Investors Are Unaware Of The Dangerous Change To The Market

What a difference a year makes. In 2017 stocks went up in almost a straight line and volatility remained amazingly low throughout the year. In 2018 stocks got dinged early but quickly recovered. For a time, it looked like things were getting right back on the same track, but in September stocks started reeling and weren’t able to recover by the end of the year.

This break leaves investors with a big question: Were the last four months of 2018 a short-term aberration that should be overlooked, or an early indication of worse things to come? The dramatic and violent nature of price swings added to the urgency of the question. The short answer is yes, things have changed, and in ways that will be very good for some investors and terrible for others.

For investors who don’t watch markets every day, the notion that “volatility returned” doesn’t begin to capture how dramatic price swings became. The Financial Times described one such interlude [here]:

“On December 24, US equity markets posted their biggest recorded crash for a Christmas Eve. But on Wednesday [the day after Christmas] they recorded their biggest rally for almost 10 years.” 

The broader return of volatility was captured by Zerohedge [here] by comparing the number of days the S&P 500 rose or fell by one percent or more.

“In the fourth quarter there were 28 such days which was well above the Q4 average of 14 since 1958. The fourth quarter tally was also considerably higher than that for the entire year of 2017 which hit a new post-recession low of 8.”

Turmoil in the markets also co-existed with turmoil in news flow. The FT listed several captions of concern [here] such as “De-Faanged”, “Turkey meltdown”, Italian alarm”, “Red October”, “Oil’s spill”, and “December mayhem”. Zerohedge also captured the chaos of the quarter with a chronology of headlines [here]. Amidst the turmoil, one thing remained clear: Market action in the fourth quarter was a lot different than anything exhibited in a long time. 

While all these items helped to unsettle markets, one of the most distinctive characteristics of the fourth quarter was how few managers were able to navigate the turmoil successfully. Almost every investment strategy failed. One quant hedge fund executive lamented [here], Honestly, nothing’s working.

Indeed, one might have expected hedge funds to make hay amidst the volatility. Bloomberg described [here],

“Wide swings in prices, a waning bull market and rising rates were seen as the elixir that the $3.2 trillion [hedge fund] industry needed to overcome years of subpar performance.” 

Arvin Soh, a New York portfolio manager at GAM Holding AG, explained,

“Big picture, hedge funds are strategies that are meant to deliver during periods of uncertainty and profit from dislocations, which we have seen plenty of this year.”

Nonetheless, Bloomberg reported,

“Hedge funds got pummeled in last month’s market swoon and are headed for their worst year since 2011.”

In addition to almost universally bad performance, another unique characteristic of the fourth quarter was that the value style outperformed growth for the first time in a long time. Historically, value outperforms growth and is one of the most robust relationships in finance. For the last 10-, 5-, 3-, and 1-year periods, however, growth outperformed value, and by a considerable margin. That relationship flipped back in the last quarter.

These phenomena suggest that the fourth quarter was about more than just price fluctuations. Something important changed. Mohamed El-Erian captured the development in the FT [here],

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Disclosure: The information contained in this article should not be construed as financial or investment advice on any subject matter. Real Investment Advice is expressly disclaims all liability ...

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