Stocks are trading true to the old adage that bulls walk up the staircase and bears fall down the elevator shaft.
From the start of 2016 through to September last year, the Australian stock market grinded higher by 33%. It then fell 14% in the late year sell-off. This followed a similar pattern before it, with a 45% rise from mid-2012 through to March 2015, followed by an almost 20% fall in the following 10 months. Human nature means we focus on the more dramatic falls, even though far more value is added in the run-up than is subsequently lost.
In the grind-up phase, the market calms down, investors become careless about risk, and complacency increasingly sets in. These periods are characterised by low volatility, which in a self-fulfilling way, both reflects and further encourages investor complacency.
But as Hyman Minsky pointed out, stability can itself be destabilising, and things can suddenly change. Investors begin to focus on whatever is the risk du jour – for example, this time last year it was North Korean nuclear negotiations – and risk aversion takes hold and equities are sold down. With investors taking their cues from the market itself, the selling feeds on itself. “The stock market is the only market where things go on sale and all the customers run out of the store”, Cullen Roche once wrote.
We saw all this in the recent December quarter. The sell-off started in October as investors worried about rising rates. Ironically, rates then started to fall as investors fled to the safety of bonds. Investors then changed their reasons for being bearish, from an economic outlook that was too hot that it portended rate rises, to one of cooling. In equities, what held up best in the late-year sell-off were REITs, utilities, gold stocks, and some other perceived safety stocks such as Woolworths, all reflecting the risk-off sentiment rather than a view of business fundamentals. Investors sought to avoid risk, but in typical fashion, did so at the year’s lows rather than its highs.
Perhaps it is understandable that investors remain so risk-phobic and reactionary today. The smell of the GFC still lingers, and we are arguably living through unprecedented times, not least with challenges to democracy, capitalism and the proper functioning of markets, the latter due to overbearing central banks. But investors should remember the future has never been clear, and yet equities have nevertheless delivered attractive returns over time.
As the RBA’s recent paper The Long View on Australian Equities points out, Australian equities have returned over 10% per annum since Federation in 1900. Interestingly, it has been less – just below 9% per annum – in the quarter century since 1993, a period without war or recession, and which has benefited from a general decline in interest rates.
Unfortunately, these superior long term returns come at a cost. This cost is higher volatility, which is really just a euphemism for price falls. However, while volatility presents risk of loss in the short term, the risk reduces the further one looks out, and becomes almost irrelevant over the long term, as any long term performance chart will attest. Truly long-term investors can benefit from this, as summed up in Warren Buffett’s quote that “I would much rather earn a lumpy 15 percent over time than a smooth 12 percent”.
For the short-term orientated – which is probably the majority of investors these days – volatility is a problem but is neither predictable nor easily avoided.
For example, 2017 was predicted to bring in a new era of heightened volatility, owing to an erratic new US President and a litany of other macro risks. Instead, it was the least volatile year on record.
Volatility ultimately comes when investors become jumpy, not necessarily because of heightened uncertainty in the outside world. And as Benoit Mandelbrot demonstrated with fractal geometry, volatility tends to cluster, quite likely because it takes time for investor nerves to settle before the bulls can then start their walk up the staircase. It is during these times when perceived risks remain high that the best opportunities are often found.
Today, investors still appear somewhat cautious following the sell-off late last year, and this is being reflected in relatively favourable valuations.
Meanwhile, the fears that justified the sell-off seem to be subsiding, either because investors have had some time now to stew over them, or in the case of rate rises and quantitative easing, because the US Fed has retreated with a softer stance.
On the other hand, investors perceive earnings risk aplenty, and are harshly punishing even relatively small earnings misses. As reporting season soon kicks off, investors should be open to the opportunities that comes with an attitude of ‘shoot first, ask questions later’. In January, Costa Group issued a soft trading and guidance update which gave rise to consensus earnings forecasts reducing by roughly 8%. Its shares fell almost 40% on the day, but have already risen 25% since.
There’s likely to be similar volatility at the stock level as results are reported through the month.
By Julian Beaumont, investment director, BEAP
First published in AFR Market Minds: https://www.afr.com/markets/julian-beaumont-looking-past-market-volatility-20190202-h1asbb