Published August 17, 2011
Strategies for minimising loss range from the simple collar to futures and structured notes
By PAUL SULLIVAN
THE stock market in the last week has been the very definition of volatile, up one day, down the next, then up again the day after. But while most investors care about volatility only when markets go down and their portfolio loses value, volatility works both ways. And smart investors are figuring out ways to smooth out the peaks and valleys.
Tony Roth, head of wealth management strategies at UBS Wealth Management, said that he considered volatility a fourth asset class, after stocks, bonds and alternative investments such as real estate and hedge funds. And he advises the firm's wealthiest clients to factor it into their portfolio even in good times. 'You're competing in a market with high-speed and hedge fund traders, and they have volatility strategies as a source of returns,' Mr Roth said. 'If you're not developing your own strategy for dealing with volatility, you're at a structural disadvantage on the playing field we call financial markets.'
While thinking of volatility as an investment may seem as odd as buying air rights for development once did (or still does), devising strategies that limit the highs and lows in the global economy are becoming increasingly common. They generally fall into two categories: strategies that look to profit from volatile markets and those that try to cushion a portfolio from those wild swings.
What has changed is that many of these strategies are no longer available only to the most sophisticated investors. (Some of them certainly got a lot more expensive this week.) Two of the strategies I discuss below are accessible to investors with even modest portfolios, and two are for wealthier investors, but they show just how much control people can now exert on their returns.
Here's a look at the strategies aimed at giving investors more control over their returns, although, of course, there are some risks.
The simplest volatility strategy is combining two types of options to create a range a stock or an index will trade in. This is done by selling a call option, which allows the buyer of that call to purchase shares at a set price, and then buying a put option, which allows the person who owns the shares to force someone else to buy them if they fall to a certain level.
Take United Parcel Service, which was hovering around US$63 a share on Monday, the first day of trading after Standard & Poor's downgraded the United States' credit rating. Tyler Vernon, chief investment officer of Biltmore Capital Advisors, which manages US$600 million for wealthy families, said that an investor could have sold a call option at US$65 a share for US$2.50 and for the same amount bought a put option at US$60. The costs would cancel each other out and the investor would have created what is called a collar around the stock.
'With volatility kicking up, this is a strategy that more sophisticated investors are taking advantage of,' Mr Vernon said. 'They're okay giving up the upside after seeing markets fall down by hundreds of points every day.'
Of course, the investor may not get the gains if the UPS stock rises above US$65 before the collar expires. But Mr Vernon said that this was a risk most clients were willing to take. 'They're having flashbacks to 2008 at this point, so that's not a bad deal.'
Futures contracts
A slightly more complex but relatively inexpensive way to manage losses is to buy futures contracts that bet an index will fall in value.
Mark Coffelt, who manages the Empiric Core Equity Fund, said that he hedged the entire US$50 million portfolio this week by buying 702 contracts that bet the Russell 2000 index, which tracks small-cap stocks, would fall in value. They cost just US$1,400. While the equities in the portfolio still fell in value, the futures contract limited the overall losses. 'Our hedges picked up US$2.5 million' the previous week, Mr Coffelt said. 'Hedging has helped us tremendously this year. It has not accounted for all the gains, but it sure has reduced some of the losses.'
A big advantage of this strategy is that the markets for futures, particularly with currencies, are easy to trade in and out of. But they require restraint.
'If everything turns around quickly, we're going to lose money, unquestionably,' said David Kavanagh, president of Grant Park Funds, which has just under US$1 billion in a managed futures strategy. 'I can't emphasise the disciplined nature enough. There is always an exit strategy.'
He said that once he took a view on an index, he would look to buy the futures contract that was the most liquid, whether it lasted one month or six.
Structured notes
With structured notes, a bank can pretty much create any trading range that clients want through a combination of financial products, including options and derivatives. But these notes are highly complicated, generally illiquid and carry the risk of the firm that created them.
This was an issue when Lehman Brothers went bankrupt in 2008. The firm had sold billions of dollars of structured notes that lost their value when the firm collapsed.
But investors who are comfortable with the firm creating these notes can virtually determine how much economic risk they are comfortable with by using a simple formula: the more appreciation they give up, the more they can protect themselves from losses.
JPMorgan Private Bank is selling one-year notes that offer what Joe Kenney, US head of investments at the bank, called 'contingent protection'. They have been structured to give a client as much as 20 per cent gains and protect losses down to 20 per cent.
