A top-tier financial web site interviews me at the start of every year. The interviewer typically asks me about specific securities, asset allocation, economic backdrop as well as the impact of events (e.g., central bank monetary policy, mid-term elections, tax reform, etc.)
This year, at the tail end of the interview , I fielded an atypical query. He wanted to know what “market surprise” might occur in 2018 (good or bad) that the financial media are not talking about.
I thought for a brief moment. Then, I answered with the following:
“You have scores of people who are doing nothing more than sticking with the trade that has worked so well for five-plus years, and that’s shorting volatility. Yet risk premia really cannot move much lower…”
“One aberration, one surprise or shockwave to the system, and volatility would soar. People are not prepared for the eventuality. Scores of traders/investors will get scorched by a rapid reversal in volatility pricing…”
Now, everyone’s talking about the violent short-vol unwind. Indeed, many blame the volatility event for the Dow’s 4.6% Monday beating. Even worse, the popular trade’s reversal completely wiped out participants in a matter of hours.
Those who had grown comfortable (and greedy) by holding positions like VelocityShares Daily Inverse VIX Short Term ETN ( XIV ) rode a runaway train straight off of the tracks. Imagine boarding just two years ago near a price point of 20. Two years later, you prematurely celebrate an astonishing 600% return when XIV hits 140. And then a singular “unforeseen” moment, nearly everything you had invested, including your principal gets eviscerated.
To be clear, I did no predict when the eventuality would occur. Yet the risk-reward of participating in a trade that taxi drivers and Uber drivers were recommending to me? I have seen enough and studied enough over 30 years.
Consider the silliness of mainstream reporters proclaiming that this is “the most hated bull market ever.” Were they unaware that nearly every measure of extreme bullishness – irrational enthusiasm for the continuation of stock price appreciation – sat in the 96th-99th percentile? A monumental shot across the bullish bow may not have been predictable with respect to time, but it inevitability was never in doubt.
Now mainstream soothsayers advocate buying this specific stock market dip. (So far, it has only been a “dip.” We have not even seen a garden-variety 10% correction off of the high.) Naturally, this may turn out to be a near-term decision with short-to-intermediate term benefits.
Here’s the problem with buying the proverbial dip. It works until it doesn’t. Those who have had some cash to buy modest pullbacks have been rewarded like rats receiving water and cheese at the end of a maze. Yet there will come a time when buying a 3% or 5% or 10% or 15% sell-off will fail miserably.
Shorting S&P 500 volatility also worked until it didn’t. Granted, the punishment was far greater than buying stocks at lower prices. Nevertheless, buying stocks on a 5% sale or a 10% discount from all-time record peaks hardly guarantees positive, long-term outcomes.
Recognize that at the start of 2001, there are those who bought the Nasdaq 100 ( QQQ ) at 50. That was 50%-plus off an all-time peak one year earlier. Seemed like a wonderful idea, right? A HALF-OFF sale!
Holding-n-hoping with QQQ at 50 meant logging a monstrous loss of capital (-65%) by October of 2002. Even if one maintained a hold-n-hope fortitude through the tech wreck in the early 2000s as well as the financial crisis in 2008, one did not meaningfully climb above an entry point until 2011 (a decade later). If you adjust for inflation, one still lost purchasing power. And this happened after buying QQQ on a HALF-OFF sale.
“But Gary, corporate earnings have never looked so terrific,” you argue. (Where was this argument against stocks during the two-year earnings recession a few years back, but I digress.)
Corporate earnings undoubtedly received a boost to the E in P/E with recent tax reform, in the neighborhood of 15%-20%. On the flip side, manipulated non-GAAP earnings are 25% higher than GAAP earnings. That is a pretty substantial gap between “operating” (red line) and “actual” (blue line).
Similarly, there are plenty of overvaluation similarities with the tech bubble that should not be dismissed outright on the “interest rates are low” argument. Price-to-sales (P/S) and market-cap-to-GDP have exceeded the tech bubble’s valuation levels. Note: Anyone justifying exorbitant valuations on the low rate mantra has not successfully explained away the four bear markets and fair price valuations during the 20-year period of low rates between 1935 and 1954 .
Finally, and perhaps most importantly, central bank balance sheet expansion is decelerating rather than accelerating. In 2016 and 2017, central banks created trillions of dollars and acquired assets everywhere they could. Demand for stock outstripped supply.
Years of quantitative easing (QE), however, is set to become a form of quantitative tightening (QT). In Q1 of this year, expansion will cease. By the second half of 2018, European Central Bank and Federal Reserve net purchasing activity will actually turn negative. That’s bad for bonds. That’s bad for stocks. Heck, that is bad for the “wealth effect.”
Admittedly, if financial markets scream and kick loud enough, the tighteners may lose their resolve. In fact, they may go right on back to more QE. Yet placing all of one’s confidence on global central bank bailouts, let alone faith in policy flip-flopping doing the trick, is a gamble. The Fed did not successfully save the day in the 2000-2002 tech wreck – they failed to minimize the ugliness of the financial crisis in 2008.
In aggregate, we haven’t made any significant moves in 2018. We still maintain our somewhat conservative allocation for retirees and near retirees of roughly 55%-60% equity, 20% shorter-term investment grade income, and 20% cash equivalents. It is unlikely we would make a significant change to the allocation without a definitive shift in the monthly close on the 10-month trendline .
Still, there always are a few low-debt value standouts that pop on the radar. I have been nibbling at Argan ( AGX ) – a holding company with subsidiaries in power industry, industrial fabrication and infrastructure services. With a price-to-earnings ratio of 7.5, no bank debt and a ton of cash, this is the one area where buying the dip has more favorable implications over a long-term horizon.
See also Freeport-McMoRan: The Dividend Is Back on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.