Trust me, you’re not the only one feeling seasick watching the daily gyrations of your Australian equity portfolio. The question becomes: is this volatility simply the “new normal”? I think the answer is yes but I would again remind you that in volatility there is investment opportunity.

Most investors react to volatility the wrong way: they head for the sidelines. My approach is to be prepared mentally and in the portfolio for volatility, then try to take advantage of it when volatility spikes.

As a professional fund manager, I do have tools available to deploy that most of you do not. These tools, if used properly, can lower the overall volatility of our returns and specifically lesson losses when markets fall.

The ability to short index futures to protect (somewhat) our investments in specific companies, globally and locally, has been the key driver in the AIM Global High Conviction Fund outperforming the MSCI World Index by +5.4% and ASX200 by +10.6% since the 1st of August 2015.

As you know from these notes, there are many growth stocks I like and am invested in. We have broadly remained invested in those stocks throughout the volatility of the last year, while concurrently trading index futures over the overall portfolio when we wanted to put on market protection then take it off.

It truly is “a market of stocks, not a stock market”. By that I mean there are always companies growing their earnings and dividends even in “bear” equity markets, or whatever this proves to be. That means we try to identify and invest in companies growing their earnings and dividends (Australian examples are Star Entertainment Group (SGR), Treasury Wine Estates (TWE), Transurban (TCL etc)) then hedge out “Mr Market” risk when we think it is appropriate to take some portfolio insurance.

Don’t get me wrong; this isn’t a note on how smart my team is. When markets are like this it’s almost impossible not to lose some money on paper. The absolute key is to lose a lot less than everyone else and have capital to deploy at cheap prices in great companies. We must always remember the idea is to buy low, not sell low, which heightened volatility and the 24 hour news cycle (which focuses on bad news) can tend to make you do.

2016 year to date has already seen stock, sector, country and index volatility. In fact, it’s not just volatility. We are also seeing every wide divergence in stock, sector and country performance. I have to say it’s the performance divergence that is most stunning to me and best evidenced by simply looking at the year-to-date performance of the world’s leading equity indices.

• Dow Jones +1.67%
• S&P500 +1.1%
• NASDAQ -1.73%
• TSX +2.59%
• Mexico +5.36%
• Bovespa +10.9%
• Euro Stoxx -10.9%
• FTSE 100 -1.29%
• CAC 40 -7.6%
• DAX -10.4%
• IBEX -12.1%
• Italy -19.5%
• Nikkei -17.4%
• Hang Seng -7.79%
• CSI 300 -12.5%
• Shanghai Composite -13.7%
• HSCEI -10.1%
• Taiwan +2.1%
• KOSPI +.5%
• ASX200 -6.61%

I can’t remember a quarter of greater global index performance divergence. It’s absolutely stunning and reflects genuine uncertainty about global growth. The outperformance of US equities is basically about the world having confidence in the US economy over all others. Investors also feel the Federal Reserve has become far more “dovish” and will delay US interest rate rises. This has seen the US Dollar Index fall and takes pressure off US multi-national companies that dominate the key US equity indices. However, there is another big factor at work driving the outperformance of US equities: the real “big short”.

There is now over $1 trillion of US equities shorted. That is 4% of the free float of the entire US equity market. That short position is now the largest since the peak of the GFC in March 2008.

That massive US equities short position is one reason US equities appear far more supported on dips than any other global index. The question then becomes if the Fed is backing off raising interest rates and the US economic data is good, why the record short position in US equities?? The answer: EARNINGS.

The majority of the shorts are based on the fact US equity earnings are going down. Let’s look at expectations for the pending US reporting season.

1Q16 earnings expectations

1Q16 US earnings expectations have been revised significantly lower ~15% in the last 12 months, the worst revision in recent quarters. The S&P 500 1Q16 EPS implies a 9.8% y/y decline, and the S&P 500 ex-Financials is implying a 10.1% earnings decline y/y. This would mark the 5th consecutive quarter where earnings have declined (data from Morgan Stanley Research).

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On a sector basis, Energy is implying a 101.6% y/y decline (meaning negative earnings $-0.22bn for the energy sector this Q), followed by Materials -22.8%, Industrials -12.2%, Financials -8.7%, Utilities 7.7%, Info Tech 7.3%, and Staples 6.1%. On the positive side, Healthcare, Discretionary and Telecom, which make up 31% of the S&P 500 earnings, are projecting a modest 4.7%,7.3%,12.6% y/y growth in 1Q16, respectively (Data from Morgan Stanley Research). In terms of just how much 1Q16 earnings estimates have come down since the beginning of the year, Energy earnings have been revised down over 100%, Materials 21%, and Financials 11%, and not a single sector saw estimates revise up (see chart below).

Given the significantly lowered estimates, earnings numbers will be more likely to beat than miss consensus, as has been the trend historically (see chart below).

The average beat since 1Q04 has been 4.19% for the S&P 500 ex-Financials, and the average positive earnings surprise ratio has been 66%.

1Q16 earnings calendar

This quarter’s earnings season officially kicks off next Monday with Alcoa. By the end of the month of April, 76% of the S&P 500 will have reported earnings. Next week, while just 6% of the S&P 500 report earnings, notably 34% of Financials will be reporting, including JP Morgan, Bank of America, Wells Fargo, and Citi. The big weeks this earnings season are the weeks of April 18 and April 25 when 33% of the S&P market cap report each week.

Percentage of sector’s announcing earnings each week

No doubt the weak US earnings expectations do justify the short position. But if short positions in US equities are at a record and earnings expectations for the quarter are already very low, then you do have the ingredients for a short-squeeze in US equities, if US earnings come in no worse than expected. If this happened alongside Oil prices rallying, the short-squeeze could be very violent to the upside.

Similarly, it’s worth noting that institutional cash levels in the US are also the highest since the GFC. The combination of record short positions and very high cash levels is also supportive of US equities on any “less worse” news.

Don’t get me wrong, there is plenty to worry about in the world and US earnings could come in worse than expected. But positioning is already in place for that scenario and on the other side central banks are becoming more and more accommodative, making the return on anything outside of equities pathetic.

Keep in mind global long bond yields made a record low average yield of 1.30% this month. While that does signal a long period of low growth and low inflation, it also signals central banks will be with us for the long run with their easy money policies. On that basis, I continue to believe being invested in the right equities that are growing their earnings and dividends will deliver total returns well above cash and fixed interest.

Either way, I wanted to explain to you today where the “real big short” is. It’s in US equities and the shorters are either going to be proven very right or very wrong over the next few weeks. Watch this space: whatever happens, when a short position is this big there will be volatility.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.