Servant Financial's risk aware portfolio positioning has successfully dampened volatility in periods of market corrections when they occur, such as S&P 500 index's losses this past February and March which marked the first run of back-to-back monthly market declines in over two years. Volatility re-emerged beginning in February, 2018 from a prolonged period of calm and investor complacency. From its nadir of 9.14 on November 3, 2017, the Chicago Board Option Exchange (CBOE) VIX index (the so called equity fear index) spiked dramatically on February 5, 2018 by 20.01 points (or 115.6%) to close at 37.32. One has to go all the way back to August, 2015 for a date when the VIX exceeded 40 when fears of a China hard landing and plunging oil prices spooked investors. We believe that the pronounced market action early this year portents the resumption of more normal market volatility going forward and the potential for tail risk scenarios.
The chart above from Seeking Alpha article entitled "The Return of Volatility" dated February 5, 2018 depicts the downward path in the global average VIX in red against the rise of global equity index MSCI ACWI (All Country World Index). We believe that global equity implied volatility will continue to rise given extreme valuations and suppressed equity risk premiums, particularly in the United States, a maturing global economic cycle, and central bank policy tightening led by the Federal Reserve.
Fundamentally, we believe that valuations and volatility levels are mean reverting in an inverse manner and often on a contemporaneous basis. Excess equity valuations will decline and suppressed volatility and equity risk premiums will rise toward their historical and normative levels over time. This mean reversion process can occur gradually or suddenly.
We've shown the chart below (registration required) of GMO's 7 year expected real returns (excludes inflation impact on nominal returns) of asset classes a number of times over the years. It is downright perplexing and scary to see with hindsight how GMO's 7 year expected real returns have progressively deteriorated from low or no expected returns in 5 or 6 years ago to the point where now GMO is forecasting negative expected real returns across all major asset classes except for emerging market equities +1.9%, emerging market debt +1.6%, and cash +0.8%. Who could have imagined an investment opportunity set this awful would emerge as valuations continued to rise from already excessive valuation levels? Reality is once again stranger than fiction and behavioral finance experts have another exceptional period of investor euphoria to challenge the rational market assumption underlying the efficient market theory.
GMO projects real annual losses on U.S. large caps of (4.2%), U.S. small caps of (2.4%) and even U.S. high quality stocks of (2.1%) over the next seven years.
In GMO's first quarter 2018 letter (registration required) to investors entitled "Is Investing Starting To Get Difficult Again?: I Hope So", Ben Inker, Co-Head of GMO's Asset Allocation team, discussed the resumption of normal levels of volatility and its impact on the investment process.
For the last eight years, investing has seemed to be a pretty easy activity to most observers. Not only have markets given strong returns, but the apparent riskiness of both individual assets and overall portfolios has been low. It has not simply been the lack of giant, horrifying market dislocations that gives the impression of low risk, but the combination of very low general market volatility and an extremely friendly correlation structure such that stocks and bonds have been wonderfully diversifying. For most investors, this has been a happy combination. For those investors targeting a given level of volatility, whether through risk parity or otherwise, it has been a license to lever up their exposures significantly, to generally good results. Last quarter, investing started to seem a little harder. Not only were returns to most assets mildly negative, but volatility rose and correlations shifted. That’s a good thing, probably a necessary thing if investors are to achieve their long-term goals. On the other hand, we’ve only started the transition from easy to hard, and that path is, almost by definition, not a pleasant one. Investing is often a case of “be careful what you wish for.” “Easy” is fun in the shorter term, and the shorter term can go on for a surprising amount of time, but it winds up being self-defeating. “Hard” is, well, hard, and it’s hard to like things that are hard. Personally, I’m hoping for a return to hard. Not only should it lead to better long-term returns to investors, but it is also a good deal more interesting. Maybe last quarter was a blip and we are going to go back to “easy” for a while longer. If determining when easy turns to hard were easy, well, hard wouldn’t be as hard. But portfolios built for “easy” are poorly designed for “hard.” If conditions prevailing in the first part of this year persist, asset valuations will very likely have to fall, and the process could become disorderly if levered positions have to be unwound reasonably quickly. (emphasis added)
In the first three months of 2018, volatility rose and correlations between stocks and bonds shifted. In other words, last quarter looked a lot more like the average conditions investors have experienced over the last 150 years than the very low volatility and strongly negative stock/bond correlations of more recent memory. The change, albeit only over a short period, should have investors evaluating whether the “easy” environment that we’ve seen through this bull market will continue. If it does, the returns we “deserve” to earn as investors should be low. If not, we can hope for a bumpier but more profitable future in the long run. Which path will the future take? My money is on the latter. As Hyman Minsky put it, “Stability breeds instability.
