THE RETURN OF VOLATILITY
Exploring A Potential Volatility Regime Change
October 6, 2020
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THE RETURN OF VOLATILITY
Describing this year as volatile would be an understatement. Many reasons suggest financial markets will remain choppy over the next few months. Waning fiscal stimulus, rising case counts and a contentious election come to mind. But we wonder what the landscape will look like after these events pass. What exactly awaits us after navigating this upcoming uncertainty?
In our view, the era of ultra-low volatility with ever-higher levitating asset prices is over. We believe the heightened volatility so far this year is a precursor for the decade to come. While the 2010s experienced low volatility and high returns, we think the 2020s will likely experience the opposite.
It is worth noting that every period with high bouts of volatility for the past twenty years have been equity bear markets except one – these past seven months. We can’t help but wonder if that speaks volumes to the unsustainability of the rally or if it’s merely due to the unprecedented velocity of the crash / bounce.
In short, we believe the market is becoming increasingly fragile for reasons explored below. We also believe the next ten years will generally experience a higher degree of uncertainty in many respects. A more fragile market structure combined with rising uncertainty suggests elevated volatility will persist beyond the next few months.
THE SET UP: MARKET STRUCTURE IS BECOMING MORE FRAGILE
The exacerbation of certain market characteristics have intensified as of late and have laid the foundation for sustained periods of above average volatility. We have chosen to focus on the three most important trends that contribute to financial market fragility, in our view.
Passive Investing Effecting the Market
The shift from active to passive has been underway for years and shows no signs of abating anytime soon. Passive vehicles have a mandate to buy stocks if there are inflows and sell stocks when there are outflows, regardless of price or any underlying fundamental factors. Passive investing strategies are valuation agnostic and do not participate in price discovery for individual securities.
Passive investment vehicles have had strong net inflows due to an increased savings rate and taking market share away from active. The personal savings rate in April was 33.7% compared to 7.5% the previous year. This suggests stimulus checks piled into the stock market instead of consumption spending. As the share of passive investing becomes a higher percentage of AUM outstanding, there are more buyers prepared to pay literally any price and less sellers who will sell stock due to fundamentals or valuation. These passive funds only become net sellers when outflows occur, at which point, they sell indiscriminately.
The index-inclusion effect partially explains why the winners become bigger winners and the losers become bigger losers. Stocks that are members of an index can have their prices distorted by net inflows. As the market capitalization for any given stock rises, these passive vehicles are required to own more of it. This dynamic ultimately creates a huge self-reinforcing process and can explain the recent narrowing of market leadership. As passive takes over the market, more money is pouring into the same handful of stocks. The other problem is that there will come a point when passive dominates so much of the market that indiscriminate buyers will have less price sensitive sellers to transact with, increasing volatility.
Mike Green, from Logica Capital Advisors, illustrated the conundrum on Grant Williams’ The End Game podcast by taking it to the extreme. What happens if the market is 99.9% passive and has inflows? What price change is required to get that last active shareholder to sell? What happens if there are one percent worth of outflows? What price change is required to clear the market and accommodate redemptions? Can that indiscriminate selling be absorbed by the market if active buyers only control 0.1% the outstanding capital?
The answer is unimaginable volatility. A scenario where passive represents 99.9% of the stock market is contrived and unrealistic, but it’s an interesting thought experiment. According to Morningstar, passive ETFs control 48% of the assets under management today, up from about 20% ten years ago and up from less than 5% twenty-five years ago. We estimate the real percentage is even higher than that, given the categorization of closet-indexers as active investment vehicles.
Tim Bergin, founder of On Beyond Investing, summarizes a more realistic scenario quite nicely.
“Management at AMZN owns ~15% of the stock, if passive investing is now 45% of the market let’s assume they own 45% of AMZN. That means ~60% of AMZN shares are not for sale, and for the most part not for sale at any price. A buyer of AMZN shares can only do so from the remaining 40% who now can charge more for their shares due to scarcity … If 85% of retirement funds are passive, and 95% of millennium funds are in passive, and both of these groups are adding to their savings everyday, then there is a daily wave of money looking to buy an ever shrinking amount of available AMZN shares (at any price)!” – Volume 4, Issue 7
The shift from active to passive had a calming effect on financial markets during the 2010s, continually providing a bid under stock prices against a benign economic backdrop. But eventually this dynamic will reach a tipping point when passive vehicles become too large of a percentage of AUM. Does that tipping point occur when passive controls more than half the market? More than seventy-five percent? Even worse, this tipping point will coincide with a time of heighted economic uncertainty which will be further explored below.