On the plus side, the notes pay a guaranteed 8 3/4 per cent return even if the market does not rise that much. The downside is that if the losses are greater than 20 per cent, the protection expires, and the investor gets all the losses. A relatively new strategy relies on publicly traded options and exchange-traded funds to create the same effect as a structured note without the credit risk of a bank.
Mitchell Eichen, president of the MDE Group, which pioneered its 'planned return strategy' in 2009, said that the strategy was meant to protect against the first 12 per cent of losses - with any additional losses starting at that point - and to double the market gains up to a cap of 8-12 per cent. Now, some US$275 million of the US$1.3 billion the firm manages is in this strategy.
Tax factor
One advantage is its transparency: All the parts that create the band are held in a separate account for each investor, with Fidelity as the custodian. Another is that the firm is putting together new offerings monthly in the hope that this product will become like a laddered bond portfolio for its clients.
Philip M Gross, a retired engineer who had worked at Warner Lambert and General Electric, said that he had about 15 per cent of his money in MDE's planned-return strategy and was adding to it. 'If I thought the market was going straight up over the next three years, I wouldn't do this,' he said. 'But this is a practical approach.'
The one caveat with this and many of the other strategies is how they are taxed. They are often at the higher short-term capital gains rate or some mix of short and long-term gains. But taxes are the last thing on Mr Gross' mind, after the market crashes in 2000 and 2008. 'I'm not sure if I'm ever going to use all my capital losses,' he said. 'I realise intellectually that's a dumb answer, but it's a practical answer.'
Given that volatility is a practical problem right now, that may be good enough. -- NYT
Showing posts with label Market and volatility. Show all posts
Showing posts with label Market and volatility. Show all posts
Wednesday, August 17, 2011
Living in a more volatile world
Published August 17, 2011
These days, 'risk free' and 'Treasuries' are no longer interchangeable terms
By JEFF SOMMER
IT'S been dizzying. The markets have been swinging madly up and down - mainly down for equities, as anyone in the stock market knows too well. How bad has it been? Despite brief rallies, the Standard & Poor's 500-stock index has fallen more than 13 per cent from its May peak. For four consecutive days, the index moved up or down by at least 4 per cent, the first time that's happened.
In a steadily rising market, investing may be a pleasant pastime, like knitting or chess or antique-collecting. Lately, it's been a blood sport. William Butler Yeats captured the feeling nicely: Things fall apart; the centre cannot hold; Mere anarchy is loosed upon the world.
There are prosaic explanations for the gyrations that have been unmooring the financial markets. Start with the unseemly squabbling over the debt ceiling in the United States, and the inability of politicians in Washington to come to grips with the nation's growing debt load.
Then there's the parallel debt crisis in Europe, which has exposed fissures in the European Union and vulnerability among its major banks. Behind all of that is a sagging global economy - highlighted, in the United States, by a moribund housing market and painfully high unemployment.
A grain of sand too much
'The distinction between developed and emerging markets has blurred and will require a fundamental rethinking.'
- Aswath Damodaran,
finance professor at New York University
While these issues aren't new, the accretion of them all is like 'adding grains of sand to a mound on the beach', said Mohamed El-Erian, chief executive of Pimco, the world's biggest bond manager. 'For a while, you add sand and nothing much happens,' he said. 'Then with just a few extra grains, the structure starts to shift.'
There has been one significant change in the structure of markets recently, he said. It was partly symbolic, but still disturbing: the Standard & Poor's downgrading of the sovereign debt of the United States. Why is this so important? It's because 'AAA' United States Treasury bonds have been the linch-pin of the global financial system, and the centre of myriad calculations in business, portfolio construction and capital markets.
In this context, Mr El-Erian said, the downgrade represents a wide perception of instability in the world's financial structure. 'We lived in a world in which 'risk free' and United States Treasuries were interchangeable terms,' he said, 'a world in which it was assumed that the United States would safeguard its pristine AAA rating, and protect the dollar, the world's reserve currency'. Now, for many around the planet, the world's core seems much less solid.
Blurring distinction
Aswath Damodaran, a finance professor at New York University, said that the true rate for a 'risk-free investment', which had been assumed to be the 10-year Treasury yield, now needs to be 'approximated', a procedure heretofore required for emerging markets. 'The distinction between developed and emerging markets has blurred,' he said, 'and will require a fundamental rethinking.'
Eugene Fama, a finance professor at the University of Chicago, said that S&P's move was 'a non-event in itself, because it merely reflected a view that was already well understood by the markets'. But, he added, it reflected 'a great deal of pessimism out there, a great deal of uncertainty' over whether Western governments would resolve their fiscal dilemmas. 'Capitalism itself is under duress,' he said.
