Diversification. It is that one word which invokes fervent debate amongst traders and investors, and is a prime thesis subject in academia. It is also something we haven't yet talked about and will hence do so in this tersely ornamented note.
Nature itself is infinitely diverse - a trait that is often sidelined as a key ingredient to Planet Earth's lasting legacy. The millions, if not billions of species that inhabit Earth has given nature its timeless splendor, and life its immense resilience. Standing the test of time, life has continued despite cryogenic ice ages and cataclysmic super-massive volcanic eruptions.
What is it that has given life the triumphant victory over death? Diversity. The very thing that Homo Sapiens have evolved to embrace through the sands of time. It is congenital and appealing to us. Vibrant pictures strike our retinas harder than those with pale color palates. Dynamic songs resonate so much better in our ears than monotonic trances. Yet we sometimes loath it, and therein lies the great paradox. But more on this later.
A lifestyle without variety is commonly thought to be boring, one not much better than being deathly acquainted to a rodent running in an endless loop. The maxim that "history never repeats itself but it often rhymes" is perhaps the zeitgeist of the modern conundrum. Is change a better bad or a worse good?
Diversification In Trading & Portfolio Management
How does all that verbiage actually apply to the business of trading and portfolio management then? Do traders actually need diversity in their books, and do they indeed diversify? We have noticed that there lies a rifting paradox between what general life entails, and what people actually do when they speculate in the financial and capital markets.
Over the past few weeks, several traders have written in to us on how in a spot they felt in the current market climate. And we agree that it's not nice weather outside; week after week of bidirectional volatility, volatility that just isn't well reflected in popular measures such as the VIX, to take the stock market for instance. As though that was perplexing enough, everything seems to be indicating a different point everywhere we look. So what are we supposed to trust?
The traders whom we spoke to are in a classic catch 22 situation. They have a choice of either being minimally exposed to the markets they usually trade (float in cash), or continue to meander through what is nearly almost unknown path punctuated with snare traps at every other turn.
The downside to the former is that when things start to clear (which may be from tomorrow to the next year), most markets would have already move substantially while we would still be sitting on a pile of cash. The upside of course is there is almost no risk of loss when exposures are trimmed to the minimal.
If a trader goes with the latter, he risks having his books ripped apart by the bidirectional volatility before the market eventually starts to clear up (which again may be at anytime). He would however stand to gain when the market turns on a dime, provided he was exposed in the correct direction.
When we talk about diversification, most traders and investors tackle at the matter by "not putting all eggs in one basket". In a typical equity portfolio, diversification can be achieved through a multitude of methods. We'll get back to this later on.
Being Part Of Any Sustainable Business
There are the known unknowns, and there are the unknown unknowns. We're not messing around with words here. Diversification is a method used to mitigate risks that we can reasonably foresee. If we equate risks to the known unknowns, and understand that it is beyond our full control to manage these risks, then diversification makes all the sense in the world.
Adding in another factor called time greatly alters the way in which success is perceived. We like to think of time as a natural moderator. A tech startup may fare most excellently in its infancy even where most of its operations are essentially cost centers. The gradual transition from a startup to an actual profit-making establishment serves as the first real litmus lest that the business will face; and one that sees a low passing rate.
A quick look at the world's most valuable company (by market capitalization) shows that as precisely as Apple has positioned itself to be in its respective niche markets, it also operates in a very well diversified manner. The recent launch of the Apple Watch exemplifies this critical acumen.
If you're an entrepreneur looking to grow your business into something significant in the grander scheme of things, it would be great folly to eschew the fundamental importance of being properly diversified. This is why wealth generation strategies that promise multiple income sources that are so called "crisis-proof" sell like hotcakes with correct marketing.
Diversification Vs. Performance
Swinging back to trading and portfolio management, many traders are under the false assumption that being well diversified means settling for a lower performance. This misguided belief is often the reason why retail traders start trading on the entirely wrong foot. We shall explain.
