Outlook For Irrational And Rational Markets for 2019 and Beyond

In the last years the market has been steadily rising and now with increased volatility or lack of predictability, we were on the search to look at strategies that are able to adjust for market changes. We interviewed Ridgedale, an alternative asset management firm to explain how they look at the market keys trends in 2019.

Are Markets Rational Or Irrational?

While we believe markets are generally rational, at times they can be irrational. Although 2018 proved to be a challenging year with no asset class producing a return of more than 5%, we believe our enduring philosophy of creating strategies for efficient (“Convergent Strategies”) and inefficient (“Divergent Strategies”) market environments will help provide Alpha in the upcoming year.

• Convergent strategies are strategies which tend to perform best when markets are rational and relatively calm in which the market processes all available information in an effort to determine assets that are over-valued and under-valued.
• On the contrary, divergent strategies tend to perform best during irrational periods of rising volatility and uncertainty, capitalizing on serial price movement across many markets in a marketplace which temporarily ignores fundamental information.

There exists a strong positive serial correlation between the performance of divergent strategies and the volatility of equity markets. Specifically, the divergent strategy experiences significantly higher performance during periods of increasing market uncertainty, and when combined with the convergent strategy the resulting portfolio: 1) reduces the volatility of the individual strategy, increasing the kurtosis of the return distribution; 2) reduces the negative outliers, shifting the skewness to the positive side; 3) enhances the return in economic environments in which the convergent strategy alone offers limited return opportunities; and 4) increases the risk adjusted performance measures significantly, obtaining the maximum return/risk trade-off. Combining both convergent and divergent strategies provides increased return and reduced risk opportunities with more favorable return distributions relative to either strategy alone.

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The Blending of Divergent, Convergent Themes

Convergent strategies include long/short equity, long only equity, long only fixed income, private equity, and real estate. Convergent strategies are based on identifying a market’s fair value. The expectation is that once the broader market recognizes this mis-valuation, the market’s price will “converge” back to its fair value,

Strategies like trend following, pattern recognition, and price breakout strategies fall within the divergent family. Divergent strategies are not concerned whether a market is valued fairly or not. They are more concerned with where a market will be in the future, whether it be 1 year, 1 month, 1 week, or 5 minutes from now. They also realize that the characteristic of each divergent event will be different in terms of its catalyst, length of the event and the process to normalization (i.e. the bank bailouts after 2008).

Identifying and adapting to the characteristics of each individual divergent event is a crucial trait to divergent strategies, which allows them to excel in a wide array of divergent events. These events range from events such as Asian Currency Crisis (1997), the US Recession / Credit Crisis (2007/2008) (including the subsequent bailouts/reactionary actions taken following crisis), Greek Debt Crisis (2010) to the Fukushima earthquake (2011), 9/11 Terrorist Attacks on USA, Feb 2018 equity volatility spike and the Q4 2018 global equity selloff.

These strategies are focused on identifying the direction, acceleration and follow through characteristics of a market’s price action and to position the portfolio in that direction. Divergent strategies need to employ a robust risk management process, where strategic stop levels are employed once a position is taken. The key is to allow winning trades to run as long as possible, and to close out losing trades as quickly as possible. It is necessary that the magnitude of winning trades is substantially larger than losing trades for a divergent strategy to be successful and offer the diversification we require.

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Key Themes Emerging In 2019 Suited For A Multi-Strategy Program

We expect 2019 to be a highly uncertain year on many fronts:

1. Impending Economic Downshift
2. Potential Loss of Diversification
3. Incoming Heightened Inflation
4. Global Shocks

Theme 1: Impending Economic Downshift >> The economy should remain positive early in the year as the benefits of the tax cuts will still be felt in the first and second quarter. However, the tax cuts will soon become a drag as earnings will be judged in comparison to last year, resulting in second half slowing;

Investors will continue to endure a choppy market into the new year. Although there is the potential for a new cyclical bull market to emerge from this, we believe there are greater headwinds that will emerge later in the year that will make it difficult for stock investors.

The Federal Reserve may be shifting toward a more neutral position as interest rates approach a more natural level. Economic growth is expected to slow though domestic recession risk remains minimal. S&P 500 constituent earnings growth may have peaked, but that may not preclude expectations drifting higher, especially on signs of global economic recovery. Absent evidence of renewed inflation and improving global conditions, bond yields likely will not move meaningfully higher.

2018 has been a departure from 2017 in many ways. The historical calm of 2017, with its maximum peak-to-trough drawdown on the S&P 500 of a measly 2.8%, faded. It was replaced with a return of volatility and the S&P 500 experienced declines of more than 3% on several trading days in 2018. This may have caught some investors off guard, but it should not have been a total surprise since in many ways we have witnessed a return to a more normal volatility environment.

With financial market volatility likely to remain elevated, narratives could continue to get more firmly entrenched. The ability, and willingness, to separate the news from the noise will remain of critical importance for successful investors. To this end, a disciplined approach is more necessary than ever.

Let’s consider for a moment that financial market volatility that reemerged in 2018 is unlikely to subside. Moreover, this volatility has emerged as the cyclical rally off of the early-2016 lows was running out of steam and stocks have moved into a cyclical bear market.

After a period of consolidation and testing, positive divergences could emerge between the broad market and the popular indexes. This scenario rests heavily on the view that the U.S. economy does not slow more than is currently expected and that the global economy shows some ability to surprise to the upside. If so, stocks could rally over the second half of 2019, finishing the year on an upbeat note as a potential new cyclical bull market emerges. However, we believe that the diminished impact of the tax cuts, deteriorating conditions overseas and Fed tightening at home will produce a greater-than-expected downshift in the U.S. economy later in the year. Under this scenario, a repeat of 2018 in terms of widespread volatility and historically poor performance across asset classes could be seen in 2019.

Under the new leadership of Jerome Powell in 2018, the Fed has continued its course of moving interest rates up to a more natural level and also shrinking its balance sheet. It raised rates four times over the course of 2018 while the pace at which it has drawn down its balance sheet has accelerated over the course of the year, moving toward a $50 billion reduction per month. These actions by the Fed led an overall shift by central banks around the world away from the quantitative easing of recent years and along a path of quantitative tightening. The uptick in financial market volatility seen in 2018 is likely symptomatic of this new central bank environment as previously ample liquidity becomes scarcer.

Theme 2: Potential Loss of Diversification >> For the first time in many years both bonds and equities may correlate causing a lack of diversification as experienced in the past;

Conventional wisdom says that when risk-hungry investors look for higher returns they shift out of bonds, pushing yields higher, into equities, buoying stock prices. On the other hand, if investors fear market turmoil, they’ll take shelter in bonds and sell their stocks. Toggling between the two assets to provide diversification may not provide the same results this time around.