Volatility returned to the equity markets when the July 31th Federal Reserve quarter point interest rate cut led to a sharp equity market selloff. The cut was so widely anticipated that Fed Chairman Powell’s statement that little additional accommodation would be needed–drove the equity markets lower. Then the August 1st snapback rally was smashed by a Trump tweet of new tariffs on Chinese goods, dashing hopes for a quick resolution to the all-important US-China trade dispute.
The global economy is weak with Europe and China decelerating. The US economy is also softening. The varied international tariff wars have been a drag on global trade and growth. The trade wars’ inevitable resolution promises a potential dose of global fiscal stimulus. Unfortunately, Trump’s new round of 10% Chinese tariffs shattered hopes for an imminent economic recovery leaving the Federal Reserve as a last discretionary lever to prop up the US economy.
The United States has good reason to press China to meaningfully change its systemic predatory trade practices, especially given its increasingly ominous economic and military position. On the one hand, global interest rates are far lower than US interest rates and a more accommodative Federal Reserve would allow for a more aggressive trade negotiating position; on the other hand, the unprecedented monetary accommodation, since the 2008 Financial Crisis, should be unwound eventually to avoid another bubble and bust cycle like 2000 and 2008.
The Fed Model data box below shows the S&P 500 at last October’s peak, the December lows, the second quarter lows and on August 2nd. As of August 2nd, 2019, the S&P 500 is trading at 17.83 times 2019 earnings and 16.14 times forward earnings. These equity valuation levels are reasonable when viewed in the context of 10-year US Treasury rates. Global interest rates are extremely low. The entire German yield curve is negative. Equities are attractive relative to fixed income alternatives.
Equity market risk is not dangerously high. Major market downturns typically are preceded by massive overvaluations such as major cycle peaks in 1929, 1987 and 2000. Today’s stock market is fairly valued though not inexpensive. Therefore, while trade war and economic news must be monitored, the likelihood of a major decline in the stock market is mitigated by the fact that the stock market is not grossly overvalued. In the Fed Model chart composite below, several quantitative metrics support our market view. The “risk premium” charted in the top panel is 4.06% and reflects good value for the stock market–consistent with many of the best times to invest in the S&P 500 over the last decade.
However, valuation is not static, the trend in earnings is very important. In the second panel, the earnings trend this year has been flat. (See red line.) If earnings start to trend downward due to trade wars, economic recession or both, the risk to the market will rise and capital preservation actions should be taken.
Since Robert Shiller wrote “Irrational Exuberance”, we have been increasingly focused on the state of psychology in timing market investments. One effective and useful measure that we have chronicled in recent years is the “VIX index.” This volatility measure is a quantitative indicator based on the pricing of S&P 500 options. The VIX provides a simple and objective measure of when investors are most complacent and when they are most panicked — e.g. a score of 12 or below reflects complacency while a score of 20 or 30 reflects real market panic. When market participants become scared, investors buy “insurance” by purchasing options which drives up their prices and their implied volatility. Consequently, the VIX index gives a real-time measure of how scared the market is. In principle, investors want to buy when “everyone is selling” and “sell when everyone is buying.” Unfortunately, man is a herd animal who struggles with separating his instincts and emotions from rational investment decision making.
The chart below shows that the VIX in July measured readings of 12 or “high complacency” when defensive market actions could have been employed. As of Friday, the panic had risen significantly—the VIX surged to 20. Had one sold out or reduced equity holdings defensively in July, the proceeds of those sales could have been reinvested at lower levels.
December’s Prudent Panic Purchases:
Our December letter http://www.incomegrowthadvisors.com/2018s-stock-market-volatility/ demonstrates how we combine the VIX signal with the Fed Model to successfully buy into the frightening December market decline, which resulted in a compelling investment return.
“The long-term chart of volatility below shows that the current spike is in the upper range of volatility levels suggesting this was among the larger spikes in the last three decades. We believe the current volatility spike, like volatility events in 1990, 1998, 2010 and 2011, can be bought because the worrisome news of the day will prove a non-event in six months.”
“We have been buying Kayne Anderson MLP/Midstream Investment Company (KYN) a closed-end MLP fund managed by Kayne Anderson. KYN 11.3% yield combined with a diversified portfolio of high-quality MLPs is an attractive vehicle for MLP investors.” Those KYN investments made in the December 24 to December 28 timeframe were about $12.8/share. Two to three months later KYN was $15.10 to $16.36/share, a total return of 19.8-29.6%.
This trade is particularly noteworthy given the low risk of the strategy.
- First, the purchase of a closed-end fund eliminates single stock risk.
- Second, KYN is a closed-end fund which typically trades at a discount to net asset value permitting the investor to buy an asset for 90 cents on the dollar.
During market panics, closed-end funds trade to larger discounts to NAV than normal. Consequently, when buying KYN in December its discount to NAV was even larger than average further reducing the risk in the transaction.
Income Growth Advisors, LLC seeks to provide attractive returns for our clients, many of whom are retired, without undue risk. With the sale of American Midstream Partners, LP units to ArcLight, clients are sitting with cash. Given the rising risks associated with the US-China trade war, weakening global economy, geopolitical conflicts like the US and Iran and or Boris Johnson’s pledged October 31 Brexit, deferring purchases until a more defined panic is at hand makes sense. This seems particularly sensible given that September and October are historically weak and prone to high volatility.
Tyson Halsey, CFA