To most retail traders, performance simply refers to returns. The way we measure and define performance affects our mindset we bear when we manage our own trading books or portfolios. Professional traders and portfolio managers know fully well that gross returns are only the tip of the iceberg.
Focusing solely on returns as a measure of performance not only puts traders in a potentially self-destructive path, but also motivates them to take on risk with wanton abandon all in hopes of inching out that marginal basis point of return.
It gets more ludicrous once traders are past that fleeting moment where a few largely profitable trades gives them that sugar high we all have experienced somewhere during our trading careers. Professional traders are never motivated by gross returns alone. Never.
This coming Thursday, 23 June 2016, the United Kingdom will vote on a historical referendum deciding on the status of its European Union (EU) membership. For the last 2 years since 2014, the UK parliament, led by acting Prime Minister David Cameron have promised a public referendum on Britian's EU membership. Britain's relationship with Europe has always been one of contention, and many have long been awaiting this once in a generational lifetime opportunity to voice their opinions through the democracy of a vote.
The global financial markets have also been eying this key event risk for some time, and since events have heated up recently as we enter the final week before the ballots are cast, there has never been a more important 4 days for English markets (that's including the pound sterling, GBP) since the "Black Wednesday" of 1992 , the day the Bank of England was broken by the markets.
We are not usually pessimists but when we see the writing on the wall getting bold redder each week that passes, we can't help but to take serious note. Just last week, we warned readers that markets might be about to get nastily volatile during the summer. So far so bad. May hasn't started well at all. The S&P 500, as of the week ending this past Friday, posted its first 3-week losing streak since January.
Recent macro developments both in the U.S. and elsewhere have however strengthened the bearish case for risk, in our opinion. It might have reached a point where downside skews in risks make a derisking maneuver potentially more rewarding than chasing beta.
As such, we have shifted our bias to the short side of risk. The positions in our portfolio (which we keep private) have partially reflected this change in view and will continue to do so as the situation evolves.
It is a known fact that credit cycles often lead business and economic cycles. It makes sense on paper and even more sense in practice. This is a subject that we havehardly yet touched on, but will be doing so in this piece. For a majority of the investing community, the topic on credit cycles remain much of a novelty.
As of March 2016, total default volumes on HY bonds (high yield) and institutional loans in the U.S. hit a 6-year peak of approximately $16.2bn, almost half that seen in the entire of 2015. Just this past week alone, we saw at least 4 corporate defaults with 3 in the energy sector.
So far in 2016 (Jan-Mar) default volumes have reached a jaw dropping $32.4bn. To put this in context, 2015's default volume (which was already abnormally high) stood at $37.7bn. If this trend were to continue through 2Q and beyond, we are talking about a full-fledged wave of defaults.
For the first 3 and a half months that have already elapsed in 2016, no asset class has seen the consistent volatility that currencies have. Central banking has been busy, almost too busy, all while the macro fundamental landscape has hardly moved an inch. With all that drama, noise, and play in monetary policies throughout the global economy, one would expect sizable trends in FX. But that hasn't been the case.
For instance, when the ECB first lowered its deposit rate to zero back in the first half of 2015, that sparked a major bear market in the euro, and a bull market in risk assets including euro bonds. When the Fed announced it planned to gradually taper QE3 and eventually end it late in 2014, the U.S. dollar began building up into what we now recognize as one of the most fervent dollar bull markets ever.
Monetary policy divergences used to herald the alpha and omega of huge trends. But not today.
Now, thanks to a comprehensive piece by Bank of America Merrill Lynch, we can provide readers with a glimps of what might be the next big trend in FX.
Last week, Bloomberg broke a story which greatly fascinated us. It involves a mysterious "specter", one which we have no clue about, flooding the Turkish stock exchanges with massive buy orders, massive to the tune of some $450mn in a single day.
