2017 1st Quarter Commentary: Is It Noisy, or Is It Just Me?
Mark Taucar talks Market Noise, Charts, and Sound Investing
Been watching much news lately? What with the new Trump administration, geopolitical strife in the middle-east, relations with Russia and the Democratic Republic of North Korea’s sabre rattling, it would seem that we are bound for upheaval of the likes not seen in generations. Who better to continue to cultivate this anxiety but the media? In its compelling, relentless reporting of up-to-the-minute scandal and conspiracy, in addition to its sensationalizing of current events, is it any wonder why more people just don’t dig a hole in the back yard, empty out a coffee canister and make a deposit of their savings?
Events of the likes of the first quarter aren’t new. We’ve seen them over and over and over—you get the point. The markets still trudge on and they do so convincingly, based on little more than just the noise quotient. Oh, there’s still the gut-check buying and selling on speculative trading that happens daily of course, but there’s also an underlying cooler head which I think will continue to prevail, at least for a little while.
PUMP UP THE VOLUME
When it concerns noise, what we in the money management business are referring to is the daily swings in asset prices that we can see in the markets. Sometimes (most times), these swings come on the backs of short-term data or news. Whether it’s geopolitical or business, the news gets digested quickly and buying and selling volume can spike.
For my part, one of the major lessons I’ve learned is that consistency is the hallmark of success. Stick with the program and have a discipline that is applied to decision making concerning buying and selling. Try not to be swayed by the daily grind of following who is buying and selling, and how much. Part of that discipline is looking at indicators that could potential identify that risk is building in the markets.
One of those key indicators for me is the VIX. VIX or The Volatility Index is a computed index much like most other indices that get reported on daily, however, unlike the common TSX or Dow the VIX doesn’t rely on a portfolio of constituent stocks to calculate its values. VIX relies on a derivative measure of those underlying constituent stocks – called implied volatility. Without getting too technical VIX is a measure of what traders feel.
Some investors refer to it as the “fear gauge” others, the “fear index”. To me, it’s what I’ve always called the “noise-meter”. Regardless what you refer to it helps us understand what traders expect in the way of volatility 30 days from today.
The chart above has been created to show the S&P 500 and VIX from 1990 all the way to March 31st. VIX is measured along the left side Axis and the SP500 along the right side. The dates corresponding to the data are on the bottom x-axis. All told, there are approximately 6613 data points, spanning over 27 years. A good enough data to draw at least some loose conclusions on what we can learn from VIX and the direction of it’s linked partner the SP500.
In this chart of the VIX we see its relationship with the index that is the basis of its valuation – the SP500. The orange line is the SP500, the black shaded area is the VIX (above and below its long-term average 19.60) – the average, here illustrated as a yellow line. When traders (now typically large institutions) feel that there will be little change in the direction of the underlying equity and that markets will deviate little from the course they have shown recently, the VIX tends to be below this 19.60 demarcation line. When traders feel that risk and uncertainty is building you will see VIX spike above the long-term average. Looking at the chart we can see, without running any sort of statistical analysis, that when the VIX is above its long-term average the SP500 tends to appreciate, when the VIX is below its long-term average the SP500 tends to trend lower.
For more of a detailed analysis of this relationship I ran a few tests to determine what the 1 year return profile of the underlying index looked like when the daily VIX was above and below this key demarcation line. The chart below shows the results. I caution that this isn’t an extensive test of the data but it was enough to show the basic concepts.
As can be seen, in total, there were over 27 years of daily trading data that we ran this test on.
The first test: VIX TEST #1, tested the resulting one year performance of the underlying SP500 during one year periods where the daily VIX was greater than the long-term average, 19.60. The result is that out of those instances, there were almost twice as many winning years (on a rolling basis) as there were losing. Not bad. The simple average of all the return data points showed about 6.66% with a standard deviation that is higher than the average SP500 long-term standard deviation. What’s important to note is that the average of 1 year positive and negative returns are high; with negative returns higher than positive.
The second test: VIX TEST #2, tested the resulting one year performance of the underlying SP500 during one periods where the daily VIX was less than the long-term average, 19.60. The numbers look a lot better. 86% of the time one year rolling figures were positive, volatility of the return data series was almost half of TEST #2 as was the simple average of all losses during that period.