Prof Fama, a leading theoretician of efficient markets, said that the current volatility 'is exactly what you'd expect when efficient markets are confronted by massive uncertainty'. Not that the Treasuries have been supplanted by another putative risk-free security. In the current crisis, Treasuries have been very much in demand. Their prices have soared, and yields, which move in the opposite direction, have plummeted. Thanks in part to a Federal Reserve pledge last week to keep rates low until at least 2013, the 10-year note fell Friday to 2.25 per cent.
Summer dip
Scott Minerd, chief investment officer at Guggenheim Partners, predicted correctly in May that the 10-year Treasury yield would dip below 2.5 per cent over the summer as the economy weakened and investors sought a haven from greater distress in Europe.
Now, he says, long-term government bond yields are likely to remain very low for several years, and the Fed is likely to ease monetary conditions further.
There is more risk in the global financial system, he says, but for canny investors, it has created a 'phenomenally good time to buy'. He sees bargains in stocks as well as in municipal bonds. Over the long haul, he said, he's also bullish on gold, but added that 'its recent parabolic rise will lead to a correction, so this isn't the time to buy it'.
If the US economy doesn't lurch into recession, and if corporate earnings stay strong, then stocks are far better priced than government bonds, said Tad Rivelle, chief investment officer for fixed income at TCW. For a while last week, the 10-year Treasury yield dropped below the dividend yield on the S&P 500, a rare occurrence, according to Birinyi Associates, a research firm. It also happened in the 2008-09 financial crisis, presaging the stock market bottom of March 2009.
While there will be opportunities for astute investors, Mr El-Erian said that in addition to a 'new normal' of slow economic growth and high unemployment, we must now also grapple with a weakening of the financial system's core. 'We will be living in a more volatile world,' he said. -- NYT
These days, 'risk free' and 'Treasuries' are no longer interchangeable terms
By JEFF SOMMER
IT'S been dizzying. The markets have been swinging madly up and down - mainly down for equities, as anyone in the stock market knows too well. How bad has it been? Despite brief rallies, the Standard & Poor's 500-stock index has fallen more than 13 per cent from its May peak. For four consecutive days, the index moved up or down by at least 4 per cent, the first time that's happened.
In a steadily rising market, investing may be a pleasant pastime, like knitting or chess or antique-collecting. Lately, it's been a blood sport. William Butler Yeats captured the feeling nicely: Things fall apart; the centre cannot hold; Mere anarchy is loosed upon the world.
There are prosaic explanations for the gyrations that have been unmooring the financial markets. Start with the unseemly squabbling over the debt ceiling in the United States, and the inability of politicians in Washington to come to grips with the nation's growing debt load.
Then there's the parallel debt crisis in Europe, which has exposed fissures in the European Union and vulnerability among its major banks. Behind all of that is a sagging global economy - highlighted, in the United States, by a moribund housing market and painfully high unemployment.
A grain of sand too much
'The distinction between developed and emerging markets has blurred and will require a fundamental rethinking.'
- Aswath Damodaran,
finance professor at New York University
While these issues aren't new, the accretion of them all is like 'adding grains of sand to a mound on the beach', said Mohamed El-Erian, chief executive of Pimco, the world's biggest bond manager. 'For a while, you add sand and nothing much happens,' he said. 'Then with just a few extra grains, the structure starts to shift.'
There has been one significant change in the structure of markets recently, he said. It was partly symbolic, but still disturbing: the Standard & Poor's downgrading of the sovereign debt of the United States. Why is this so important? It's because 'AAA' United States Treasury bonds have been the linch-pin of the global financial system, and the centre of myriad calculations in business, portfolio construction and capital markets.
In this context, Mr El-Erian said, the downgrade represents a wide perception of instability in the world's financial structure. 'We lived in a world in which 'risk free' and United States Treasuries were interchangeable terms,' he said, 'a world in which it was assumed that the United States would safeguard its pristine AAA rating, and protect the dollar, the world's reserve currency'. Now, for many around the planet, the world's core seems much less solid.
Blurring distinction
Aswath Damodaran, a finance professor at New York University, said that the true rate for a 'risk-free investment', which had been assumed to be the 10-year Treasury yield, now needs to be 'approximated', a procedure heretofore required for emerging markets. 'The distinction between developed and emerging markets has blurred,' he said, 'and will require a fundamental rethinking.'
Eugene Fama, a finance professor at the University of Chicago, said that S&P's move was 'a non-event in itself, because it merely reflected a view that was already well understood by the markets'. But, he added, it reflected 'a great deal of pessimism out there, a great deal of uncertainty' over whether Western governments would resolve their fiscal dilemmas. 'Capitalism itself is under duress,' he said.
