Reminiscent of the terrible 2005 Hurricane season, the third quarter of 2017 witnessed a series of
natural disasters which caused historic flooding in Texas, ravaged the entire Florida peninsula and
devastated the island of Puerto Rico. Out West, destructive wildfires are leaving some of
America’s finest wineries in ashes. All are producing promises of government assistance which
has economists busy calculating the stimulative effects of the increased spending. Replacing
almost a million cars in Houston and rebuilding homes throughout the affected areas are sure to
generate brisk sales, but the premise that destructive events are good for the economy was
disproven centuries ago. French economist Frederic Bastiat posited his “Broken Window Fallacy”
in 1850 telling a story of a child who breaks a shopkeeper’s window. The glazier hired to fix the
window obviously benefited, so maybe it would make economic sense for more children to break
more windows. The absurdity is revealed on the “unseen” side of the story when the shopkeeper
doesn’t have enough money to buy a new pair of shoes after paying to repair his window. The
glazier benefited at the shoe salesman’s expense and the shopkeeper was no better off and had less
money in his pocket.
While still very early, we have yet to see any benefits of the recent disasters. The September
employment report came in negative for the first time since the last recession, with waiters and
bartenders suffering a monthly decline of more than 100,000 positions. That will be reflected in
lower sales and earnings at their employers. The economic effects of 2005’s storms were mostly
restrained with a growth spurt several months later which may be why the stock market showed
little concern this time. The S&P 500 continued its rally finishing the third quarter with another
record, and as these letters have highlighted recently, with valuations extended. The almost 4%
quarterly gain brought the post-Election Day rally to more than 20% with the index trading at 25
times reported earnings over the past year. Aside from recessions, that price earnings ratio has
only been exceeded around the crashes of 2001 and 2008.
That valuation is probably not driven by expectations of the Trump Administration reforming
health care and taxes. The former crashed and burned again in the third quarter as the swamp
masters in the US Senate seem to want the President to fail more than they want their own agenda
to succeed. It is hard to fathom how Republican Senators from high tax states will support the
proposed tax reform that abolishes the deduction for state and local taxes. Meanwhile, Democrats
are firmly ensconced in the #NeverTrump camp forestalling any hopes of bipartisan reform.
Despite legislative gridlock, the Administration’s regulatory rollback is clearly benefiting the
economy which could account for the 3.1% economic growth reported for the second quarter, the
strongest in over two years. The storm ravaged third quarter is unlikely to match that but a
sustained growth rate of 3% will work wonders on the deteriorating US budget deficit. Maybe
the market is hanging its hat on America becoming at least less bureaucratic if not great again.
The VIX Is In
Another case for record valuations is the new moderation that central bankers have seemingly
achieved with their quantitative easing programs that have added more than $12 trillion to
financial markets worldwide. We will soon see the other side of those programs as the US Federal
Reserve has confirmed it will begin reversing their expansions beginning this month. Since 2009,
the Fed has created $3.6 trillion to buy mostly US government bonds which will now begin to
mature and “roll off” the balance sheet. That means the money created to buy the bonds will be
eliminated after they are redeemed rather than reinvested into new bonds. This has never
happened before. Fed Chairman Janet Yellen is undertaking what has been dubbed the Great
Unwinding, it is projected to continue beyond her successor’s term that begins next February. She
and her colleagues assure us the economy and markets are firm enough to sustain a multiyear
removal of liquidity and markets seem unbothered by the clear signaling.
The Fed’s unprecedented policies were intended to drive interest rates near zero so that money
would flow into risk assets like stocks and real estate. They have succeeded to such an extent that
risk has been driven out of those markets. The price of options to buy and sell stocks at various
points in the future factor a measure of the underlying asset’s volatility interpreted as its risk. If
the asset price continuously rises, the volatility goes down. Combining the volatility measures of
all the companies in the S&P 500 produces a market-wide volatility index commonly known as the
VIX, and of course there are myriad securities derived from that. With stocks trading at record
highs, the VIX closed the third quarter at an all-time low.
In our financial markets driven by
algorithmic trading, lower VIX readings are
programmed to increase stock exposure.
Enough are piling into this trade that the
short interest in VIX contracts on the
Chicago Board Options Exchange are also at
historic levels, as you can see on the
accompanying chart. The winning strategy
has been to enlarge and extend these short
positions while adding to equity portfolios
but at some point, these trades will have to
be unwound. If it coincides with the Fed’s Great Unwinding we should be prepared for a similar
the unwinding of stock prices as the VIX reverts to its mean.
