Investors facing opportunity in volatility
Australians may generally be an optimistic lot, but as investors it’s a different story.
That’s not necessarily a bad thing, though – the saying ‘what goes up, must come down’ is not accompanied by an opposite phrase along the lines of ‘what goes down, must come up’.
As an investment manager looking at stocks and the broader market, if you’re not worried and watching something then you’re probably not doing your job. It’s important to protect your investors’ capital.
In recent months investment markets have experienced an increase in volatility. This can make investors and fund managers alike somewhat nervous, and yet there are opportunities for vigilant and active managers in times of volatility.
What has been driving this increased volatility?
Firstly, let’s put this into perspective.
In 2017 the S&P 500 Index (a broad measure of the US stock market) recorded eight days of a one per cent or greater move (either up or down), with no days seeing a move of two per cent or more for the entire year.
Since the start of 2018 (to 10 April) there have been 68 trading days in the US. Across this timeframe, the S&P 500 Index has recorded 28 days of a one per cent or greater move in either direction.
The largest daily move was more than four per cent, as well as one day of more than three per cent and six days of more than two per cent.
An increasing mix of factors has contributed to this noticeably higher level of volatility, including a divergence in price/value between classifications of stocks; industry trends; and macro-political influences.
Stock prices – a tale of two regions
Domestic growth is relatively sluggish when compared to many offshore regions and countries.
There is quite a divergence in the valuation between stocks which gain a significant portion of their revenues from offshore versus those who operate a domestic-based business.
This dynamic is illustrated by the widening gap between the forward earnings per share (EPS) lines between Australia and the World in Chart A.
Do you pay up for the implied higher growth, or seek the value and possibility of improving growth down the track? Here’s where the importance of active stock picking really shows.
Chart A – EPS of Australia versus world (12 month forward)
Source – UBS Research
February reporting season and some very discerning investors
The investor reaction to company results throughout the recent reporting season was at times quite stark.
Overall the reporting season was positive, with companies reporting results that were better than expectations outnumbering those who missed their guided numbers by almost two to one.
However, individual share price reactions to both beats and misses were strong, with companies well-rewarded for positive results and equally punished for poor results and negative outcomes.
This is not uncommon, but the extent of the divergence between good and bad was high.
Passive management increasing
The increased use of passively managed strategies, including index-based exchange-traded funds (ETFs), has perpetuated the degree and strength of some share price movements – both up and down.
By their very nature the indexing strategies see a stock purchased as it rises and sold as it falls – hence exacerbating the degree to which the stock price is already moving.
There is no informed fundamental assessment or view of whether a stock is overvalued or undervalued – it is simply purchased or sold in relation to its changing capitalisation within the index.
What’s on the worry list
Active investment managers always have many micro level company-specific items to monitor. However, across 2018 and beyond, managers are also closely monitoring four broader items.
Rising interest rates
As a trend this is well-known, especially in relation to rising US interest rates. However, the speed and trajectory of rate rises may cause concern.
The US 10-year bond yield has increased strongly since late 2017, much more so than the yield on rate-sensitive stocks.
Many stocks considered ‘low risk’ have relatively high levels of gearing that must be monitored, and many stocks categorised as ‘low volatility’ are on forward P/Es over 20 per cent above the long-term average.
Chart B – 12-month forward P/E of the 40 stocks in GSG’s 'low volatility' screen
Source – Goldman Sachs Global (GSG) Investment Research
The US deficit
The US Federal budget deficit continues to grow, with no sign of a reduction in current spending levels. The net interest expense in the US, as a percentage of GDP, is at its highest since the mid 1900s.
Unemployment in the US is low and as the economy moves towards full employment, wage pressures are beginning to emerge. This typically eats into company margins, as well as being a source of inflationary pressure – another reason to watch interest rates closely.
Chinese economic growth
A deliberate slowdown was communicated from the extreme economic growth highs of 2010-2011, yet several measures illustrate that this slowing continues today.
A declining GDP trend is in place, along with an even stronger declining trend in the China Physical Activity Index. Whether this has been due to the impact of winter shuts remains to be seen.
Chart C – China Physical Activity Index
Source – UBS Research
The rise of passive
In the United States almost 40 per cent of assets under management are passively managed. This is large in its own right and has been an increasing trend over the past decade.
Within Asia (including Australia) this number is just under 10 per cent, but the increasing trend has persisted in recent years and does not appear to be dissipating in any way shape or form.
What does this mean for investing?
Increased volatility can and does mean opportunities will be presented. Yet only if you implement an active and somewhat flexible investment strategy will you be in a position to take advantage of them.
In terms of achieving solid long-term returns, capital preservation during many shorter-term time frames is particularly important.
In periods of increased volatility like those we have experienced since the start of the year, we are reminded of the fact that for many investors it is not simply about obtaining a certain performance outcome, but how consistently – or not – it is achieved.
Stuart Fechner is director, research relationships at Bennelong Funds Management.
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