Prof Fama, a leading theoretician of efficient markets, said that the current volatility 'is exactly what you'd expect when efficient markets are confronted by massive uncertainty'. Not that the Treasuries have been supplanted by another putative risk-free security. In the current crisis, Treasuries have been very much in demand. Their prices have soared, and yields, which move in the opposite direction, have plummeted. Thanks in part to a Federal Reserve pledge last week to keep rates low until at least 2013, the 10-year note fell Friday to 2.25 per cent.
Summer dip
Scott Minerd, chief investment officer at Guggenheim Partners, predicted correctly in May that the 10-year Treasury yield would dip below 2.5 per cent over the summer as the economy weakened and investors sought a haven from greater distress in Europe.
Now, he says, long-term government bond yields are likely to remain very low for several years, and the Fed is likely to ease monetary conditions further.
There is more risk in the global financial system, he says, but for canny investors, it has created a 'phenomenally good time to buy'. He sees bargains in stocks as well as in municipal bonds. Over the long haul, he said, he's also bullish on gold, but added that 'its recent parabolic rise will lead to a correction, so this isn't the time to buy it'.
If the US economy doesn't lurch into recession, and if corporate earnings stay strong, then stocks are far better priced than government bonds, said Tad Rivelle, chief investment officer for fixed income at TCW. For a while last week, the 10-year Treasury yield dropped below the dividend yield on the S&P 500, a rare occurrence, according to Birinyi Associates, a research firm. It also happened in the 2008-09 financial crisis, presaging the stock market bottom of March 2009.
While there will be opportunities for astute investors, Mr El-Erian said that in addition to a 'new normal' of slow economic growth and high unemployment, we must now also grapple with a weakening of the financial system's core. 'We will be living in a more volatile world,' he said. -- NYT
Sunday, August 14, 2011
Amid turmoil, try to be content
The Straits Times
Published on Aug 14, 2011
Work to acquire more important things and stop craving things we cannot have in this volatile period
By Christopher Tan
The global economic recovery is in serious trouble. That much you would have learnt from the media over the past few weeks.
At the beginning of this year, we shared through our writings that, over the next few years, we will be in an environment of uncertainty and risk, including slower growth in developed nations as well as lower investment returns and higher volatility.
This situation arose because of the great financial crisis in 2008. Developed nations are now repaying their debts, so these economies will be growing at a slower pace than in the past.
The prognosis was for the gross domestic product growth of the most badly hit economies to be 1.5 per cent to 2per cent in the coming years, slower than that in previous decades. So what has been said in the media recently about slower growth is not new.
Why then the sudden fall in the stock markets now?
Economic data revisions released last month confirmed that the slow growth scenario is indeed playing out in developed economies. This has raised fears that the United States may be going into a recession.
These fears have been compounded by the political disarray displayed by US political leaders during the debate on raising the country's debt ceiling. This has made investors wonder if US politicians can come together to tackle the bigger issue of long-term debt reduction. It has also led rating agency Standard & Poor's to downgrade the US credit rating below AAA.
In Europe, while a Greek default has been averted, the highly indebted countries of Spain and Italy have come under pressure as bond yields have moved higher over the last month. All these factors have created an uncertain atmosphere, and investors have lost confidence and sold down risky assets.
But the selldown is driven more by sentiment than a fundamental change of views. Slower growth is something we have expected all along. Besides, while the recent US economic data has been weak, there are still reasons to expect that the global economy will avoid a recession.
First, US consumers have already cut back on spending during the last three years and rebuilt their savings. Second, corporate balance sheets are in good shape, with companies reporting strong earnings and holding record levels of cash. Therefore, consumers and companies are better placed to ride out this period of economic weakness. Consumer spending and corporate capital expenditure will rebound once confidence returns.
Global industrial production has also been impacted by the earthquake in Japan in March and, as the country's industrial production improves, it will support global growth. Governments have also moved to restore market confidence.
The Group of Seven has issued a communique stating that it will 'take all necessary measures to support financial stability and growth', and the Group of 20 has also issued a similar statement.
Meanwhile, the European Central Bank has started buying Italian and Spanish bonds. The political debate which has generated so much uncertainty is, unfortunately, part of the adjustment that developed countries will have to go through as they slowly resolve longstanding problems. It is out of crises that the needed change in behaviour comes.
Investors need to be able to ride out the volatility caused by changes in sentiment and focus on their longer-term investment objectives.
