere, a severe decline took place in a matter of days. "Markets in turmoil!" Suddenly, many appear to be scrambling to manage risk, when in reality risk must always be managed beforehand, not afterwards. Charlie Bilello, our Director of Research, wrote a great piece about risk and reward, available by clicking here. Would highly recommend you tune in to CNBC this Monday at 11:30 AM EST and watch him be interviewed live.
This is not because of China (NYSEARCA:FXI). If it were, large-cap multinational stocks (NYSEARCA:SPY) would have been underperforming small-cap stocks (NYSEARCA:IWM) in advance of the sudden move. Nor is this about the Fed and when rates will rise. I have noted continuously both here and on Marketwatch that the yield curve has been sending a clear message that something remains ridiculously wrong as inflation expectations collapse globally. Why it comes as a surprise that stocks fell with such ferocity is beyond all logic given how disconnected they have been from all the negativity surrounding them.
The Fed conditioned people into thinking that the volatility of stocks in the last few years is normal, and that everything else around it is "too volatile" by comparison. Expectations simply need to be reset. Normalization means a market which cares about risk. It was only a matter of time for that to happen. The very nature of corrections is that they tend to occur when you least expect it, unless you follow tried and true leading indicators such as the ones outlined in our award winning papers.
Now, after the greatest 5-day advance in history for the VIX (NYSEARCA:VXX), there is a growing chorus that the Fed needs to bail the market out yet again and delay rate hikes, using the 1937 analogy whereby early tightening resulted in a recession and massive decline in the Dow Jones Industrials. This is complete and utter insanity. If all it takes is three days of stock market declines to cause everyone to flip their opinion on Fed policy direction, then we are in a shockingly fragile environment. Furthermore, if you think the worst is over, spend time looking at the behavior of commodities, emerging markets, and junk debt as of late. The risk is no longer heightened in those areas of the investable landscape. The risk is in US stocks which completely defied historical co-movement and disregarded risk management entirely.
Our equity and alternative investment strategies which build upon our proven leading indicators of volatility and which tend to thrive in highly volatile periods for stocks remain in defense mode. Stocks could certainly rebound here short-term, but if they do so without yield curve steepening and cyclical leadership, then things might end up getting a lot worse before they get better. There are a lot of very weak hands to shake out given how "the world changed in three days" which is a completely ridiculous way of looking at investing. If indeed this is how the vast majority view the world of stocks, then very likely far more declines need to occur to break the risk-free return mentality that exists in equity markets.
Managing Risk Pre Not Post,
Michael A. Gayed, CFA
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.