A Winter Storm Warning is in Effect

I’m officially tired of winter. Here we are, at the end of February and most of the USA is stuck in what is being called “The Siberian Express.” A few weeks ago, according to the Weather Channel, we had winter storm “Juno.” I’m not sure when it happened, but everyone seems to have fallen in love with naming things. I just took a look at the Weather Channel’s homepage, and they’ve actually chosen names for winter storms that haven’t happened yet. My favorites are the Greek names – I doubt we’ll get to winter storms Sparta and Zelus, but it would be pretty fitting given the current negotiations in Europe (let’s not forget that “Greek exit” is so hard to say that we’ve even named that the “Grexit.”) This gave me an idea – since we know that there will inevitably be a time where the broad markets go down in value and the media will deem this time a “crisis,” I am calling dibs on naming the next one. We will call it “Financial Storm Alpha.” Fittingly, alpha is the first letter of the Greek alphabet and according to Webster’s dictionary can be used to mean “something that is first; the beginning.”

Investopedia gives us the financial definition – “A measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha.” Effectively, alpha measures the skill of the manager away from the ‘beta,’ or index, that could have been owned passively. That sounds harmless enough, doesn’t it?

Here’s the problem. Alpha is extremely difficult to achieve over long periods of time. In a former life, my job was to generate alpha for fixed income investors versus the Barclays Aggregate Index (formerly the Lehman Agg, before the financial storm of 2008/9). The problem is that in good times (as risk falls) you are forced to take larger and larger positions to generate alpha and as soon as volatility increases (risk rises), you lose a large portion of that accumulated alpha. Logically you might suggest that a manager could take less risk as volatility falls, but since it often takes a few years to cycle through, few managers or clients want to fall behind in the alpha game even if it means getting hurt when the tide turns. It is during these low volatility periods that alpha generation becomes dangerous. When alpha opportunities are few, it often means that the ‘beta’ is overvalued and investors are reaching further and further to achieve their returns.

This is where the storm name comes from. We live in a Hobbesian investing world – a world which is “nasty, brutish and short,” with snap judgments made in short time horizons for fear of missing out on the next big trade (click for more our view of investment horizon). Central banks, which have largely become market watchers themselves, have added fuel to the fire by forcing investors into the market by making cash impossible to hold (see negative rates in Europe) and buying the entire stock of risk-free debt in the major bond markets. Combining low volatility, high valuations, and money printing will eventually have real consequences.

Let’s take a big step back here. This all sounds very doom and gloomy, but we need to put it in perspective. It has been an amazing run. Does anyone remember the S&P index trading at 666? It broke 2100 last week. And that bond market everyone hated? It has done pretty well too. That’s exactly the point. Valuations rise and valuations fall. Very few predicted the valuation rise we’ve had (I’ve admittedly been more right on bonds than equities) and likely very few can accurately predict when they will fall again. The fall may be totally normal and innocuous – but I don’t think that markets will see it this way. There are too many investors chasing too little return for fear of missing out for anyone to see a serious correction as harmless.

Here’s the other good news. Just like Winter Storm Juno, or the Siberian Express, we can prepare for Financial Storm Alpha. Here’s a quick checklist.

  1. Barbell more – hold more cash against risky positions, even if this means not capturing a further run from here. This cash will be useful for future investments with higher expected returns.
  2. Assume higher correlations between asset classes – don’t assume that bonds will hedge equities or vice versa. In fact, there are many reasons to believe that higher yields could weigh heavily on equity valuations.
  3. Start to lose faith in central banks – “Don’t fight the Fed” has never been a better investment mantra – but the limits may be near.
  4. Seek out less liquid investments that won’t fall victim to a liquidity crunch – Give us a call at Blue Elephant, we have some specific ideas on this one.

I could go on, but it just started snowing again and I need to get out there and shovel. Hopefully you get the idea. By planning well for winter storms, we will all make it to spring. Eventually, markets will have a setback – you and I will know that it is nothing more than Financial Storm Alpha blowing through – but I assure you, it’ll feel better if we’re prepared.