Growth in passive investment vehicles also leads to greater concentration in the asset management industry in general. It is estimated that the top four passive mutual fund and ETF managers had 46% of the overall market share as of December 2019, compared to 25% twenty years prior (Vanguard, BlackRock, State Street, and Fidelity). Increased industry concentration has profound corporate governance ramifications that we may explore in a future memo.
Debt Outstanding Soars (Yet Again)
The economy emerges from every crisis with more debt than when it began. Debt outstanding grows in every corner of the financial markets. Federal government debt, state/provincial debt, municipal debt, corporate debt, mortgage debt, household debt, etc. Central banks lower interest rates further than they had been during the lows of the previous cycle and encourage borrowing of any kind to re-stimulate economic growth.
The aftermath is always a more fragile market, less able to deal with negative external shocks to its system. This explains why central banks are required to implement what were previously unthinkable policies in sheer magnitudes that push the envelope of what was considered acceptable. The problem is that we are much closer to reaching the limits of monetary policy than we were at the beginning of the year.
Interest rates have hit zero percent and the Fed has indicated there will be no rate hikes for at least another three years. In fact, Jerome Powell is not even thinking about, thinking about raising rates. But new credit creation is easier said than done, regardless of where rates are. Central banks cannot force creditworthy borrowers to take on more debt, or force uncreditworthy borrowers to become creditworthy.
The Fed can enable large corporations to issue new bonds but cannot force them to use the proceeds in a productive manner. Buying back stock and acquisition binges will not create the outcome that central bankers yearn for. Mortgage rates could be interest free and government guaranteed, but homeowners would still need to make the monthly principal payments. Monetary policy is getting closer to the end of the line in terms of how much lower rates can boost the wealth effect through rising asset prices.
Perhaps the Fed or the Bank of Canada will continue experimenting with more unconventional policies. The Fed has already ventured into the junk bond market. Maybe a formal yield curve control program is next. Will they get desperate enough to try negative rates? What about buying equities? Anything is possible. But either way, central banks are closer to reaching the limits of monetary policy efficacy than they would probably like to admit.
Valuation Sensitivity When Earnings Yields Approach the Zero Bound
Value investors are tasked with discerning the relationship between a stock’s value and its price. The underlying value of a business may not change much day-to-day, but its price might. Approximating fair value depends heavily on the earnings yield applied to a company’s income stream.
Equity prices are sensitive to changes in the required earnings yield and the degree of sensitivity increases as risk-free rates approach the zero bound. Earnings yields will fall as interest rates fall assuming the equity risk premium remains unchanged. The result is higher asset prices and higher valuation multiples.
But the range of possible fair values becomes wider as the earnings yield on equities approaches the zero bound as illustrated below.
The relationship between asset prices and changes in earnings yields is non-linear and the margin for error on valuation becomes narrower as stocks become more expensive. When business fundamentals change, as they always eventually do, changes to the required earnings yield will cause more volatile swings in fair value the closer the earnings yield is to zero.
Any changes in perceived business quality, growth expectations or risk profile will be more catastrophic or beneficial at lower earnings yields. Equity valuations are expensive on an absolute basis right now. This means an investor’s assessment of fair value carries a smaller margin for error and potential changes to individual businesses may cause more volatile price swings going forward.
For this reason, we view expensive, low growth stocks as risky investments. Stocks trading at 33x earnings with revenue growth in the low single digits carry significant valuation risk. Should any negative fundamental or perceptual developments occur, the market may deem an earnings yield of 4% to be more appropriate. In which case, the stock would drop 25% and, assuming 3% top line growth, it would take more than seven years for the stock to reach its highs again.
This dynamic is especially true for unprofitable companies that are expected to generate cash flows many years from now. The value ascribed to these businesses is heavily dependent on terminal growth assumptions and low discount rates to justify aggressive valuations. Even a slight reduction in growth rate expectations or an increase in the discount rate could severely impair stock prices. These kinds of stocks have done well recently in what is essentially a long duration trade.
Further exacerbating this heightened sensitivity is the magnitude of corporate debt. Excessive debt within capital structures mean equity prices are even more sensitive to changes in valuations. For instance, if a business is capitalized with 50% equity and 50% debt, and the value of that business drops by 10%, the equity value drops by 20% while the value of debt outstanding remains fixed. Taken to the extreme, stub equity trades more like an option than an actual ownership stake in a business.