Turkish locals refer to this entity (whoever or whatever it is) as "the dude", crowning the figure with an amphibious demeanor worth of a chapter in Slenderman. We have no idea, absolutely no idea who or what "the dude" is, how it specifically operates, and what its motives are for slamming a relatively illiquid market with order sizes so large, they scare the living daylights out of even the staunchest of permabears.
All we know is that local authorities have been rattled, investors shaken off to the sidelines, and a stock market that is now a stellar outperformer in the emerging market (EM) space. Even with the gruesome terror attacks in Istanbul over the weekends, an attack which has killed at least 37 people the last we checked, the Borsa Istanbul Index has now rallied for the 9th straight day.
That's right, we need the U.S. dollar to be BOTH strong AND weak at the same time for continued upside in equities. Much has been said about the greenback ever since the end of the Fed's QE3 program in late 2014. It was then all about king dollar leading up to the Fed's first (in a decade) rate hike in December 2015. Speculators kept piling in on the the freight express train that was the long dollar trade du jour, creating what has become one of the most crowded trades in modern history.
It's likely going to be a tug of war between these forces we've highlighted in this piece. Again, we make no predictions as to direction. We do however expect this conundrum to continue until a novel catalyst emerges that alters the way market participants trade and position. What this novel catalyst is, we don't know.
This conundrum is big, as we shall explain below.
The top 0.01% of the erudite elites control more than 60% of the world's wealth, while the 80% of us have a collective net worth less than the top 1% of society. In a world decorated with such gaping inequalities, risk and opportunities present themselves. While problems may be plentiful, there are also long term opportunities to capitalize on the mother of all trends: A globally aging demographic.
Which is what Janus Capital's Bill Gross, well revered as being called the "Bond King", is driving at in his latest investment outlook. In the race between the tortoise and the hare, the former analogous to a gradually aging population, the latter to technological advancements, the tortoise eventually catches up. Time isn't on our side, and we're sitting in a ticking time bomb.
It's a known fact that a large majority of the world's baby boomers are not adequately primed for retirement, lack the financial resources to meet mounting healthcare and insurance obligations as they further age, and are more dependent on the state's hospitality than ever before. But who pays the ultimate price?
The prospect of $20 oil prices has been raised thanks to this one Black Swan. A Black Swan is also known to statisticians as tail risk, or events that are highly improbable but are of great significance. One can liken such an even to a large meteoroid making its way through the Earth's protective atmosphere and impacting land or sea; an extremely unlikely event but if actually true, mankind's existence would be threatened.
Low oil prices have been the bane of many oil producing and export nations, whose currencies and economies have taken incessant hits every cent crude continues to plunge. The ruthless combination of a huge supply overhang and waning global demand has led to a deadly concoction oil producers and exporters have no choice but to drink. What other choices would they have anyways?
Whatever we said on 5 November came true. For the first time in 9 years, the Fed hiked the Fed Funds target interest rate by 25bp to 0.25-0.5%, ending an eon of zero lower ground rates and marking the start of a new paradigm. A paradigm that is, much as most would hate to admit, unprecedented in terms of scale and bredth.
As we approached 16 December, markets had increasingly discounted a Fed liftoff, but there was still some element of uncertainty. That uncertainty now shifts to what the Fed will do in 2016. Will it continue to gradually hike rates? Will it reverse on its path of monetary tightening and start to ease? These are but a multitude of questions that everyone is asking, but no one can really answer.
Does dovish rhetoric from Europe's ECB, continued stimulus from China's PBoC, the reluctance of Japan's BoJ to step up QQE despite headwinds, New Zealand's RBNZ policy being put on hold signal a soon imminent Fed rate hike?
While correlation might not necessarily be causation, especially in the ubiquitously tangled web of central banking, we believe this development is too significant to turn a blind eye on. Ironically, market-based odds for a December Fed rate hike have never been higher.
Do central bankers know something about the Fed's near term actions which the general market doesn't? If anyone knows what the other will do, it's probably them.
We'll leave this up to you to decide. The proof is in the pudding, and this one's pretty dense. So take it for what it is, we're playing it cautious but not holding our breaths.