People with longer-term time horizons can shift their investments to areas which are less affected and more likely to do better. These include emerging market equities, Asian corporate bonds, energy and agriculture.
But beyond just thinking about our investments, perhaps this is a good time for us to reflect on how we have been responding to the world post-2008.
Perhaps we have been overly confident. Despite living in uncertain times, we keep pushing property and car prices to ridiculous new highs. We fund our purchases by taking on more debt which will take our entire lifetime to pay. We live our lives as if the good times will always be here and we will always have our jobs.
Can we see that we are behaving in the same way that the developed world did decades ago? One day, this house of cards will tumble. We are motivated to chase the Singapore Dream and, as a result, we buy things we do not need, with the money we do not have, to impress the people we do not know.
My fear is that our pursuit of money to fund our dreams will lead to families which are broken, children who become delinquents and hearts that are less tender. Thus, we unknowingly make money our god.
As we revisit our financial plans in consideration of what is happening to the world now, perhaps it would be good to adjust them to meet our needs, instead of chasing our dreams.
This requires us to adopt an attitude of contentment, a state of mind achieved by deciding that we cannot have everything in life. We then work to acquire things that are more important and stop craving things that we cannot have. I have learnt that deliberate contentment is one of the surest paths to happiness.
The writer is the chief executive officer of wealth management firm Providend.
Published on Aug 14, 2011
Work to acquire more important things and stop craving things we cannot have in this volatile period
By Christopher Tan
The global economic recovery is in serious trouble. That much you would have learnt from the media over the past few weeks.
At the beginning of this year, we shared through our writings that, over the next few years, we will be in an environment of uncertainty and risk, including slower growth in developed nations as well as lower investment returns and higher volatility.
This situation arose because of the great financial crisis in 2008. Developed nations are now repaying their debts, so these economies will be growing at a slower pace than in the past.
The prognosis was for the gross domestic product growth of the most badly hit economies to be 1.5 per cent to 2per cent in the coming years, slower than that in previous decades. So what has been said in the media recently about slower growth is not new.
Why then the sudden fall in the stock markets now?
Economic data revisions released last month confirmed that the slow growth scenario is indeed playing out in developed economies. This has raised fears that the United States may be going into a recession.
These fears have been compounded by the political disarray displayed by US political leaders during the debate on raising the country's debt ceiling. This has made investors wonder if US politicians can come together to tackle the bigger issue of long-term debt reduction. It has also led rating agency Standard & Poor's to downgrade the US credit rating below AAA.
In Europe, while a Greek default has been averted, the highly indebted countries of Spain and Italy have come under pressure as bond yields have moved higher over the last month. All these factors have created an uncertain atmosphere, and investors have lost confidence and sold down risky assets.
But the selldown is driven more by sentiment than a fundamental change of views. Slower growth is something we have expected all along. Besides, while the recent US economic data has been weak, there are still reasons to expect that the global economy will avoid a recession.
First, US consumers have already cut back on spending during the last three years and rebuilt their savings. Second, corporate balance sheets are in good shape, with companies reporting strong earnings and holding record levels of cash. Therefore, consumers and companies are better placed to ride out this period of economic weakness. Consumer spending and corporate capital expenditure will rebound once confidence returns.
Global industrial production has also been impacted by the earthquake in Japan in March and, as the country's industrial production improves, it will support global growth. Governments have also moved to restore market confidence.
The Group of Seven has issued a communique stating that it will 'take all necessary measures to support financial stability and growth', and the Group of 20 has also issued a similar statement.
Meanwhile, the European Central Bank has started buying Italian and Spanish bonds. The political debate which has generated so much uncertainty is, unfortunately, part of the adjustment that developed countries will have to go through as they slowly resolve longstanding problems. It is out of crises that the needed change in behaviour comes.
Investors need to be able to ride out the volatility caused by changes in sentiment and focus on their longer-term investment objectives.
People with longer-term time horizons can shift their investments to areas which are less affected and more likely to do better. These include emerging market equities, Asian corporate bonds, energy and agriculture.
But beyond just thinking about our investments, perhaps this is a good time for us to reflect on how we have been responding to the world post-2008.
Perhaps we have been overly confident. Despite living in uncertain times, we keep pushing property and car prices to ridiculous new highs. We fund our purchases by taking on more debt which will take our entire lifetime to pay. We live our lives as if the good times will always be here and we will always have our jobs.
Can we see that we are behaving in the same way that the developed world did decades ago? One day, this house of cards will tumble. We are motivated to chase the Singapore Dream and, as a result, we buy things we do not need, with the money we do not have, to impress the people we do not know.
