Executive Summary
Volatility is an essential characteristic of equity markets but one which is difficult if not impossible to predict. While some investors choose to reduce portfolio volatility by investing in more defensive asset classes such as bonds and cash, others embrace volatility as an opportunity to enhance long-term portfolio returns. While we do not believe that investors can consistently time the market, there are a range of strategies that investors can adopt to protect against permanent loss of capital and potentially profit from market corrections.
Background
The almost 10-year rally in equity markets since the depths of the Global Financial Crisis (GFC) is considered to be one of the longest bull runs in history. The rise of equity markets, however, has been punctuated by frequent bouts of volatility driven by events such as the Greek debt crisis, the QE ‘taper tantrum’ and Brexit. There is now increasing media speculation about the next potential source of volatility and even the possibility of a market correction similar to the GFC.
Volatility in share prices is an essential characteristic of equity markets and volatility is conventionally considered a measure of investment risk. Investors need to understand, however, that the most important risk to guard against is the permanent loss of capital. Those investors that can tolerate fluctuations in the quoted value of their portfolio can use volatility to enhance their long-term investment returns.
Equity markets are likely to experience 10-20% falls at least every two years, with major corrections of up to 50% or more in times of crisis. In this article, we explore four different types of market corrections and the investment strategies that can be used to protect and potentially enhance portfolio returns in anticipation of market volatility.
Four types of corrections
When we look back over the last 20 years, we can see 4 different types of market corrections:
- Earnings recessions
- Confidence-induced corrections
- Asset price bubbles
- Black Swan events
We apply different strategies in anticipating each type of market correction, and use different methods of taking advantage of each type. It is important to note though that our strategies are not immune to underperformance but our investment objectives are to protect against the risk of permanent loss of capital and to take advantage of market dips when they happen.
We shall explore each type of market correction below.
1. Earnings recessions
An earnings-driven recession is the type of correction to fear the most. The real economy goes into recession (two or more quarters of negative GDP growth), company earnings drop and wages fall. The trigger point is typically high interest rates, which causes financial distress in businesses which find it increasingly difficult to fund their operations and growth. Consumers also reduce spending due to higher mortgage interest payments, higher unemployment and job insecurity. Earnings-driven market corrections are usually the deepest and take the longest to recover from.
The Global Financial Crisis (GFC) starting in 2007 is the most recent earnings-driven recession, with the Great Depression which dominated the 1930s being the other most notable correction in history. Australia managed to avoid a general earnings recession during the GFC due largely to the strength of the mining sector, with the last broad-based earnings recession occurring in the early 1990s.
Our view is that the imminent risk of an earnings-driven recession is low. Interest rates globally and in Australia are still at record lows and the world economy as a whole is on an upwards growth trajectory. The big unknown, however, is how economies will respond to the withdrawal of the extreme levels of monetary stimulus implemented after the GFC. The risk is that extreme levels of government debt will cause economies to react more rapidly to interest rate rises than they have in previous cycles.
Our strategy to anticipate an earnings-driven recession is to increase our weighting to more defensive assets such as cash, bonds and credit as interest rates rise. As economic growth accelerates, we will also reduce exposure to highly leveraged and cyclical businesses (the combination of the two can be particularly dangerous as many found out in the GFC).
Our willingness to adopt counter-cyclical strategies over recent years has been a key factor driving our superior investment returns. While many investors have flocked to the more defensive sectors of the market such as healthcare and utilities, we have taken positions in the out-of-favour sectors with more exposure to improving economic conditions. As the economic cycle matures, however, we will adopt a more defensive position, even if that means underperforming the market for a period in anticipation of the next market correction.
2. Confidence-induced corrections
The level of market confidence typically moves in cycles, from highly optimistic about the future to pessimistic about the chance of growth. This drives fluctuations in prices, and markets can experience a 10-20% correction simply on the basis of fluctuating levels of confidence.
In Australia, confidence-induced corrections happen every couple of years and without warning. In fact, since the markets started to recover from the depths of the GFC in 2009 there have been three market corrections of 10% or more. These sell-offs provide opportunities for the astute investor that maintains the investment capacity and fortitude to act.
The Brexit sell-off in is example where the markets fell 6% in the immediate aftermath of the vote outcome only to recover and exceed the previous high by 4%.
Market sentiment can turn rapidly and without warning, which is why we don’t try to predict these market turns but remain ever vigilant to their possibility. Markets have had a recent run of unusually low volatility, which makes us increasingly cautious that a change in sentiment is imminent. A re-escalation of tensions over North Korea and a looming budget crisis in the US leading to a possible government shut-down are two possible scenarios that could dent market confidence.
Our strategy to take advantage of confidence-induced corrections is to hold tactical cash balances of 5-20% of a portfolio’s value to deploy rapidly as market opportunities arise. Investors, however, must be willing to act quickly and in the face of negative market sentiment.
3. Asset Price Bubbles
A bubble is the extreme and rapid inflation in price a particular group of companies (or assets more generally) which typically drives up the value of the whole market or asset class.
Much has been written about the causes of bubbles, but they are often characterised by a strong social narrative, elevated use of debt (leverage) and ongoing rationalisation of increasing prices (“this time it's different”).
While an overall market can recover quickly from bubbles, the specific companies involved the bubble may not recover to those prices for a long time, if ever. For example, during the Dot Com boom of 2000-2002, Cisco’s share price fell 78% and is yet to regain those levels whereas other companies such as Walmart were hardly impacted by the market fall.
The US tech sector is the most obvious current example of a potential market bubble although valuations are well below those at the height of the Dot Com boom and the underlying fundamentals of companies such as Amazon, Facebook and Alphabet are very strong. Perhaps more concerning are the more defensive sectors of the markets, the so called ‘bond-proxies’, that have reached record valuations on the back of historically low interest rates.
Our strategy when anticipating bubbles is to avoid the highly inflated areas of the market, regardless of the general level of optimism about those sectors and companies.
4. Black Swan Events
A black swan event, as popularised by Nassim Nicholas Taleb in his 2007 book, is an event which is hard to predict, has a surprisingly large impact and is often rationalised with the benefit of hindsight. In contrast to confidence-induced corrections, black swan events occur less frequently but with greater severity. The terrorist attack on 9/11 is an example of a black swan event.
The risk of a black swan event is ever-present but their occurrence and severity cannot be predicted. Investors need to ensure that their investment strategies can withstand a sudden and severe market falls by adopting tactics similar to those of confidence-induced corrections.
Conclusion
Any investor in equities needs to have the risk tolerance and capacity to withstand volatility in their portfolio value and the ever-present risk of market corrections. At JJT Advisory, we embrace volatility and position client portfolios to enhance long-term returns when corrections occur.
Disclaimer
This publication is issued by JJT Advisory Pty Ltd and is intended to be general information only without taking into account the investment needs, objectives and financial circumstances of any particular investor.
Past performance is not a reliable indicator of future performance.