New article from Tatton Investment Management: Meteoric stock markets crash bac

9 February 2018

After the prolonged period of calmly up-trending stock markets (see chart above) the market correction that occurred over the last 10 days was perhaps overdue and did not come entirely unexpected as regular readers will know. As I wrote in my stock market assessment email on Tuesday, many (us included) had anticipated and warned this might happen, but nobody to my knowledge had been able to predict when exactly it would happen, nor expected the vehemence and cause.

Now that the first dust is beginning to settle, it is becoming clear that stock markets began to wobble in the US when equity investors finally came to realise that the return of more normal levels of interest rates and yields are the inevitable consequence of consistently improving economic condition worldwide which had given them ever improving corporate profitability. This wobble, or slight increase in market volatility led to a chain reaction that was triggered by derivatives based retail investment products whose returns were tied to and geared around low levels of volatility. When volatility exceeded certain thresholds, they become forced sellers of stocks to cover their exposures, while all more fundamentally based (human) investors were unwilling to buy their excessive volumes, given how expensive stock had recently become (again see chart above – last 6 weeks).

What followed was what can only be described as a flash crash, given how quickly equity prices collapsed back to where they had been trading at the end of last year. At those levels, valuations were no longer as extended, which brought back the fundamentally driven buyers and resulted in a gradual stabilisation of markets. We have dedicated a separate article to the dissection of the causes of the flash crash, written by our market trading expert Sam Leary.

The difficulty investors now face is to decide what is likely to happen as a consequence of this violent dislodging of the previous trend order. Firstly, market earth quakes as we just experienced tend to be followed by further tremors as witnessed Thursday and Friday. Secondly, the eruption of market volatility can lead to a fundamental market reassessment by investors leading to a break from the previous trend and finally, the sell-off itself can create a negative feedback loop into the real economy, with the potential to disrupt the previous economic balance or trend.

The aftershocks should begin to recede over the coming 2 weeks, while the fundamental reassessment should lead to the insight that with valuation levels now once again closer to the historical norm, further upside can only come from corporate profit growth. The still ongoing quarterly earnings report season is showing earnings growing at +13.5%, which still provides plenty of upside potential and should mean that there is little reason to anticipate the coming of a bear market. Ideally, the market correction will have acted as a warning shot and see market dynamics return to a more sustainable path that is tied to the reality of actual earnings growth, rather than fantastic expectations of future profit growth on the back of assumed technological quantum leaps.

Unfortunately, there remains the possibility that the market upset creates a new economic reality in which the reduction of capital market driven liquidity, together with the already reducing central bank provided liquidity leads to an economic slowdown which sours capital markets more fundamentally.

At the moment we can observe two camps of forecasting approaches to evaluated the probabilities for the above. The first is trying to predict the near future by comparing the status quo with the most comparable historic precedent. The second group is applying a more fundamental approach of analysing the prevailing economic fundamentals in order to reach conclusions what might follow from here.

The first approach struggles, because quantitative monetary tightening has no historic precedent and ‘next best’ fits offer a vast array of possible outcomes. The fundamental analysis establishes that there are none of the usual warning signs for a turning over of the economic or indeed market environment, as there would normally be slowing corporate earnings, rising default levels or falling business sentiment. This leaves the uncertainty how the still somewhat fragile global economy and capital market environment will cope with interest rates and yields finally rising again after such a prolonged period of historically low levels.

In the Tatton investment team, we have relatively high conviction for our central case that the global economy is not going to slow materially or fall into a recession this year. However, we cannot be as certain how capital markets will trade from here in light of the end of the goldilocks environment of strong corporate profit growth and low cost of capital.

I am inclined to expect that once again, the further monetary and economic development will be characterised by far less radical shifts and changes than market debate has currently been spurred into predicting by the reawakened equity market volatility.

Despite our more defensive portfolio positioning in anticipation of a potential market correction have our portfolios lost some of their previously achieved returns. Sadly, this is unavoidable in order to capture the returns that are available to investors with some certainty over the longer term. 

However, over the shorter term, and until the picture becomes clearer to merit any more fundamental portfolio repositioning, we will continue to utilise the trade execution timeliness the overlay funds in our managed portfolios provide us with to steer portfolios towards valuable investment opportunities as they always also arise when major market disruptions occur.

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