A Black Swan in the making?
Last Sunday as I was sitting on a train headed for Geneva to attend a few meetings, many global equity markets had just finished the week at or close to new highs. After a day in Geneva, and a quick return to see the family, my plan was to jump on another train to Milan for another two days of meetings. BUT Sunday night I spoke to a friend of mine who said, “Have you seen what is going on in Northern Italy, with the coronavirus?”. I hadn't but quickly realized that the outbreak was no longer contained to Asia, in fact it was only a few hundred kilometers from where I was sitting.
We all know what happened in the financial markets during the last week of February. And in fact, the drop in the S&P in the last 7 trading days is the fastest drop larger than 10% from a new high in history. But it's not the only records that were set this week. Interest rates on US 10-year bonds, declined another nearly 25% to hit an all-time low of less than 1.13% (30-year bonds also made new record lows).
This is important, as it sends a very different message than that of equity markets recently hitting valuation highs not seen in at least twenty years. The bond market is saying that economic growth and activity is going to be so muted over the next ten years that a mere 1.13% yield will be a fair return on investment!
The question on many investors minds after this week, is likely to be…”Is this the beginning of a much bigger crisis or crash of the world economy?”.
Most severe financial crashes have three requirements:
2. A catalyst; and
3. Investor sentiment changing from greed/complacency to that of fear.
I won't debate here point 1 & 2, but point 3 is in my view the most interesting.
This is the risk that fear will replace greed and complacency. It is this risk that I think could be widely underappreciated.
Importantly, fear, just like the greed and complacency that precede it, can feed on itself and become a self-fulfilling prophecy. For one, the coronavirus makes people fearful of travel. Due to this, millions of businesses around the world, both large and tiny, will be hit hard economically…and so the spiral begins (potentially).
So looping back to where this email began, I too got concerned about my own travel and decided not to go to Milan this week…which in hindsight looks like a good decision. And as the coronavirus spreads here in Europe, it may not be the only trip I decide to postpone.
The above is not meant to be a prediction of what will happen, but only a reminder to encourage you to think extra carefully about your current investment portfolio.
Data suggests that most large investors (such as US Pension Funds) have significant equity exposure (70+ percent) and with the trillions of dollars now passively tracking equity indices around the world one must wonder what the underlying investors are thinking right now and if massive liquidations could lead to further declines.
And so the question that all investors should ask themselves (in my humble opinion) is: “What do I have in my portfolio that can make money if we get a new long-term crisis?”
As many of you know, investors have in recent years sold their hedge funds and CTA's in order to make more room for equity-linked exposure, such as illiquid Private Equity commitments. And I can't help think if they have managed to do this, just before they need them the most? If so, it wouldn't be the first time.
Market moves this month:
Trend Barometer statistic this month
The Trend Barometer finished the month at a very strong level of 77, a level we have not seen for a long time, illustrating well how many markets have reacted strongly to the fear of what the fallout will be of the coronavirus on the world economy.
The next chart below shows a snapshot of a 44-market portfolio with markets listed in “groups” of market sectors:
The number of markets recorded in a trending state at the end of the month surged to 29…up from 23 in the previous month, and if we include those ending right at the neutral reading (indicated by the “grey” shade right at the 30% level) we get up to 34, which leaves the Trend Barometer in a very strong overall state. Please note that for the individual markets a reading of 30 is considered neutral as opposed to the Trend Barometer itself, where this level is 45.
In the RED camp (down trends) this months, we mainly have Energy, Equities, Base Metals and a few other Commodity markets, with Live Cattle trending down the most. Carrying the GREEN flag (up trends) at the end of the month, we are not surprised to see Fixed Income markets dominating the small group of markets in an up-trend.
In the chart below, I have grouped the markets into 10 sectors. Since last month, the number of sectors exhibiting an overall trending state, jumped to 7 out of 10 sectors. This is the highest number we have seen for years, and may indicate the beginning of a new more volatile period ahead.
The loss of momentum in many leading economies, monetary restraint, high debt levels, flat profits and excess capacity – will bring about slower growth and continue to subdue core inflation in 2020. But perhaps the key factor to look at is the volume of world trade. Since 1980, we've had four recessions, and only two of those recessions did World Trade Volume decline, in the devastating days of 1982 and then again of 2009. The volume of world trade did not decline during the 1990 recession or the 2001. It came down close to zero, but it did not decline. Last year, for the full year, we had a decline of five tenths or six tenths of a percent.
The reason that this is so important is that traditionally, World Trade Volume is above the rate of growth in GDP, it's world trade that connects the disparate units of the global economy and allows the global economy to expand. World trade is contracting and the IMF and others are still saying global GDP is 2.5% or something. And let's not forget…events of the past 3 to 4 weeks are not even in the data yet. Just imagine how economists will react when we see the updated data.
So as usual I pose the question. How will investors protect their portfolios in a world of no/slow growth and interest rates at or below Zero?
If you want to check the current state of trend following, join me each weekend on The Systematic Investor Series, where we give you a raw and honest account of what it's like to be a rules based investor and share with you which trends are happening right now.
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS
I hope you found the information useful as part of your own evaluation of the trend following part of your investment portfolio. I will continue to do my best to keep you up-to-date with regards to the environment for diversified trend following strategies and would love to discuss any of this information with you. Just reach out to me.