The Foundation Has Been Laid
The combination of these factors alone does not necessarily guarantee higher volatility. Every one of these trends intensified throughout the 2010s with unbridled complacency. But, unlike the past decade, the 2020s will not have the same unusually calm economic backdrop. Even worse, the market is more vulnerable to external shocks than it was at the beginning of the last cycle.
We believe extraordinary fragility is coinciding with a period of significant real uncertainty and there is no easy path out. We see the potential for sustained higher volatility if any of the below negative developments occur and are worse than expected.
THE NEXT DECADE: RISING UNCERTAINTY
We believe there are many sources of significant uncertainty over the next ten years, any combination of which could potentially result in sustained volatility for prolonged periods. It is important to note that negative outcomes in any one of these categories may be enough to destabilize financial markets given how vulnerable and fragile its structure is.
Economic Rebound Uncertainty
Nobody knows when or how COVID-19 will subside. History tells us that eventually we will hit herd immunity, find a vaccine, or learn to live with recurrences of the virus like the common flu. But the big question is what does the economy look like on the other side of this pandemic? How quickly can the economy bounce back? How much economic damage is permanent?
Let’s pretend a central bank of medicine exists and has the ability to magically print vaccines out of thin air. In effect, a medical bailout could be signed, sealed, and delivered to everybody’s doorstep by tomorrow morning. How long would it take for the economy to rebound completely?
We believe there is a real possibility, even if COVID-19 disappeared tomorrow, the economy may only get back to 90% of where it was before the pandemic over the next two or three years. Many small businesses have permanently closed. It will take time for new entrepreneurs to fill the demand left behind. If a second wave hits, many more businesses will be forced to declare bankruptcy.
Many companies have laid off or furloughed workers, only to learn the workload can be handled by less people going forward. Companies will become even more efficient from a headcount perspective. A 90% economy may not sound catastrophic in general, but for many companies and industries it’s the difference between business as usual and liquidation proceedings.
The worse the recession is, and the longer the lockdown measures remain, the higher the likelihood of lasting changes in behaviour. At what point is business travel permanently impaired and partially replaced by video conferencing? Congress is putting forth another airline bailout package for ~$25 billion to protect ~48,000 jobs for six months. That amounts to an annual salary of more than $1 million per job. Where is the money going? Is this the best use of taxpayer funds? These airlines will inevitably be back at the trough in another six months asking for more.
Other lasting behaviour changes could extend to restaurants, hotels, movie theatres, amusement parks, brick-and-mortar shopping, etc. all of which rely on high capacity to cover largely fixed costs. Widescale permanent work from home measures would have a serious effect on the commercial real estate market with knock-on consequences for financial institutions holding their debt. Further, the potential talent pool companies can recruit from suddenly becomes global. Our guess is that wages will not rise for some time if this is the case. Unemployment rate and underemployment could remain elevated.
Mounting data points to a decelerating recovery and an uncertain economic future, despite the stock market suggesting otherwise. Our base case is a partial recovery over the next couple of years. Either stocks will have to adjust downwards to meet economic reality or the trajectory of the recovery will have to improve quickly enough to meet V-shaped expectations. Either way, volatility is coming.
Deglobalization and Shifting Supply Chains
Geopolitical tensions are rising in a general sense, especially between the United States and China. Tariffs have begun and trade relations may deteriorate into a full-blown trade war. Companies are already beginning to move their supply chains out of China.
Going forward we think more companies will opt to invest in supply chains closer to where their end products are sold, build more redundancies into their network, and carry more inventory on hand. The pandemic has demonstrated just how costly becoming overly efficient can be.
Many companies found themselves without reliable access to component parts from other continents causing manufacturing bottle necks, the means of transporting them from place A to place B, or adequate capacity to ramp up production as demand unexpectedly skyrocketed. Maximizing efficiency optimizes long-term profits only when conditions are completely stable and predictable.
Businesses that saved nickels and dimes over the past few years by perfectly calibrating supply chains to remove costly redundancy likely sacrificed dollars worth of profit in doing so if they ran into any of the aforementioned issues. The decision to trade efficiency for robustness will weigh on margins and some of that additional cost could be passed onto the end consumer depending on demand elasticity. Manufacturing in more expensive parts of the world increases costs as well. Could these changes be enough to create more inflation than expected?
