It’s been a week on the wild side in markets, though amid all the confusion and commotion the main story is simple. The uplifting vaccine news from Pfizer has invited markets to consider how a world without the virus looks like. Taking the initial reaction at face-value, this is a world basking in the glory of reflation—and accelerating nominal GDP growth—higher long-term interest rates and a sustained rotation from growth to cyclical and value stocks. Let’s start with the obvious point. There is now a chasm between those basing their world view on an effective vaccine, and the end of Covid-19, and those staring down the barrel of a still- uncontrollable spread of the virus, and associated lockdowns to contain it. As far as the economy goes, forecasters now have to pass Fitzgerald’s test for a first-rate intelligence. The near-term outlook for developed economies is not pretty, and as restrictions encroach on December, the Q4 GDP forecasts are sinking without a trace. We’re currently living in a start-stop economy. The question economists have to answer is whether this situation has to be assumed for 2021? It’s certainly possible in Q1 and Q2, but Pfizer’s news has thankfully made such an outcome less likely. The problem is timing and whether we have to be on lockdown-lite through parts of H1, as we wait for the ‘shot’. The best case scenario is that the population at large gets the shot in the first half of the 2021, but that’s a Hail Mary. Take it from me, a professional economist whose day job it is to put numbers on the state of economy over the next six- to-12 months, we don’t know.
Read MoreIt’s been a while since I updated these pages, mainly because I have recently moved across the country, back to the Big Smoke, where I am now nestling in the hopefully up-and-coming part of southern London. I will be up and running with my market updates and videos soon enough, but first things first. I have been sitting on this piece, mentally more than anything, for a while, and I thought it would be a nice way to re-start my posting. I have long been thinking about whether it is possible to provide a good quantitative argument in favor of the defunct value equities, or more specifically the value “factor”. I think it is, but as always, I leave to you to judge. In my last post before my temporary hiatus, I made the argument that the vast majority of investors are structurally short volatility. Accepting this premise raises the obvious question; how does one achieve a cheap and effective long vol position? In this post I will try to offer a concrete and quantitative perspective on this question using the simplest tools available to us from finance theory. Before I get to that, though, I want to state the problem more precisely. In a nutshell, the traditional 60/40 portfolio is doing too well. The increasingly concentrated leadership in equity beta centered around the ubiquitous growth factor—essentially U.S. technology firms—and the correlation of this position to the performance of government bonds—driven by structurally falling interest rates—has been a boon for investors. A 60/40 portfolio with a concentration in growth stocks has increased by a factor of almost 4 since 2010, beating the MSCI World by almost 25%, not to mention breezing past the main regional indices—MSCI EM and MSCI Europe—by a factor of 2-to-2.5. That’s great news, but it also puts investors in a bind. If a balanced portfolio is winning on both legs what happens when the tide turns?
Read MoreThe Narrative™ is treading water at the moment, consistent with price action. The direction still looks decent for the bulls, but it’s getting a bit choppier, which is not a huge surprise. The global equity index is up by 35% since the lows three months ago, but the next three months won’t be as spectacular. This is not a huge insight, leaving the main question of whether equities edge higher, even at a slower pace. The simple stock-to-bond model discussed last week suggests that they will, by 5-to-6% over the next three months to be exact, but it’s probably best not to not hold me on that prediction. Meanwhile, investors and analysts continue to have the same tedious debate about the likelihood of a "V-shaped" recovery, and whether markets will sell off if we don’t get one. This conversation on occasion takes place at an extremely low level of sophistication, so just to make it clear. A V-shaped rebound in growth indicators and surveys, the latter which are often normalised around a trend of ‘zero' growth, is not the same as a full recovery in the level of output. Yet, the idea that markets will sell off if a V-shape in the economic fails to materialise is still presented with alarming regularity. I am not sure how it ever got to this. A full recovery of output always takes a long time after a recession, but markets don't wait around. After the financial crisis, for instance, real GDP in the US didn't fully recover until in the first half of 2011, at which point the MSCI World has already rallied by a cool 92% of its lows. In other words, markets trade on the margin of the data, and that margin is currently well-oiled by policy.
Read MoreThat screeching sound you heard in equities last week was caused by a train wreck underneath the surface of a steady uptrend in the market as a whole. The hitherto outperformance of growth and momentum reversed sharply, a move that coincided with a steeper curve and a tasty outperformance of value and small caps. The dramatic rotation across equity sectors, and the steepening yield curve, vindicate the story peddled on these pages recently. But the question is whether this is the beginning of a sustainable shift in markets, or whether it’s merely an invitation to buy the dip in an eternally winning strategy? It’s difficult to say. Robert Wiggleworth’s expertly written overview of the flurry in the FT certainly suggests that strategists have taken note, equating last week’s gyrations to the so-called “Quant Quake” in 2007. Apart from the fact that the event is significant enough to merit at least a small footnote in modern finance history, the quotes garnered by Robin indicate that strategists are at least mulling the idea that the shift has legs. This, in turn, presumably means that they’re advising their clients to run with the reversal, which almost surely would do nicely for the portfolio.
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