My fear is that our pursuit of money to fund our dreams will lead to families which are broken, children who become delinquents and hearts that are less tender. Thus, we unknowingly make money our god.
As we revisit our financial plans in consideration of what is happening to the world now, perhaps it would be good to adjust them to meet our needs, instead of chasing our dreams.
This requires us to adopt an attitude of contentment, a state of mind achieved by deciding that we cannot have everything in life. We then work to acquire things that are more important and stop craving things that we cannot have. I have learnt that deliberate contentment is one of the surest paths to happiness.
The writer is the chief executive officer of wealth management firm Providend.
Saturday, October 27, 2007
Enter the mature bull - and higher volatility
Teh Hooi Ling
Sat, Oct 27, 2007
The Business Times
STOCK investors need pretty strong nerves to stay invested in the market of late. It is not uncommon to see the Straits Times Index (STI) open up 50 points but end the day at -50. And a 100-point plunge in one day may be followed by a similar jump the next.
This is a sign that investors are jittery. On the one hand, equities around the world have done spectacularly well in the last four-and-a-half years. During that time, the STI has more than tripled. That's a lot of profits to lock up. On the other hand, there are just as many compelling reasons to hold on to, as there are to quit, equities now.
The economic force that the emergence of China and India unleashes into the world, as hundreds of millions of new consumers flood the marketplace in the next few years or decades, is unimaginable. Meanwhile, the wealth accumulated thus far in these two countries is scouring the world for viable investments. That liquidity flow will continue to support asset prices globally.
On the flipside, the economy in the United States - still the world's biggest market today - is slowing down. The impact of the sub-prime mortgage crisis on consumer spending is still a big question mark. If US consumers tighten their purse-strings as they see their home prices fall, then many of the exporters around the world will be hit by declining profits. Demand from Asia may not yet be enough to make up for the shortfall. But increasingly, the market wisdom is that problems in the US are not severe enough to cause a recession there, and hence the impact on the global economy may not be as great as initially feared.
Still, the increased volatility is symptomatic of a maturing bull market.
Four-phase cycle
In a report this month, Citigroup Global Markets' equity research said that the global equity bull market that began in March 2003 is maturing, but not finished yet. We are now into the third phase of a four-phase market cycle, according to Citi.
The first phase is when the economy is emerging from a recession. It follows the bottom of the credit bear market. Spreads fall sharply as companies repair their balance sheets, often through deeply discounted share issues. This, along with continued pressure on profits, keeps equity prices falling. Phase two begins as profitability turns and equity prices start to rally. Credit spreads fall even further as corporate cashflows rise strongly. This is an immature equity bull market. In the current cycle, this phase began in March 2003.
The third phase is when the credit bull market comes to an end. Spreads start to rise as investor appetite for leverage wanes. The equity market decouples from credit and continues to rise. "We think that the market is entering this phase now. This is the mature equity bull market," says Citi.
And after that, the market enters the bear phase, when equity and credit prices are falling together. This is usually associated with falling profits and worsening balance sheets. Insolvencies plague the credit market, and profit warnings plague the equity market. At this stage of the market, a defensive strategy is most appropriate - cash and government bonds are the best-performing asset classes.
Citi tries to identify the four phases in the last 20 years' market cycles. It found that the different phases are not equal in length. For credit market, phase one tends to be fast and furious. It lasted 18 months in 1991-92 and just five months in 2002-03. But the returns are significant - spreads collapsed by 29 basis points (bp) per month in 1991-92 and 50 bp per month in 2001-03.
Phase two tends to be longer. It lasted five years in the mid-1990s and just over four years in the early 2000s. Spreads fell by a more leisurely 3 bp a month in 1992-93 and 10bp a month in 2001-03.
The credit bear market begins in phase three. Spreads rose by around 300 bp in 1988 and 1997-00. This time round, they have already risen by 120 bp since spreads bottomed on June 12, 2007.
Spreads keep rising in phase four as defaults increase and corporate profits fall. This tends to be the most painful period for credit investors, notes Citi. It lasted 30 months back in 2000-02.
While the credit investor makes money in phases one and two, an equity investor makes money in phases two and three. In phase three in 1988-90, global equities rose by 38 percent despite a 317 bp increase in credit spreads. And in phase three in 1997-2000, equities rose by 57 per cent despite a 282 bp increase in credit spreads.
While equities perform well in phases two and three, phase two - the immature bull - lasts longer and is less volatile.
