To our clients –
Let me begin by first saying that I am not an expert on virology1, just-in-time manufacturing, public policy, or geopolitics. And I’m absolutely not an expert at the intersection of these areas. Even if I had strong views, I hope I’d urge you not to listen to them.
Quants at Newfound have three primary focuses: research, operations, and communication. In periods of calm, we research, build, and test our systems so that we can follow our process when waters get rough. It is during these times that we believe communication is the most meaningful, and effective way we can help clients.
With that in mind, my goal in this letter is to provide:
- An alternative narrative on market volatility; and
- Insight into our process and positioning.
When markets move quickly, our natural fight-or-flight tendency kicks in. So, let’s begin with some positive anchoring: investors with reasonably diversified portfolios are faring much better than headline equity market losses would imply. A globally balanced, moderate allocation is in a drawdown just north of -10%, but still up 4.7% year-over-year.
Source: Sharadar. Calculations by Newfound Research.
Market Volatility: When Financial Engineering Goes “Boink”2
Equity markets are, at least in theory, discounting decades of future cash flows. “Fair value” for the market should have very little to do with how much earnings decline this quarter or even this year. Consider the following table – authored by NYU Finance, Professor Aswath Damodoran – which forecasts fair value for the S&P 500 under certain assumptions about earnings loss in 2020 versus recovery by 2025.
Source: Aswath Damodoran
What the table makes clear is that intrinsic value is less sensitive to how much earnings drop in the short-term and far more dependent upon the speed at which they recover. This table would suggest that given the current price of the S&P 500 (around 2880), markets are pricing in a fairly permanent negative growth shock.
But given the sheer magnitude of day-to-day market gyrations, are we to interpret that fundamental views are changing at an equally rapid pace?3 While headlines would suggest that volatility and panic are synonymous, I would argue that volatility is symptomatic of a fragile market state (e.g. thin participation, great uncertainty, and potentially “price-insensitive” actors), which can create exaggerated price moves in both directions.
Volatility begets volatility for a number of reasons that can have absolutely nothing to do with fundamental outlooks. Consider this example.
On Friday, March 6th, the VIX plunged from 54 to 41 and the S&P 500 rallied about 2% from 3:00pm ET until market close, actually driving the market positive for the week. Were investors expressing a view that markets were oversold?
Unfortunately, modern markets are far more complicated than that. In this case, reports have circulated that cite the primary driver of this move being the forced liquidation of an options market maker.4
A highly simplified explanation of this narrative is that the market maker sold put and call options on the S&P 500. As markets turned south, the calls moved out of the money and the puts moved in the money. To hedge their exposure to further drops, the market maker began shorting the S&P 500 (hedging options with the underlying is standard procedure).
As the market continued to fall, the market maker had to increase the size of their hedge, shorting increased notional exposure. However, increasing the size of their hedge also required them to post more collateral.
Eventually, unable to post the necessary margin, they were forced to unwind their trade – a forced de-leveraging – by the exchange. At this point, they become a price-insensitive seller, taking whatever prices the market would give them to buy back their shorts and sell their options. This action drove the market up.
And as the market went up, other options market makers and dealers may have had to decrease their hedges as well, increasing buying pressure and driving markets up further.
The example above exists for more than just one market maker, exacerbating the price effects.
I highlight this only to say a large amount of activity that happens day-to-day in modern markets, particularly during volatile periods, cannot be ascribed to the headlines we read in newspapers. Nor does it necessarily correspond to the behaviors, fears, or beliefs of individual investors participating in these markets.
The trap is when this volatility causes investors to panic, which can cause forced de-leveraging by market participants, which can create greater volatility and lead to further panic.
That is not to say that there is not plenty of room for rational re-assessment and re-pricing of risk. Rather, when the days start to feel like weeks and the weeks like months, it is important to recall that volatility can be easily intensified or attenuated by the actions of market participants who are expressing no actual view on the macro-economic picture.
Tied to the Mast: Our Course of Action
Newfound began providing research for trend equity strategies in August of 2008. These strategies aim to participate in equity market growth and avoid significant and prolonged declines through the use of trend following signals.
When equity market trends are positive, the strategies typically invest in broad market exposure. When equity trends turn negative, the strategies de-risk to safety assets such as short-term U.S. Treasuries.
By Fall of 2008, most of the signals we provided were negative and remained so until Spring 2009. Since then, strategies that follow our signals – including mandates we manage – have introduced at least some level of de-risking in 2011 (US debt downgrade), 2012 (European debt crisis), 2015-2016 (China’s “hard landing”), and 2018 (both February and Q4).
While we’ve endeavored to make our strategies more robust over time – e.g. introducing tranched allocations to avoid rebalance timing luck, signal ensembles to avoid specification risk, and the addition of a tactical U.S. Treasury futures strategy on our trend equity mutual funds – taking a strong defensive posture never seems to get any easier.
Nevertheless, we design our strategies during periods of calm specifically so that we can stick to them – systematically and without exception – during periods of market volatility.
This is important because our strategies are designed to be pieces of a bigger whole. We work closely with our advisor clients and advocate that investors utilize our portfolios as a complement to their existing strategic asset allocation, expanding their how and when diversification.5 By expanding these degrees of diversification, we believe investors can design an allocation that can better withstand the many different environments the market can throw at us.
Which means our job is to tie ourselves to the mast and avoid the siren’s song to meddle with our process. As different tactical signals change, we will continue to adapt our portfolios, making steady transitions to our new targets so as to avoid the wrath of timing luck.
During periods of heightened volatility, this can often feel too slow. Some signals stay positive longer than we wish they would and sometimes we’re left saying, “it would have been nice to just shift entirely defensive when that first signal went off.” But that is all easier said with the benefit of hindsight.
The truth is, we have no idea which signals will be the most accurate for a certain sell-off until well after the dust settles. And just as quickly as the market drops it could turn around and rally (let us not forget the lessons of Q4 2018). Our process of steady changes based upon an ensemble of signals is designed specifically to acknowledge these realities and diversify our risk of choosing the wrong signal or rebalancing at precisely the wrong time.
Below is a table showing a sample of trend models and parameterizations applied to broad U.S. equities (this table is updated daily on our Newfound U.S. Trend Equity Index page). We can still see significant disagreement among trend signals. The natural conclusion, in our opinion is to be partially de-risked. And that is precisely the position the position our mandates have been, and will continue to, migrate towards.
A partially de-risked position straddles both participation and protection. If the market continues to sell off over the coming months, the mandates should dampen initial losses and continue to de-risk. Should markets rally meaningfully, the mandates will partially participate while re-risking. The net effect, in the short term, will be a dampening of day-to-day volatility.
As our positioning continues to evolve, we will endeavor to provide as much transparency as we can. That said, if you have any questions, please do not hesitate to reach out. And, finally, please do not forget to wash your hands!
Corey M Hoffstein
Chief Investment Officer
- Though I am partial to this primer on COVID-19
- With apologies to Bill Watterson
- Why equity prices are so much more volatile than equity fundamentals is a question Robert Shiller published on as far back as 1981.
- I have done my best to independently corroborate these reports.
- This reflects how I incorporate these strategies into my personal portfolio as well (not to mention the huge implicit exposure I have via my 50% ownership of Newfound Research).