When the next market decline comes, we believe it will be sharper and deeper than investors expect. Four compounding concerns keep our team up at night: monetary policy, rules-based strategies such as smart beta, the Volcker Rule, and circuit breakers.
1. Monetary Policy: Back to the Future?
Looking back at the past four decades is like watching remakes of the same movie. We watched the original played out in the 1980s, and remakes in the 1990s and 2000s. Now we're on version four. Each version is a little different, but the plot is the same.
In the 1980s, the U.S. dollar was so strong, the governments of France, West Germany, Japan, the United States, and the United Kingdom agreed to depreciate the currency (under the Plaza Accord) then subsequently halt its decline (under the Louvre Accord).
During the intervening period, American monetary policy was stimulative, and during such environments three characteristics tend to appear: market volatility is relatively low, real returns are relatively high, and mis-pricing leads to a bubble that ultimately bursts.
That's how Black Monday in October 1987, the S&P 500 Index dropped more than 20% in a single day, when the S&P 500 Index dropped more than 20% in a single day.
In the 1990s, we experienced another period of stimulative policy. Federal Reserve Chairman Alan Greenspan, in response to Black Monday, engaged in “the Greenspan put,” which entailed aggressively stimulating whenever the market fell.
Market participants began to feel that the Fed would always truncate their downside. Consequently, investors viewed technology as a less risky investment opportunity to improve productivity.
During this period we again experienced low volatility (the longest stretch of it I can recall), a significant real return on equities, and a market mis-pricing that led to the dot-com bubble bursting in 2000.
As we rebounded from the bursting of the tech bubble and progressed beyond the summer of 2002, monetary policy again became stimulative, partly in response to the dot-com crash. And once again, this led to low volatility and higher real returns.
It also drove the mis-pricing of the real estate segment, which was exacerbated by subprime security issuance, and when that bubble burst, we experienced the Global Financial Crisis of 2007/2008.
Noticing a pattern? Different movie, same plot: stimulus followed by low volatility, high real returns, and a reckoning at the end.
Now we're in a new decade, and monetary policy is once again stimulative—not just in the United States, but around the world. Volatility has been relatively low, and we've experienced a prolonged bull market, especially in the United States. The exposition for this movie has been made but the last scene hasn't been filmed.
My concern is that with each remake, the period of monetary stimulus gets longer, and the reckoning ultimately becomes more difficult.
2. Smart Beta: Is it Smart?
Currently, the marketplace has a plethora of strategies that are somewhat or completely rules-based, such as smart beta strategies. These are often packaged within exchange-traded funds (ETFs).
By using strict rules to invest, these strategies may have characteristics that allow only for investing in the United States or contain only high-dividend stocks, small-cap stocks, or low-volatility stocks.
There's a lot of overlap in the securities these strategies own. For example, a high-dividend strategy might also invest in low-volatility securities, resulting in a concentration of flows into certain sectors and securities.
Because these strategies are contractually obligated to transact when outstanding shares begin to decline (or to rise), they are likely to exacerbate any market decline that may occur, just as portfolio insurance did back in 1987.
Portfolio insurance was a method of hedging a portfolio of stocks against market risk by short-selling stock index futures. It essentially replicated a put option: if the market went down, portfolio insurance would reduce the portfolio's exposure.
This exacerbated the 1987 market decline, compressing a lot of it into one day (Black Monday)—and with many rules-based strategies data mining consistent factors, the same thing could be happening today.
How much of the market is invested in these strategies depends on how “rules-based” is defined.
AI machine-learning strategies aren't anywhere near as rules-based as smart beta, but they are still driven by quantitative models. And when the market declined in the first quarter of 2018, both of these strategies went down, suggesting that both are investing in the same areas.
Risk parity strategies, which focus on the equal allocation of risk rather than allocation of capital, aren't rules-based, per se, but I have a similar concern about them—the correlation between stocks and bonds is rising, which may force an overall deleveraging by those players.
If we add up the strategies that are to some extent rules-based, we think they comprise about 6% or 7% of the equity space. And, if rules-based strategies lead to an environment like the one we had in 1987 with portfolio insurance, they would significantly exacerbate any market downturn.
3. Volcker Rule: Where's the Liquidity?
My third concern is the Volcker Rule, which was part of Dodd-Frank, the financial reform law enacted in 2010. One of its mandates is to prevent investment banks from engaging in proprietary trading, which is when a bank invests for its own direct gain instead of on behalf of clients.
This essentially prevents trading desks at investment banks from maintaining an inventory of securities. In the absence of inventory, they cannot fulfill a function that they have fulfilled for decades—expanding or contracting their balance sheets, which provides a valuable source of liquidity by buying during market declines.
Investment banks have now become middlemen, merely passing along the securities they take to other players (and often those players are high-frequency traders).
The result has been a significant decline in the size of transactions. There are fewer 50,000-block trades and more 1,000-block trades.
The markets, especially some fixed income segments, are not nearly as meaty as they once were. We don't know from where liquidity will come in the event of a significant market decline.
High-frequency traders have no obligation to step in and buy and they can stop trading on a dime, as they did in August 2015, a couple of weeks after the China currency devaluation. Today, there's a fragility to the market that we've never seen before.
4. Circuit Breakers: Can We Get a Break?
My final concern is circuit breakers. Developed in response to Black Monday, circuit breakers were designed to pause the markets for a brief period after a significant decline, to allow investors time to gather information and make informed decisions.
With each crisis, however, we've seen more circuit breakers. We now have stock-specific circuit breakers and marketwide circuit breakers, and exchanges around the world all have different circuit breaker rules. These circuit breakers have two effects: a magnet effect and a spillover effect.
The magnet effect occurs when a declining market approaches the circuit breaker. Sellers who wouldn't otherwise sell are drawn to do so because they want to ensure they get it out before the threshold is reached.
The spillover effect is an exacerbation of the magnet effect and acts like water going over a cliff. The first circuit breaker is hit and when trading resumes, the magnet effect is provoked—even more sellers who wouldn't normally sell get out. So then another circuit breaker is reached, and the same scenario plays out.
In the United States, circuit breakers kick in when the markets are down 7%, 13%, and 20%. Ultimately, the waterfall of selling finds a way to get to the river below, and then it spreads out, through streams and tributaries.
But when there's no place for the water to go, when no one will buy what they're selling, traders will reduce their risk by going someplace else. And the next best alternative could be another country's market, which causes the crisis to be much broader than it otherwise would be.
The Next Decline
With these contributing factors, the next market decline will likely be sharper and deeper than investors expect, and it's important to be ready.
While it is difficult to know exactly when the decline will occur or what might cause the “avalanche,” we must position the portfolio in a way that will allow us not only to navigate this disruption but also to be ready to appropriately step into the resultant opportunities.
Brian Singer, CFA
Partner & Portfolio manager
William Blair Investment Management
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