For example, the US Vix measure of implied volatility has averaged 15 in phase two and 22 in phase three. This is a key difference between a mature bull and an immature bull. "The returns may be as good, but the quality of those returns is worse," says Citi. "Sharpe ratios and risk-adjusted returns deteriorate." As for now, the Vix is 16 - having peaked at 30 in July. "But we would expect the overall trend to be rising as the mature bull market develops."
This suggests that while it is still right to be overweigh equities in phase three, the overweight should not be as great as during phase two. And a leveraged strategy is less appropriate as volatility rises.
Among the sectors, Citi's analysis showed that travel and leisure, retail, media and industrial goods and services performed well in phase three of the last two cycles. Banks underperformed during this phase as credit spreads rose.
Meanwhile, the mature bull phases are also when major bubbles develop. In 1990, Japan rose to a 60 times trailing earnings multiple and accounted for 50 per cent of total global market cap. It now accounts for only 10 per cent. In 2000, technology, media and telecoms (TMT) also rose to 60 times PE and accounted for 40 per cent of global market cap. It now makes up 20 per cent of global market cap.
"These bubbles usually build on a theme that has already been performing strongly through phase two. Into phase three, easier monetary policy and rising capital inflows from other asset classes provide the fuel to drive prices to spectacular and ultimately unsustainable levels. This then bursts and proves a major downward force on global equities in the bear phase four," says Citi.
Next equity bubble
The next equity bubble could be building in emerging market or commodity plays. "These are stocks or markets which are perceived to be most positively exposed to a robust global economy, irrespective of the US slowdown."
However, the Asia ex-Japan index, at 19 times PE, although a premium to the MSCI World's PE of 16 times, is still a long way off the 50-plus times multiple more typical of the peak in these mature bull market bubbles.
"The key point is that if the bubble for this cycle is to be created in the global growth trade, and the Asia Pacific/emerging markets indices in particular, then they could have a lot further to go.
"Investors who try to fight the current re-rating of these markets could suffer the same fate as those who tried to fight Japan in the 1980s and TMT in the 1990s. Probably the right call, but the timing could hit you," says Citi.
According to Citi, signs of the end of the mature bull run include rate hikes and extended equity valuations. Both don't apply now.
So while the recent dislocation in financial markets suggests the end of the credit bull market, it is not the end of the equity bull market. We are entering the mature bull phase, which will still provide decent returns for equity investors. However, it is becoming increasingly unstable. This is the phase where a major speculative bubble typically develops in the global equity market. Perhaps this time round, it is in emerging markets and commodity plays. However investors should remember that these bubbles can go a lot further than anybody expects - it can prove fatal to bet against them too early, cautions Citi.
The writer is a CFA charterholder. She can be reached at hooiling@sph.com.sg
Sat, Oct 27, 2007
The Business Times
STOCK investors need pretty strong nerves to stay invested in the market of late. It is not uncommon to see the Straits Times Index (STI) open up 50 points but end the day at -50. And a 100-point plunge in one day may be followed by a similar jump the next.
This is a sign that investors are jittery. On the one hand, equities around the world have done spectacularly well in the last four-and-a-half years. During that time, the STI has more than tripled. That's a lot of profits to lock up. On the other hand, there are just as many compelling reasons to hold on to, as there are to quit, equities now.
The economic force that the emergence of China and India unleashes into the world, as hundreds of millions of new consumers flood the marketplace in the next few years or decades, is unimaginable. Meanwhile, the wealth accumulated thus far in these two countries is scouring the world for viable investments. That liquidity flow will continue to support asset prices globally.
On the flipside, the economy in the United States - still the world's biggest market today - is slowing down. The impact of the sub-prime mortgage crisis on consumer spending is still a big question mark. If US consumers tighten their purse-strings as they see their home prices fall, then many of the exporters around the world will be hit by declining profits. Demand from Asia may not yet be enough to make up for the shortfall. But increasingly, the market wisdom is that problems in the US are not severe enough to cause a recession there, and hence the impact on the global economy may not be as great as initially feared.
Still, the increased volatility is symptomatic of a maturing bull market.
Four-phase cycle
In a report this month, Citigroup Global Markets' equity research said that the global equity bull market that began in March 2003 is maturing, but not finished yet. We are now into the third phase of a four-phase market cycle, according to Citi.
The first phase is when the economy is emerging from a recession. It follows the bottom of the credit bear market. Spreads fall sharply as companies repair their balance sheets, often through deeply discounted share issues. This, along with continued pressure on profits, keeps equity prices falling. Phase two begins as profitability turns and equity prices start to rally. Credit spreads fall even further as corporate cashflows rise strongly. This is an immature equity bull market. In the current cycle, this phase began in March 2003.
