Tatton Investment Management's Stock Market Correction Assessment

6 February 2018

After an exceptionally strong January in equity markets, which followed strong 2017 returns, stock markets around the world have now suffered a considerable downward correction without there having been any one particular trigger. Indeed, last night’s 4.5% fall in the US coincided with macro-economic data releases showing both the US, as well as the European economies in even better shape than previously anticipated. However, to give perspective, US markets last night still only fell back to where they were already at the beginning of the year.

Such seemingly irrational market actions, can naturally cause  concern, if not fear, that there is something worse afoot. With the Global Financial Crisis (GFC) of 10 years ago still fresh in our collective memories and having enjoyed above average investment returns since that time, this is entirely understandable.  

For regular readers of Tatton’s Weekly Market Comment this market correction will not have been quite as much of a surprise. Over the past weeks we have repeatedly commented that stock markets appeared to ignore rising inflation expectations and what this does to bond yields, i.e. pushing them higher. As such we warned that a market set back was entirely possible. Finally, last Friday I wrote how the equity markets had now somewhat belatedly noticed this changing dynamic and started to sell off in a hurry. At this point it is important to note that compared to the last equity market correction of January/February 2016, there are currently no widespread concerns about a slowing economy or rising corporate default risks.

Instead, and just as ourselves there had been Increasing concerns voiced by institutional investors that equity market valuations particularly in the US had become overextended - unless the exceptionally low interest rate and low yield environment of the past years was to continue indefinitely. Against the backdrop of slowly normalising inflation expectations this became an increasingly unrealistic position.

As a result of the widespread valuation concern, investors have in recent times made significant moves towards systematic and easily tradeable investment strategies such as passive funds and “risk-parity” funds. These funds have pre-set rules for trading, and are designed to avoid human intervention. However, they rely on market liquidity provided by other investors.

As bond yields gradually moved higher it appears that active (human) managers became extremely wary since last week, reducing market liquidity through their increasing unwillingness to continue to be buyers of equities. On the other side, the acceleration in markets price moves actually increased the systematic funds’ need to find buyers, i.e. market liquidity. Without any human intervention, these funds have sold at whatever prices have been available. While systematic trading has existed for almost as long as markets, its current extent is the largest ever. The resulting move as we witnessed last night may be considered to be equivalent to an external shock such as an earthquake.

The result of the market correction thus far is that equities are trading at much less extended valuation levels than before and in some instances, have even fallen back to long term historical averages as observed during periods with interest rate and bond yield levels more in line with what may be ahead now. This return of value upside potential to markets has historically attracted back the aforementioned active (human) investment managers into buying the equities that the systematic strategies are forced to sell. This leads to a gradual return of buyers/liquidity to markets and generally presents a buying opportunity for rational investors.

At Tatton, we fall into the latter camp, which is why our investment portfolio strategies have since last summer been more cautiously positioned than the upward momentum strength may have normally warranted. This means that this market action has further reduced our equity positions to underweight against peers and our risk profile benchmarks. While this means that our investors are suffering slightly lower portfolio declines than if they were invested passively or in many instances elsewhere, it also means that when markets regain their footing and bounce back with the return of liquidity, they would participate less in the recovery.

At junctures like these in the past we have therefore conducted ad-hoc rebalancing of portfolios and deployed portfolio cash to bring our equity positions back up to target.

The challenge of this undertaking is that it is just as difficult to forecast the market turning points in a downtrend as it was previously to exactly pinpoint if and when markets turn after a prolonged and very consistent market rally. Just as markets have recently overshot on the upside it is now entirely possible that they will overshoot on the downside. We will therefore put all available resources to work, to make the best use of our discretionary investment mandate to align Tatton investors’ portfolios in the best possible way to this unfolding change in market direction dynamics.

The low volatility, high return environment of the past 14 months was a pleasing, if unusual experience for long term investors. This sudden return of market volatility is a timely reminder that higher returns do come at the risk of higher capital fluctuation over the shorter term.  At this point it is key for investors to remember that the route to superior long-term returns is determined by ‘time in the markets’ rather than attempting to ‘time the markets’ as so many investors in the above mentioned systematic risk parity strategies are just finding out again.

On this note, I suggest that just as was the case during previous market upsets, the best advice for investors is to ‘keep calm and carry on’. Unless this market rout morphs into a major and lasting liquidity crunch, for which there is little indication, then the upward direction of travel of the global economy and consequentially corporate earnings and dividends set the longer-term course of investment returns.

Finally, to repeat what I said in last Friday’s Weekly Comment:

Given the economic and corporate news-flow was very positive over the week, we interpret this sell‑off as a temporary profit taking and also hope that it will quell recent US equity investor exuberance for a while longer. 5-6% global stock market growth in a single month (without being a recovery from a previous fall) has just all hallmarks of an overheating capital market environment which usually leads to nasty corrections in due course. If this current episode leads to 2018 not shaping up to look like 1987 than that would be a good thing.

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