Likewise in his latest investor letter entitled "Comfort is Not Your Friend," John Hussman examines Minsky's stability mantra from the standpoint of investors' perceptions of comfort and safety in peaking economic and investment trends:
The key point is that strong investment opportunities are almost always born out of discomfort. Likewise, market collapses are almost always born out of confidence and euphoria. Markets peak when investors feel confidence about the economy, are impressed by recent market gains, and are comforted by the perception of safety and resilience that follows an extended market advance. So several features generally go together: 1) extreme optimism about the economy and corporate earnings, 2) depressed risk-premiums, and 3) steep market valuations. Poor subsequent market returns ultimately follow, though not always immediately. In contrast, markets trough when investors are frightened about the economy, are terrified by recent market losses, and are paralyzed by the perception of risk and fragility that follows an extended market decline. So several features generally go together: 1) extreme pessimism about the economy and corporate earnings, 2) steep risk-premiums, and 3) depressed market valuations. Strong subsequent market returns ultimately follow, though not always immediately.
The chart below illustrates this regularity. The areas shaded in red are rather comfortable periods, featuring an unemployment rate below 5% and within 1% of a 3-year low, an S&P 500 price/revenue ratio above 1.15, typically reflecting a period of strong recent market gains, and an ISM purchasing managers index above 50, reflecting expectations for an expanding economy. Notably these periods of comfort were followed by S&P 500 total returns averaging zero over the following 3-year period, with deep interim losses more often than not. In contrast, the areas shaded in green are rather uncomfortable periods, featuring an unemployment rate above 5% and within 1% of a 3-year high, an S&P 500 price/revenue ratio below 1.15, typically reflecting a recent period of dull returns or market losses, and an ISM purchasing managers index below 50, reflecting expectations of a contracting economy. Notably, these periods of discomfort were followed by S&P 500 total returns averaging 15.3% annually over the following 3-year period.
Hussman closes this discussion with this uncomfortable warning:
The upshot is straightforward: the best investment opportunities emerge from reasonably valued markets and uncomfortable economic conditions, while the worst risks emerge from richly valued markets and comfortable economic conditions.
Investors make a very expensive habit of buying stocks at elevated valuations because things feel very comfortable, which is exactly what they are doing now. Later, they sell stocks at depressed valuations because things feel very uncomfortable. Over the complete market cycle, that constant desire for comfort is extremely costly.
Strong investment opportunities are almost always born out of discomfort. Likewise, market collapses are almost always born out of confidence and euphoria.
What made the recent cycle unusual in that respect is that the Federal Reserve’s deranged policy of zero interest rates encouraged investors to speculate even after euphoria and extreme “overvalued, overbought, overbullish” syndromes repeatedly emerged. That speculation finally amplified valuation extremes beyond what we observed at the 1929 and 2000 market peaks. It was certainly an aspect of this half-cycle that we had to adapt to (by requiring explicit deterioration in market internals before adopting a negative market outlook, regardless of the severity of “overvalued, overbought, overbullish” conditions, and with no exceptions).
But the relationship between euphoria and subsequent loss hasn’t been repealed. Rather, the duration of this episode of euphoria has been stretched to an extent that will make the depth of subsequent losses far worse than in most prior market cycles. Based on the valuation measures we find best correlated with actual subsequent market returns across history, I continue to expect the S&P 500 to lose nearly two-thirds of its value over the completion of the current market cycle, with slightly negative total returns on a 10-12 year horizon. (emphasis added)
Servant model portfolios have been positioned for the resumption of volatility, an increase in risk premiums and cross asset class correlations, lower valuations and the instability that comes with "hard" and "uncomfortable" times and concomitant tail risk.