Blog

What should you sell in a volatile market?

The first two months of 2018 have been a wild ride for Australian shares, with big falls and then big recoveries. However, from looking at the headlines in the financial press most investors would be surprised to find out that the ASX 200 index actually finished February exactly where it started the year.

Last week we looked at the causes behind the volatility in February – Volatility and Melting Markets – and in this week’s piece we are going to look at how we approach market dislocations.

Surviving previous crashes

In my funds management career, I have had the “fortunate” experience of having observed both the GFC in 2007-08 and the Tech wreck in North America in 2001 from the front lines, helping to manage large institutional equity funds when the prices of all stocks regardless of their quality were falling heavily.  During both of these crashes, I worked with firms that ran conservative value-style funds, based on fundamental analysis of companies.

During these periods the portfolios were populated with companies paying dividends from stable recurring earnings such as TransCanada Pipelines and Amcor. These portfolios had no exposure to companies that were reliant on the previous frothy market conditions continuing such as Pets.com, Nortel, Babcock & Brown, or Allco Finance. What I learned from these experiences is that a portfolio constructed in a conservative manner populated by companies paying stable and growing dividends with low gearing will bounce back from the blackest nights of doom and gloom.

Know when to hold them

In a perfect world, investors with perfect knowledge would head into a major market meltdown having sold all equities would have a 100% cash weight. However practically that would never happen due to both taxation consequences and the risk that the call may be very premature or even wrong. Many investors may remember RBS’s advice in January 2016 to sell everything as oil was going to $15 a barrel and equities markets were going to fall by 20%. Consequently investors and fund managers only tend to have hard looks at their portfolios when the bull market stops and stock prices are falling.

In our opinion the worst thing that investors can do is look at the sea of red on your computer screen for hours at a time, or read the some of the breathless market commentary in the financial press or coming out of the trading desks at the investment banks. The former is designed to sell newspapers and the latter is produced in an attempt to influence you to incur brokerage, when doing nothing may be the best option.

When a major market dislocation occurs, the best thing for investors to do is step back and think what this particular dislocation will do to the earnings and dividends from the companies held in their portfolio.  If the answer is not much and the dividend stream will be largely unaffected, then the falling market has given you the opportunity to add to positions at a discounted price. For example, it was hard to see how the falls in the US market in February were going to impact rental income from SCA Property’s portfolio of neighbour shopping centres, or Amcor’s sales of PET soft drink bottles and flexible food packaging.

Know when to fold them/ know when to walk away
Conversely, companies in an investor’s portfolio that rely on benign debt and equity markets to finance their growth or are still proving up their business model should be looked at with the most critical of eyes. These companies are typically characterised as “concept stocks”. Often they are companies with exciting technologies in new markets that may have significant future value, but are often have minimal current earnings and assets that could help them weather the inevitable storms. Recent examples of high growth concept stocks that have run into trouble include GetSwift and BigUN.

Amongst the larger stocks on the ASX, investors should look critically at companies with both high PE ratios, high gearing or those that have recently made significant acquisitions. During major corrections, companies with these characteristics tend both to get sold off the most, and might also face dilutive equity raisings due to pressure from their bankers.

All weather stocks

Whilst listed property trusts as a sector are viewed with suspicion by many investors at the moment we continue to like SCA Property. This trust is exposed to domestic food, liquor and services consumption via long-term leases to Woolworths. During major market meltdowns such as the GFC, consumers tend to cut back spending on discretionary items such as clothes and going out to restaurants in favour of cooking and drinking (larger than normal) glasses of shiraz at home, all of which are supportive for SCA Property’s earnings.

Woolworths’ landlord continues to benefit from the supermarket giant’s battle to regain market share from Coles, as a portion of the rent is tied to turnover. The trust is conservatively run by an experienced and honest management team and importantly has low gearing and minimal near-term debt maturing. In February management upgraded profit guidance for 2018, yet the trust is trading on a yield of 6.3%.

Current Positioning

In the current environment Atlas see that investors should be looking through their portfolios for the stocks that could “torpedo” portfolio performance. In early 2018 rather than scouring the market for the next Blackmores or A2M Milk, we are spending time thinking about what could go wrong with the various companies in our existing portfolios.  As a quality style manager, we are spending time looking closely at the quality of company earnings and the percentage of earnings that are derived from recurring earnings that will hold up over time, rather than profits coming from revaluations, accounting changes, asset sales or performance fees.

In terms of sector positioning Atlas are very cautious on the mining sector, especially at the sexier end of lithium and graphite. The frenzied activity, promise and hype in this sector looks like a movie that I have seen before.  Whilst the consensus view is that commodities will stay strong in 2018, a large part of the price moves we saw in 2017 was the result of Chinese stimulus plans enacted in 2016 which has begun to fade. Declining Chinese dependence on fixed-asset investment to drive growth will put downward pressure the prices of commodities such as coking coal, iron ore and copper.

