Markets

After a relatively non eventful August for markets (the steady climb in US market indices being almost volatility free of late), September kicked off with a bang.

Two declines and some stutters

Readers will have noted the sharp sell off, especially of the NASDAQ, last week, sharp enough to break some short term trading records, although only taking index valuations back a few days in reality – just very suddenly.

The fall in the dollar (until this morning, which change I don’t yet understand) suggested that markets were taking the same view that I expounded in my monthly commentary: that US interest rates are not rising any time soon and the the Fed may be the most accommodative of the global central banks.

This morning we see a very sharp sell off in the Japanese conglomerate Softbank (about which business I have written before). This is a business that appears to be operating to make money from trading the shares in other firms, not actually being interested in operating them. Such ‘corruptions’ of management as I would phrase it usually end in tears.

Other troubling stories are also rumbling around, like suspension of a rather obscurely run set of funds sold in the UK by Nataxis H2O, but after intervention by the French regulators.

Baillie Gifford, whose enthusiasm for Tesla stock seemed to be one of the main driving forces behind the share’s literally incredible rise have now sold out a large chunk of their holding and that spooked the markets too.

They say that the price rise had put the investment into an overweight and that must be true, but I wonder if even the manager of The Scottish Mortgage Trust (which now seems to be absurdly named given it invests mainly in US and Chinese technology and consumer services) has decided that he has travelled long enough on a bandwagon that he was helping to propel along with his legs over the side.

A technical helper on the extra volatility

Readers probably know that there are these days many millions of people trading in shares using newer technologies (mainly apps) who are without that much experience. I am not talking about people who build and maintain long term portfolios of funds but those who are often called ‘day traders’.

Because such people are often looking for a better life than one that has maybe not gone too well so far, they frequently start with very little capital, maybe even borrowing to get started. That makes it attractive for them to buy derivatives, rather than actual shares, because you get a large market exposure for not much money that way (ie you are ‘geared’). Courses are offered to people by experienced professionals to help them get started, but in my experience, even people sensible enough to take the training have only a limited understanding of what they are getting into.

One of the safer ways to play the markets with a small sum of money is to buy call options. For a premium that is much less than the price of the share or index you want to back, you buy the right (a contract) to purchase it (or a fixed number of shares in reality) at a future date at a given price. If the price is higher than the contract price on that date, you make a profit which might be a huge multiple of your small stake. If it lower, you let the contract lapse and lose your (hopefully) small stake.

Because the other party can just pay you out the excess profit on the shares if they are worth more than the contract price, rather than delivering the shares to you and obliging you to do the selling, the existence of such options in effect increases the number of transactions in those shares above the level of the real stock actually being traded

I can explain more, with examples, for any subscriber who wants a more comprehensive explanation, or you can take a look at Investopedia.

Heads they win, tails you lose

The reason for adding this educational note is to get you to think about the other side of the deal – the business that ‘writes’ the option. You might think that if you are buying a call option based on a share price rising and will profit if it rises a lot, the guy on the other side of the deal must be expecting it to fall and to be fleecing you for the premium when he is proved right.

That may be true, but actually, the other party may already own the share or index, or be capable of buying it and so has the risk of it rising covered.

If the share price goes up, they do only make the gain up to the option price because the excess goes to you, but that may be all they want in a rising market, bearing in mind that all the time they are collecting premiums (which might give them an income of 4% per annum, for example).

If we take a slightly deeper look at what happens when markets suddenly turn around, we shine a light on heightened market volatility. If your counter parts sees markets turning and a pretty high chance that you won’t make money on your contract, they are likely to sell the asset. They don’t need it to cover the risk of paying you out and they will look to bank any profit they have already accrued. They may even start ‘shorting’ the share.

So, without going into too much detail, we can say that the enthusiasm of a significant bunch of new investors for option contracts, which effectively multiplies up the trades in shares at market inflection points, is likely to also multiply volatility.

My balloon ran out of gas

Another well established influence on the markets is the ‘reversion to mean’ effect where the price of an asset will fall back sharply to its long term trend level when there is a relatively minor change in sentiment if it has moved a long way ahead of trend. Recent changes in the price of gold bullion can be seen doing exactly that if you take a look at a graph for the last few weeks

These influences on volatility are like weather effects: a chill in the air, a dark cloud, a few drops or rain, even a rumble of thunder. They may only be transient, but they might also mean the end of Summer. It is best to look out your umbrella and even check where you put your heavy coat.

This is a notoriously hazardous time of year for investors. If you are sitting on worthwhile profits, you need to consider the relative risk of missing out on more upside versus the consequences of a sharp correction.

If committing cash to the markets, prudent investors will always want to be sure that the current price is good value. That may be so in some cases be the highest price ever paid so far, but that will not often be true.

It is always easier to make money buying when everyone else is scared after a rout. You may have to wait years for such an opportunity but keeping some cash on hand will be well rewarded in time.

It is easy enough to find quotes from ‘experts’ suggesting that stock markets have gone mad. Indeed I have written on several occasions attempting to explain why stock markets seem to be doing better than one would expect when we are are now into recessions in most developed economies, with probably worse to come.