Essentially, what this graph and table tell me is that I would rather be invested in the market during periods where the daily “noise-meter” is below its long-term average. Suffice it to say, as of the end of Quarter 1 the daily VIX was 13.95 vs the average of 19.60. To me, solely on this data and from a quantitative perspective what this tells me is that we should see a relative period of calm.
However, never make decisions on singular sources of data – we must have supporting evidence to confirm any opinion!
CANADA’S POP CHART
The overall economic performance of Canada has shown some resilience and strength coming out of 2016. Employment continues its trek lower with a recorded 6.6%. The best number since mid-2014 and before that, 2009. As you can see below, the red line indicates the state of unemployment in our country.
Capacity Utilization, the green line, is a measure of the utilization of the country’s working assets. The trend for working Canadian assets has been upward since 2009, however, lately we’ve seen a stall in its progress. I believe this is primarily due to the energy sector selling off in the last two years, resulting in capacity sitting idle in the oil patch.
Lastly, encouraging signs of normalized inflation (CPI blue line) has been observed lately. This may signify a return to a more normalized interest rate policy for the Bank of Canada. A good sign for yield-starved retirees seeking higher returns from fixed income securities but perhaps signalling the “last-call” on an over-inflated regional real estate predicament many large Canadian cities find themselves in.
Continued strength in earnings has underpinned stability in the Canadian stock markets. When we look at key fundamental data concerning equity valuation (like that of Price-to-Book— an Assets-minus-Liabilities metric that helps us understand what people are willing to pay for a stocks business relative to the equity of the business), we see that there is still room for equity prices to appreciate as P/B remains lower than its long-term average.
GLOBAL SOUND CHECK
Based on the above data we remain constructive on the economy, not only here in Canada but globally. Are there headwinds on the horizon? Yes. Key indicators within the US economy are starting to get a little too far ahead of themselves. When we look at aggregate valuation metrics we do see trends to higher valuations. Price-to-Book, Price-to-Earnings and Price-to-Sales have all trended higher. I think the concern here is that the market is waiting on infrastructure promises by the Trump administration to come to pass.
We are cautious as “The Donald” has been somewhat of a disappointment concerning keeping his promises, and his policy initiatives seem to be somewhat erratic. However, there remains enormous strength in the US consumer with confidence levels sky high; evidenced in consumer spending, disposable income and housing starts all being very, very strong. If there’s anything that we can point to it’s that so long as the US consumer continues to wish to spend, it’s hard to bet against the US economy. The rule of thumb (in the US at least) is, so long as there remains a promise of large infrastructure spending in the United States, never bet against the liquidity provided by governments or central banks – at least in the short-term (3-5 years).
At a macro level we are watching, with keen interest, overall US stock market capitalization to GDP, as by the St. Louis FED – the graph above.
Again, this is only one piece of data but within the context of fundamental aspects of equity valuation, general consumer confidence and employment data we can divine a potential inflection point to the direction of the markets.
Globally, we remain in an environment of artificially low interest rates. This isn’t a healthy situation, although with increases of interest rates south of the border some solace can be found that we are on the path to a more normalized environment. There are better alternatives from a valuations perspective outside of the US and therefore we’ve added to the portfolios by becoming exposed to International regions through VEA (Vanguard FTSE Developed Market ETF) and VEE (Vanguard FTSE Emerging Markets All Cap ETF).
We hold a larger cash position for our portfolios than what would be suggested by our long-term target model weights. In most instances, depending on type of mandate, our cash positions can range from 3% to 15%. We will, before too long, be acting on those cash positions and allocating to equities.
Lastly, we added short-term fixed income in our portfolios, of the likes of XSB – Dex Short Bond Index. It is our opinion that only short duration fixed income is suitable for portfolios now because of the potential for increasing interest rates. Conceding the fact that coupons may be higher farther out the term structure we understand that there is also an elevated risk to the prices of bonds – due to there increased sensitivity to interest rate changes. Given that we’ve been in a 30-year bond bull market, we’d rather stay short-term and be early to protect assets and leave the last drabs of longer term bond returns on the table than get caught holding rate sensitive investments when interest rates begin to rise.
Capital Utilization, CPI and Unemployment Data: Morningstar
St. Louis FED: Market Capitalization to GDP
VIX Data: http://www.CBOE.com