The third phase is when the credit bull market comes to an end. Spreads start to rise as investor appetite for leverage wanes. The equity market decouples from credit and continues to rise. "We think that the market is entering this phase now. This is the mature equity bull market," says Citi.
And after that, the market enters the bear phase, when equity and credit prices are falling together. This is usually associated with falling profits and worsening balance sheets. Insolvencies plague the credit market, and profit warnings plague the equity market. At this stage of the market, a defensive strategy is most appropriate - cash and government bonds are the best-performing asset classes.
Citi tries to identify the four phases in the last 20 years' market cycles. It found that the different phases are not equal in length. For credit market, phase one tends to be fast and furious. It lasted 18 months in 1991-92 and just five months in 2002-03. But the returns are significant - spreads collapsed by 29 basis points (bp) per month in 1991-92 and 50 bp per month in 2001-03.
Phase two tends to be longer. It lasted five years in the mid-1990s and just over four years in the early 2000s. Spreads fell by a more leisurely 3 bp a month in 1992-93 and 10bp a month in 2001-03.
The credit bear market begins in phase three. Spreads rose by around 300 bp in 1988 and 1997-00. This time round, they have already risen by 120 bp since spreads bottomed on June 12, 2007.
Spreads keep rising in phase four as defaults increase and corporate profits fall. This tends to be the most painful period for credit investors, notes Citi. It lasted 30 months back in 2000-02.
While the credit investor makes money in phases one and two, an equity investor makes money in phases two and three. In phase three in 1988-90, global equities rose by 38 percent despite a 317 bp increase in credit spreads. And in phase three in 1997-2000, equities rose by 57 per cent despite a 282 bp increase in credit spreads.
While equities perform well in phases two and three, phase two - the immature bull - lasts longer and is less volatile.
For example, the US Vix measure of implied volatility has averaged 15 in phase two and 22 in phase three. This is a key difference between a mature bull and an immature bull. "The returns may be as good, but the quality of those returns is worse," says Citi. "Sharpe ratios and risk-adjusted returns deteriorate." As for now, the Vix is 16 - having peaked at 30 in July. "But we would expect the overall trend to be rising as the mature bull market develops."
This suggests that while it is still right to be overweigh equities in phase three, the overweight should not be as great as during phase two. And a leveraged strategy is less appropriate as volatility rises.
Among the sectors, Citi's analysis showed that travel and leisure, retail, media and industrial goods and services performed well in phase three of the last two cycles. Banks underperformed during this phase as credit spreads rose.
Meanwhile, the mature bull phases are also when major bubbles develop. In 1990, Japan rose to a 60 times trailing earnings multiple and accounted for 50 per cent of total global market cap. It now accounts for only 10 per cent. In 2000, technology, media and telecoms (TMT) also rose to 60 times PE and accounted for 40 per cent of global market cap. It now makes up 20 per cent of global market cap.
"These bubbles usually build on a theme that has already been performing strongly through phase two. Into phase three, easier monetary policy and rising capital inflows from other asset classes provide the fuel to drive prices to spectacular and ultimately unsustainable levels. This then bursts and proves a major downward force on global equities in the bear phase four," says Citi.
Next equity bubble
The next equity bubble could be building in emerging market or commodity plays. "These are stocks or markets which are perceived to be most positively exposed to a robust global economy, irrespective of the US slowdown."
However, the Asia ex-Japan index, at 19 times PE, although a premium to the MSCI World's PE of 16 times, is still a long way off the 50-plus times multiple more typical of the peak in these mature bull market bubbles.
"The key point is that if the bubble for this cycle is to be created in the global growth trade, and the Asia Pacific/emerging markets indices in particular, then they could have a lot further to go.
"Investors who try to fight the current re-rating of these markets could suffer the same fate as those who tried to fight Japan in the 1980s and TMT in the 1990s. Probably the right call, but the timing could hit you," says Citi.
According to Citi, signs of the end of the mature bull run include rate hikes and extended equity valuations. Both don't apply now.
So while the recent dislocation in financial markets suggests the end of the credit bull market, it is not the end of the equity bull market. We are entering the mature bull phase, which will still provide decent returns for equity investors. However, it is becoming increasingly unstable. This is the phase where a major speculative bubble typically develops in the global equity market. Perhaps this time round, it is in emerging markets and commodity plays. However investors should remember that these bubbles can go a lot further than anybody expects - it can prove fatal to bet against them too early, cautions Citi.
The writer is a CFA charterholder. She can be reached at hooiling@sph.com.sg
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