But it pays to re-check the actual facts from time to time. Although some share prices have shot up, most of the time that is the claimed “V” or similar recovery shape from deep lows. Here are a few broader facts (data taken from the BBC):

• The S&P 500 (the main US equity index) tech sector is up roughly 25% this year.
• The energy sector of that index is down about 37% and the financials group down 20%. Overall the market as expressed by this index is up a little on its February 19th record.
• Over half the shares listed in the S&P500 are trading lower than they were at the start of this year
• The FTSE 100 is 20% LOWER than its January high.
• The French CAC 40 is also down about 20%
• The Japanese 225 index is within 4% of its pre-crisis high (that will be in Yen terms)

An analyst at the Dow Jones index company is quoted by the BBC as saying that the risks of the US election and the potential for disappointment if the recovery already anticipated by the market does not happen are reasons for caution.

My take is that in many developed countries there is no real chance of an economic recovery in the next few months.

I would expect a ‘lagged’ impact from the Spring lockdowns across the world and the temporary burst of consumer spending that is only a release of built up frustration to fizzle out as job cuts and reduced salaries begin to be felt.

The businesses that have benefited from the lockdowns will in some cases now see tougher competition. It has been reported that traditional retailers, having been forced into upping their game online, are now taking market share from Amazon.

That does suggest it is a good time to hold shares in businesses specialising in online retail technology and distribution, something some fund managers will have picked up.

I hope I am wrong, but I am deferring my hoped for return to optimism.

I am interested in psychology because I am interested in human behaviour, not just as it impacts on investments, but with all its joys and horrors.

There is a clear overlap between neurology and psychology and I have read that neurologists can agree with the idea that over time, our brains get programmed with biases, or ways of making decisions that are based on sub-conscious training of the process by past experience and maybe even inherited ‘coding’ of parts of our brains.

This is very relevant for investors who cannot avoid looking at the past when deciding how to position their investments for the future. If the past (insofar as we are aware of it) does not include any similar patterns to a developing situation, when that situation finally develops, we will be caught out – what has been called a ‘black swan’ event.

I think that where we are now with stock markets is actually a very white swan event. I have seen those birds ever since I was a little boy!

If one refers to the financial pages of newspapers and even web sites (which look oddly archaic) from 1999 – now a simple task thanks to Google, they read like they were written yesterday. What followed?

In March 1999, the NASDAQ peaked, then a whole series of events which were spread out over a whole year undermined the false and in some cases crooked (Worldcom and Enron, you may recall) valuations of many businesses. In the end, the NASAQ fell by around 75% – yes 75%! Other markets fell from the knock on effects and investors had to wait some 2 to 3 years to start making money again.

I read that in the second quarter of 2020 there were large net inflows into UK operated mutual funds (OEICs), with the exception of funds actually invested in the UK, which had outflows. Bond funds, index trackers and SRI funds all had positive flows of investor money. This was described in the article I read as ‘bargain hunting’.

If you want to see how history repeats itself, Google an article published by money.cnn.com called ‘Investing: 2000 and beyond’ and compare it with what pundits are saying now. Then check out what happened next to markets. You will find other articles if you have the time, referring to bargain hunters and new paradigms.

You will perhaps smile at the concluding advice in the CNN piece that US investors ought to reduce their market exposure to only 80% US and risk a whopping 20% elsewhere! In 1999, most UK investors would have adopted a similar stance and been heavily biased to their home market. If they were still doing that now, it would have cost them very dear.

I decided to write this post about the similarities with 1999 based on my own experience and memory, but notice while researching the history that many others, including academic writers, have seen the same swan sailing across the lake.

We can’t know that history will repeat itself, but they say that a fool is a person who repeatedly carries out the same actions and expects a different result. Maybe this time it will be different but do you want to risk it?

Where I live, there have been no quarantine (lockdown) restrictions for some time, except for special situations like going to the doctor or dentist or visiting a hospital when masks and proper disinfecting are compulsory. The weather is warm and humid with thunderstorms and today is a National Holiday – the anniversary of the crowning of the one and only King (Mindaugas).

It feels like Summer in every respect, that time when global stock markets usually go a bit flat as the big players take holidays, volumes fall, politicians stop meeting and messing things up and I suppose everyone usually feels a bit less like working overly hard.

This year things will be very different depending on where you are. The relaxing of lockdown restrictions and opening of travel borders will allow many mostly younger people to try and forget Covid-19. That same opening up will, I am sure. re-ignite infection rates in places that were otherwise well in control.

As has already been demonstrated in the USA and Australia, there will not be so much a second wave as a resumption of hostilities. I get the feeling that the fight with the pandemic may be somewhat like the Great War, when gains and losses ebb and flow for years and many lives are sacrificed with the ‘donkeys” (ie leaders) mainly to blame for their ignorant and selfish leadership.

Yet, in spite of all that global stock markets are valuing companies as if nothing happened. This is in my opinion, and that of many others, simply because there is a glut of money (not real wealth) and it has nowhere else to go.

I suspect that over the Summer weeks to come, recent steady increases in share prices will stutter along upwards. The news flow on global economies will be terrible and there will be massive insolvencies and job losses but initially the market will pay no attention.

It is in my judgement certain that fundamentals like the need for businesses to make profits and borrowers to repay debt in a viable capitalist system will re-assert themselves.

At that stage, the market correction may be more dramatic than even what we saw in March 2020.

One can ‘make hay while the sun shines’, but one must get that hay under cover before the hurricane hits.