 

Volatility and Melting Markets in February

Over the last two weeks investors have been bombarded with a range of financial commentary, some of which comes with the conclusion that investors should sell everything as we are facing price falls in 2018 similar to what happened during the GFC a decade ago. This intensified after the S&P 500 fell -3% on Monday, its biggest one-day fall since 2012.

In this week’s piece we are going to look at some of the factors behind February’s fall and subsequent market volatility, and how we approach investing during times when the Chicken Littles are suggesting that “The sky is falling in!”.

Setting the Scene: A shaky background in January
Prior to the market volatility in February, the stage appeared to be set for a correction. The US market had enjoyed a two year run without a major correction,  as the S&P 500 smoothly gained 54% from the 12th February 2016. In late January US stocks were trading at lofty valuations: the S&P 500 was trading on a price to earnings ratio of 21 times, fuelled by improving corporate profits and impending tax cuts.

However, the market was also concerned that if the US economy gets much stronger, we could see inflation, something that many younger analysts only dimly remembered from dusty economics textbooks. Finally, with the changeover in the leadership of the US Federal reserve occurring on the 3rd February, there was concern that the US Fed would drive up interest rates in 2018 and that this would be done too aggressively, triggering a fall in equities.

Low Volatility
Against this background, market volatility had declined to extremely low levels, as the share market enjoyed a prolonged period of smooth rally without a correction. Moreover, this low volatility extended to a range of assets including shares, currencies and bonds. The decline in volatility is something that we had observed over the past year, and which influenced income in the Atlas High Income Property Fund.

Whilst Atlas have been unhappy about the prices we have been receiving due to the low volatility, a range of hedge funds have been profiting from this phenomenon. Essentially this involves betting that stock markets would continue to remain benign. This is done by shorting the volatility of the market 1. Short volatility has been a very consistently profitable trade over the past year, collecting consistent premiums every few months from derivative positions that return a profit if the stock market does not swing wildly in either a positive or negative direction.

A Crowded Trade and the Stampede out the Door
At the end of January there was US$3 billion in exchange traded funds (  ETFs) in the US using this strategy. Amazingly two ETFs alone – VelocityShares Daily Inverse VIX Short-Term ETN, and ProShares Short VIX Short-Term Futures ETF – increased assets by US$1.7B between them in January 2018. After the first of these funds fell more than 90% in a week, Credit Suisse are in the process of shutting it down.

However, it would be incorrect to think that a few small funds alone contributed to the market falls we have seen in February. According to Bloomberg in the wider funds management universe more than $2 trillion of investments are linked to this short volatility strategy. These hedge funds are connected via systematic strategies such as short volatility, risk parity, and volatility targeting. This very profitable trade betting on low volatility soon became a crowded short, vulnerable to a short squeeze when a large number of traders are forced to try and make the same trade at the same time. A situation similar ten people trying to quickly leave a room through a doorway when a giant rat falls from the ceiling.

What we have seen over the past fortnight was the unwinding of a crowded trade, and the resulting squeeze. The market movement – as these funds unravel and hedge funds using these strategies see outflows – has fed into weakness in the underlying shares due to forced sales of equities.

 1. The short volatility trade involves two constituent parts; 

a) Initially selling longer-dated futures on the Volatility Index (VIX) which were priced based on the expected volatility of the S&P 500 a few months in the future. The VIX is itself derived from the volatility of options on the S&P 500 which are primarily derived from the recent volatility in the price action of the market itself.  Atlas have observed the declining volatility of markets over the past year, because as a seller of covered call options, the premiums we have been receiving for the call options sold have been declining.

b) As for the past two years up until February these futures in volatility traded above the current level of volatility or VIX, provided the market remains placid,  the short seller covers their short sales as the price of the future falls towards the spot price as the future expire.

Our take

Atlas considers that what we are seeing at the moment is the disconnect between the “financial economy” and the “physical economy” and an element of reality returning to stock market valuations.  At the halfway mark of the February profit-reporting season, the overwhelming theme is that both Australian and US companies are making healthy profits.

When a major market dislocation occurs, the best thing for investors to do is step back and think what this particular dislocation will do to the earnings and dividends from the companies held in their portfolio. If the answer is not much and the dividend stream will be largely unaffected, then the falling market has given you the opportunity to add to positions at a discounted price. This is markedly different to the conditions that investors faced ten years ago. At that time the seizing up of the credit markets both disrupted the ability of most global companies to refinance their debt, and also saw profits fall heavily as global trade declined sharply.

Monthly Newsletter January 2018

  • January was a weak month as the listed property sector was sold off -3.3%, due to rising bond yields weighing down on income stocks globally.
  • The Atlas Fund returned -2.7% in a month where there were few places for investors to hide,  as all trusts were sold down with little regard to the quality of their property assets,  nor their earnings outlook.
  • The Fund remains positioned towards Trusts that offer recurring earnings streams from rental income rather than development profits. As the Fund’s distributions are supported by long-term lease agreements with blue-chip industrial companies, and not swinging emotions of the market, we see that the Fund will be well placed to weather current market volatility.Go to  Monthly Newsletters for a more detailed discussion of the listed property market in January and the fund’s strategy going into 2018.