Global markets have already served up a financial blizzard of sorts in 2015. Currencies of all stripes and reliabilities have quickly melted versus the U.S. dollar as the economic slope-roofed shelters become increasingly scant.
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The price of petroleum has halved on what experts call “structural” and/or “supply” issues while economic bellwethers including – copper, iron ore, steel rebar have tumbled as economists with pocket protectors and smudged glasses reach for reason – all the while regretting previously dubbing physical material as an asset class comparable to stocks and bonds.
From rallying government bonds to a widening of high-yield corporate spreads to a flattening yield curve, investors are beginning to see the effects of interest rates frozen over at zero. Like snowflakes before the storm – volatility picks up as fair warning on whether this weather system is fundamentally driven or simply a bubble about to burst?
Random Events Part of the Game Plan?
The eurozone equity markets are staying warm and cozy in front of an 8% plus year-to-date rally while the S&P 500 slips about the flat-line. Likened to the upcoming NFL Super Bowl, consensus feels U.S. markets are simply stalled - waiting for Coach Yellen to retrieve Ben Bernake’s original monetary playbook which was loaned out to Draghi and team ECB last week.
While some pause for Coach Yellen to tear a scrap from the reliable QE playbook, bear in mind European equities have – on average – underperformed their U.S. counterparts by more than 50% since the end of 2009. In addition, if one should take into account – adjust for – the Eurocurrencies decline versus the U.S. dollar; the return differential would be far less than published.
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Although I’m deeply convicted of owning European equities as part of a diversified, balanced portfolio, I don’t think it’s quite as simple as lending the QE playbook to Draghi given the unique defensive schemes and trick-plays have been seen before – the opposing team is well prepared. Other words, the early U.S. Fed campaigns occurred during a completely different market environment – where corporate earnings, global activity, economic indicators, and investor sentiment were all encased in a tomb of ice. The Fed marched down the field of recovery on cleverly designed “Hail Mary” plays – providing shock and awe to a desperate fan base. The ECB is attempting a similar plan but, they are playing against a very mature economy and their playbook needs approval from every team member, coach, and trainer.
Money-Changers Driving on Icy Roads
The dramatic shift in gears by the Swiss National Bank, and the abrupt avalanche of recent foreign currency moves don’t look to be a concern to anyone – yet. The sheer number of countries with currencies recently depreciating more than 10% is astonishingly high. More randomness? A straight-forward result of general mismanagement aggravated by those desiring to peg their value to the U.S. dollar? A lack of confidence in the global economy combined with fewer safe places to wait out the impending blizzard? Fundamental driven trend, boom-bubble-bust, or was QE just a sham?
Icebergs and a Big Question Mark
Today, the energy sector seems to be deeply underrated while banks and diversified financials appear attractively underpriced. As you would guess, beneficiaries of lower energy prices include – retail, food & staples – all of which are a bit pricey. If when interest rates go up, banks, autos, and semiconductors should benefit while software, utilities, and healthcare should suffer. Value tends to benefit from rising rates while growth benefits from falling rates.
In general and in theory, a stronger dollar benefits stocks that conduct their business inside our country – (e.g. Republic Services (RSG), Southwest Airlines (LUV)). However that equation is based on history – any further extrapolation requires explanation on why the dollar is strong. It’s been true that the average small-cap stock gets half of its revenue from international sources compared with large caps – it would make sense that small caps should beat large caps when the dollar rallies. But again, this is only reliable if the U.S. dollar is rallying for the “right” reasons.
Surviving a Snowball Fight
The current landscape brings into view why maintaining a long-term and disciplined approach to investment is so important. To me, this means following the principles of diversification and rebalancing.
Sadly, many investors have implicitly and unwittingly bought into a view of action and behavior that overestimates thinking. This is even true in pockets of the industry that are suspicious of technical and quantitative trading. We overestimate thinking when we assume that our action and behavior are the outcomes of discrete decisions we make (i.e. energy prices, U.S. dollar, interest rates) on the basis of what we know. When we assume that, then we construe trading as the result of primary information dissemination. But, on a gut level, we all know this doesn’t work. We simply don’t know what we don’t know!
We are surrounded by the beautiful notion of randomness - there is no free lunch in investing. To think otherwise is to misunderstand the nature of markets, risk and reward. In order to earn a return over inflation, we have to seek returns from something more volatile (i.e. “risky”) than Treasury bills or cash. So we rely on a wide array of stocks and alternative investments, seeking a premium over the long haul that we know will likely “cost” us some potentially scary volatility in the short run.
The investment gurus attempt to convince us they can predict when this volatility will happen and what to do when it does. Nonsense! Volatility – like the markets - is random and unpredictable. That’s precisely why there’s an implied return associated with it. During downside volatility times it may not be easy, but it’s necessary: stop thinking and embrace the random!