In my previous “Perspectives”, I wrote about the perils of complacency, the value of humility and the virtues of the diversified portfolio, even when all about us appears becalmed. As if to reinforce the point about humility in the face of the unpredictable, support for that concept arrived sooner than we might have anticipated.
Heated rhetoric from both North Korea and the US fell like a rock into the still pool of the markets last week. As we mark a string of round-number anniversaries of major financial crashes, this turn of events invites us to think about what periods of volatility from the past can teach us about how to build portfolios today.
The “seven-year” curse
If you work in financial markets, you could be forgiven for thinking there’s a curse on the third and fourth quarters of years ending in a seven.
In 1987, equity markets peaked, up more than 30 per cent year-to-date, in mid-August. Black Monday seemed to come from nowhere two months later.
In 1997, Thailand, straining under a mountain of debt and unable to get enough hard currency to defend its currency peg against the US dollar, had to let the baht float in July. Instead, it sank, bankrupting the country and sending a vicious contagion through much of Southeast Asia. Thailand and the Philippines requested IMF aid, Indonesia and South Korea were forced to follow suit in the fall, and by October the panic had spread to the developed markets.
In 2007, on August 6, a combination of overcrowded positions, leverage and complacency led to a build-up of pressure in some quantitative investment portfolios. That pressure was unleashed in a “quant quake” that rattled equity markets for a week and scarred systematic and value investors for years.
Three days later, in one of the signal moments of the credit crisis, interbank money markets suffered an unprecedented seizure after BNP Paribas had to suspend redemptions from three supposedly safe asset-backed securities funds. Within a month customers were queuing outside a major UK High Street bank trying to get their cash out.
Volatility can strike without warning
The confluence of these anniversaries is apt to make investors think about the nature of market volatility and risk while the sudden return of market volatility late last week, in response to US and North Korean sabre-rattling, is apt to make us think about these anniversaries.
What stands out is the capacity of financial markets to ignore stresses and strains for a long time before pricing them in all of a sudden.
Black Monday and the “quant quake” came without any apparent warning. The sub-prime crisis and credit crunch were perfectly evident if you wanted to see them: Freddie Mac stopped buying sub-prime mortgages as early as February 2007; New Century Financial had filed for bankruptcy by April; Bear Stearns suspended redemptions from asset-backed securities funds in June, two months before BNP Paribas.
And yet the S&P 500 Index finished July 2007 up almost 7.5 per cent year-to-date. Even after wobbling in August and November, it ended the year up 4.4 per cent. Few guessed that a five-year bull market had peaked, and that one of the most devastating crashes in financial history was about to unfold.
Prediction is difficult, especially about the future
Should the dangerous rhetoric of the last week escalate into something more serious, historians will note that investors didn’t see this coming, either.
Even as the war of words got heated and Asian markets began to tremble through the first half of last week, the S&P 500 pressed on, adding to its all-time record of consecutive trading sessions without a move bigger than 0.3 per cent. It took until Thursday for the penny to drop.
But only those blessed with hindsight and no money committed to risk assets would blame investors for these oversights. The recent volatility appears justified. The potential human and economic cost of an exchange of fire between North Korea, the US or its allies, and the proximity of the crisis to such an important economic and geopolitical player as China, means that even moving from almost-zero probability to a slight probability of such an outcome may be enough to raise financial risk. At the same time, however, the likelihood is that this will blow over. That will likely send us back to balance sheet and business fundamentals, still basking in the glow of two very good earnings seasons.
Anyone who positioned for a sub-prime crisis in 2005 or 2006 only to watch their clients drift away nursing painful losses can tell you the importance of positioning for market volatility — but also for the capacity of investors to ignore signs of stress, to focus on one set of data over another, to get swept up in stories or trends.
In our view, the best lesson to take from 1987, 1997 and 2007 is that complacency and overconfidence in anyone’s ability to predict what will happen over the next week, month or year should be abandoned. Instead, here is a much more certain prediction based on our experience of those three momentous falls: the properly diversified portfolio is the one most likely to be intact in 2027, 2037 and 2047.
— Erik Knutzen, Chief Investment Officer — Multi-Asset Class, Neuberger Berman
