From Research Affiliates:
Uncertainty continues to dominate global securities markets and heightened volatility is the result. Feifei Li, partner and head of equities, asks Rob Arnott, the founder and chairman of Research Affiliates, about the implications of increased volatility on investment strategies and where investors can find the best opportunities.....MUCH MORE
Feifei Li: What do you make of the current volatility environment?
Rob Arnott: Whereas heightened market turbulence can stir fear, panic is unhelpful. Volatility can be our friend if we’re ready to reassess which markets or assets are newly formed deep-value opportunities and which remain fully priced and to trade accordingly. As I’ve frequently said, market volatility can serve investors well if viewed as a means to respond to opportunities.
Volatility has spiked. The VIX Index peaked above 80 on March 16, over fivefold higher than its long-term average level. Investors who average into markets that are priced to deliver attractive return prospects are reliably rewarded in the long run, as long as they are patient.
The COVID-19 pandemic is an unprecedented shock to the economy, but only one of the catalysts for the current market volatility. Prior to the virus’ outbreak, we noted various warnings from the macroeconomy, credit conditions, and asset class valuations that indicated the capital markets may have been approaching an inflection point.
The extent and duration of market turbulence may depend in part on the level of contagion the shocks generate within the financial system and the response from governments and central banks. While many banks are much better capitalized today than they were during the global financial crisis, interest rates are already effectively at zero. Moreover, following more than a decade of global quantitative easing, sovereign debt in all the major economies is at historically high levels. If the responses from the government and central banks are not measured, the risk of inflation poses a potentially severe threat to sustained market volatility.
Feifei: In your opinion, which have been the worst performing strategies during the sell-off?
Rob: This has been a take-no-prisoners market crash; even countercyclical assets such as commodities are down big. Generally, the hardest-hit markets in the current crisis are those trading at high valuation levels and those with a high market beta, but there are a number of exceptions to this general pattern. Year-to-date through March 24, the US equity market, trading at extremely high valuation premiums relative to its own history and to multiple other developed markets, has plummeted by 24%, and over the same span, REITs are down 37%, emerging market stocks are down 28%, and commodities are down 21%.
Feifei: You have said the time to buy into markets is when we are at peak fear. Which signals do you look at to ascertain this?
Rob: It’s impossible to pinpoint peaks and troughs. We don’t believe we have any special knowledge or skill to divine peaks or troughs ahead of the pack, particularly in the short term. But we do have the discipline to buy the assets people fear most and sell the assets that are most beloved. Stocks will begin to recover long before the pandemic is on the wane. The strongest bull markets are not built on a foundation of good news, but on diminishing bad news.
Wouldn’t it be nice if the world of academic finance had coined the expression “equity fear” premium instead of “equity risk” premium?! The risk premium is at its best when fear is at a peak. It’ll be hard to be perfectly right on the turning point, naturally, but don’t wait for good news—just wait until the pattern of bad news lets up.
Many of today’s leading indicators, such as capital market signals, are available in real time. In contrast, real-economy measures arrive over weeks and months. Today’s observation of market signals such as stock prices, real bond yields, commodity prices, credit spreads, yield curve slope, and implied volatilities point to a deep economic contraction. In the coming weeks and months, leading indicators from the real economy will offer estimates of the magnitude of the present contraction....