The Stepping Stones fully invested equity ETF strategy reacted to the record low VIX readings
with strength in our riskier positions. The semiconductor and China positions both enjoyed double
Source: ZeroHedge.com
digit quarterly returns with the energy positions and European fund close behind. The Japan and
Value Line funds each rose more than 5% and as we moved down the risk scale we saw the weaker
performance. The defensive gold miners rose in line with the market but the utility fund lagged
at 2.9%. The only negative return came from the consumer staples fund barely missing breakeven,
discarded by a market embracing risk. While we consider the portfolio to be in a defensive
posture, the riskier positions made the difference generating a 6.16% quarterly return compared to
the S&P 500 which gained 3.96% and the MSCI All World Index gaining 5.08%.
Reminiscences of a Market Crash
Most managers of large portfolios use VIX contracts to hedge the risks inherent in equity
portfolios. As the index trades lower, that insurance becomes cheaper to deploy. This innovative
tool to manage risk is akin to the portfolio insurance that became popular in the late 1980’s. After
rising more than 37% in nine months into 1986, the market added another 37% into 1987 largely
justified by the risk reduction that these new strategies offered. As we all found out 30 years ago
today, the portfolio insurance commonly used in 1987 did not reduce risk and in fact exacerbated
the worst one-day percentage decline in the history of the stock market.
The strategy of programming computers to sell index futures when the market declined and buy
when the market rose was introduced in 1982 and became widely employed by 1983. In March
1987 interview, New York Stock Exchange president John Phelan feared that program trading
could lead to a “first-class catastrophe.” That’s the title that NY Times writer Diana B. Henriques
chose for her recently published history of the crash of October 19, 1987, when the Dow Jones
Industrial Average declined by 22.6%. It was twice as bad as the worst day of the 1929 crash and
no day in 2008 even came close. The author discusses how “titans and their trading toys” linked
various markets like stocks, bonds, and futures so the declines were not isolated to just one asset
class like prior panics had been. She explains how large pension funds were new participants in
the stock market in those days and they used these strategies to hedge the risk they had added to
their portfolios. In effect, it spread the risk into the bond and money markets where pension funds
had previously confined their assets before these strategies enabled them to take the leap into
equities. Henriques shows how the 1987 crash reflected permanent changes that technology
foisted on financial markets.
20 years later, markets were again complacent about record valuations. Again a novel financial
instrument, the collateralized debt obligation (CDO) was said to have mitigated risks involved
with mortgage securities by dividing them into so many pieces and reassembling in a way that risk
would only be realized if a national decline in housing prices were to occur; something that had
never happened before. It can be argued that the first such instance of a national real estate
decline and the 2008 financial crash were caused by the widespread use of CDO’s and their toxic
offspring. Again, the financial panic was not confined to one particular troubled asset class but
infected all financial markets.
The stock market today appears as complacent as it was prior to those other debacles. Central
banks around the world have been buying equities for the first time in history. They are
undoubtedly using VIX instruments to hedge their newfound risks and are probably as sure of
their posture as their predecessors were prior to other panics. The misconception is that VIX
signals future risk when in fact it is merely a reflection of what a particular risk has been. The
lessons of 1987, 2001, and 2008 are how quickly that perception can change. Driving volatility
measure down to historic levels does not mean the risk is lower; it has actually masked the risks that
are inherent to any economy.
The growth spurt after the storms of 2005 quickly faded into the economic downtrend that
culminated in the financial crisis of 2008. That doesn’t mean the hurricanes brought on the crash,
but it supports Bastiat’s message more than a justification for record stock prices. The crash of
2008, like the crash of 1987 was brought on by a mispricing of risk through novel esoteric
financial products. Today’s esoteric risk management products tell us that natural disasters,
worldwide political volatility, and an unprecedented monetary retrenchment are benign to stock
prices. Maybe corporate earnings and stock prices are safe from these threats or maybe the
market’s risk measure has been skewed beyond any usefulness into a misguided justification for
complacency. If so, then rising government deficits, a weak growth trend and paltry corporate
earnings pose substantial risks to current prices. Valuations at levels correlated with poor returns
will provide little support if risk perceptions suddenly change. While we are enjoying the record
prices on our long positions we are not adding risk to our portfolios until valuations are more
favorable.
By Dan Hickey
http://www.steppingstonesmanagement.com/Commentaries.html