Rising Social Tensions
A discussion about rising social tensions cannot be adequately addressed in a short memo but there are very clearly socioeconomic issues that run deep. The distance between the haves and the have nots is unhealthy and that distance continues to grow at a faster pace over time. We believe these issues, in large part, are created and exacerbated by central bank policy. Regulatory capture plays a role too.
Analysts expect $161 in EPS for the S&P 500 next year (vs. $163 in 2019), almost as if the pandemic never happened. Either (1) expectations are overly optimistic, and those estimates will come way down or (2) the largest companies will run their businesses essentially unscathed while small businesses simultaneously experience record bankruptcies. In which case, the divide between those at the top and those at the bottom – for both businesses and individuals – will become even more extreme, tearing at the social fabric even further.
Underfunded Pension Liabilities
Approximately 21% of the total population in the United States will be 65 years and older by 2030, compared to 16.5% in 2019 and 13.1% in 2010. We wonder when the pension crisis will come to the forefront. It is estimated that underfunded pension liabilities amount to trillions of dollars despite overly optimistic return assumptions. Pension funds struggled to generate 7% annual returns when ten-year Treasuries were 150 basis points higher. It certainly will not be any easier over the next few years.
This is one of the many reasons why central banks are determined to backstop risk asset prices. The concept of too big to fail no longer applies to just big banks. It applies to all financial assets. Underfunded pension plans will inevitably need bailouts even with stocks at all-time highs. It’s worth contemplating what equity markets look like when demographics change, and pension funds become net sellers of stocks. Can pension funds and passive vehicles gracefully unwind assets to raise cash for retirees? Will there be enough marginal buyers to absorb so much indiscriminate selling?
The Potential Unwinding of Risk Parity
Bonds have been negatively correlated with equites for the better part of thirty years since the Greenspan Put. The Fed cut rates every time the stock market went down, causing bond prices to go up. This negative correlation gave rise to risk parity investment strategies. The optimal portfolio becomes a levered one when it is possible to add a negatively correlated asset that carries a positive return.
However, with rates already at zero, the Fed has less flexibility to ensure bonds are negatively correlated during future market corrections. Instead of risk-free interest rate, we have reached a point of interest-free risk. Holders of U.S. Treasuries are barely paid to own these yield-less bonds but still take on significant interest rate and duration risk.
Mike Green, from Logica Capital Advisors, has some interesting thoughts on risk parity strategies as well. He believes these portfolios are only viable when ten-year U.S. Treasuries offer a positive yield. Historically these bonds have put-like characteristics and pay investors to own them but, when rates hit zero, the asset no longer offers a positive yield. Once that positive carry put ceases to exist, the risk parity portfolio no longer works and must collapse.
We agree and believe this dynamic could potentially lead to an institutional unwinding, especially if interest rates go negative. What is the purpose of levering a portfolio using Treasuries if the asset no longer provides diversification benefits and does not pay bondholders to own it? Risk parity may not unwind with rates at zero, but once there is a cost associated with the carry via negative rates, look out.
Growth Risk
The investment community believes real GDP growth will return to 2-3% after the recovery concludes. We are not so convinced. Annualized real GDP only grew 2.3% during the 2010s. The ballooning amount of debt outstanding, both public and private, will weigh heavily on growth going forward compared to the previous decade, in our view. Further, it is unlikely another corporate tax cut occurs.
Circling back to our discussion about terminal growth rates and stock price sensitivity to changes in key assumptions. Reducing a terminal growth rate by even one percent will have a material impact on valuation models. The risk of inflation cannot be ignored either. Earnings yields will go up quickly if inflation rises faster, causing lower asset prices. For instance, let’s assume earnings yields are 4% while inflation is 2%. If inflation goes to 4%, investors will require a 6% nominal earnings yield, all else equal. This means a multiple compression from 25x to 16.7x, a 33% decline.
VOLATILITY MEANS OPPORTUNITY
The volatility experienced so far this year has been nothing short of remarkable. The last period of any significant volatility was almost ten years ago. It is hard to imagine this level of instability remaining for the entirety of the 2020s, but we think it will likely be elevated relative to the 2010s.
In fact, returning to slightly more volatile conditions in general would be more normal from a historical standpoint. The past ten years have been unusually benign and expecting another decade like the last is simply unrealistic. Active stock pickers will have a tremendous opportunity to add value through choppy markets and we look forward to relentlessly searching for market inefficiencies in turbulent times.