Volatility is the new normal

Chief Investment Officer and founder of Aitken Investment Management
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The one thing I’m absolutely certain about is that equity market volatility is in the infancy of normalising.

This is a very important development for all investors. As volatility normalises, individual stock prices can swing wildly, as we have seen in recent weeks. This is particularly so in this era of high frequency traders (HFT) being the marginal liquidity provider in equity markets. Note well, the Dow Jones Industrial Average has had five 200 plus point swings in the last 15 days (chart below).

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In these periods, everyone needs to realise that stock prices can overshoot, both down and up, as equity risk premium is priced back into equities with associated volatility. Everyone also needs to realise that “research” and “valuations” mean very little in these periods, in fact they can cost you money believing them. This is all about liquidity, risk, momentum, volatility and sentiment.

The new picture

After five years of quantitative easing (QE) and six years of zero interest rate policy (ZIRP) from the Federal Reserve, it’s somewhat easy to forget what “normalised” risk asset price volatility looks like. QE and ZIRP drove up asset prices and drove down volatility.

What “normalised volatility” looks like is what your screens are starting to show over the last 30 trading days with currency, bond and equity prices moving sharply, diverging back to underlying fundamentals (in both directions).

The chart below shows the last 25 years in terms of the CBOE VIX Index, Fed Funds lower band target cash rate (purple line) and total Federal Reserve Balance Sheet assets (green line).

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What it is telling is, that over 25 years, the VIX averaged 19.93. The recent move we have seen to around 15, while +50% from recent lows, remains well below the average levels seen with normalised US interest rates and a smaller Fed balance sheet.

I strongly advise you that if you didn’t enjoy the cross asset price volatility of the last 30 days, then you need to reassess your asset allocation. This is not going to be one-way traffic or smooth sailing in equities as I have warned.

Quite simply, benign volatility and the “buy every dip” strategy that combined to work so well over the last five years has bred complacency, concentration risk and over-confidence in the private investor sector. This is particularly so in self-managed super land in Australia.

Self-inflicted super?

What I am trying to avoid in these notes is self-managed super becoming self-inflicted super, as capital losses rack up in the most widely held SMSF names. Yes, I will make some mistakes along the way in small caps that should have been no more than 1% of your portfolio, and I apologise for that, but the main event is getting the biggest market cap, most widely held stocks right (particularly the banks). That combined with asset allocation is what really matters.

The average SMSF in Australia has in effect a giant carry trade on at the peak of FED largesse and the bottom of the US dollar. The average Australian SMSF is massively over-exposed to Australian yield assets in Australian dollars, which is a carry on a carry and exactly the trade we have witnessed foreign investors exit with gusto over the last month. The ASX200 is now down -3% in US dollars for 2014. Australian banks are down nearly -13% in US dollar terms from their recent peaks.

If you are an Australian SMSF and all you care about is tax-effective dividend income streams in Australian dollars, then please continue to ignore me. However, if you care about the capital side of your SMSF balance in global dollars, then you still need to be very vigilant, as I believe we are watching a major global and domestic trend change event. I can’t stress that point enough.

Clearly, you can’t have US GDP growing +4.6% and US interest rates remaining 0%. QE ends this month and I believe the markets are trying to tell you, correctly, that US cash rates will rise earlier than previously expected. This view is in a world that is currently short US dollar collateral.

The US dollar itself is normalising and it’s taking cross asset class volatility up with it. You simply don’t get moves like we have seen this month if the world is properly positioned for them.

To put the recent US dollar move in context, I also think it’s worth looking at a 25-year chart of the US dollar Index (DXY). The high is 151.47 in Dec 1984, the low is 7.18 on 31 March 2008, and the 25-year average is 99.02. The current price is 85.26.

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Australian dollar target of 75 cents

My thinking is if the US dollar simply reverts to the 25-year average over the next few years, then that alone sees a +15.5% rise, and vice versa for currencies denominated in US dollars. You can see how I come to my long-term 75 US cents Australian dollar target as we re-correlate to our key commodity export prices.

To my trading eyes, everyone was trying to squeeze the last cent out of the carry trade, waiting for the FED to physically give the green light on cash rate rises, but US data has been so undeniably strong that markets have started moving ahead of the FED, leaving carry traders holding the yield baby as such. Good news has become bad news for markets because it means the Fed is closer to pulling out the monetary policy morphine drip.

In an Australian context, the most remarkable aspect of the carry trade unwind is how little resistance it has run into. There have been pretty much-uninterrupted falls in the Aussie dollar and high yield Australian industrial equities, with marginal buyers hard to find. I suspect this is because most high yield Australian industrial names were already very well held by Australian investors, while it was also underestimated just how big a carry trade parking lot the Aussie dollar and high yield equities were for foreign investors.

Excess builds up over long periods and this FED inspired cycle of carry trading and yield compression has been an unusually long one. It was absolutely right “not to fight the FED” on the way up, but now that all reverses, as the process of US cash rate normalisation commences.

September and early October has been a genuine trend change month in my view. It’s like all tradable markets hit some clear air turbulence. My point today is, however, that the volatility we have seen in September is NOT even normalised volatility on a long-term average view. The CBOE VIX averaged 13.43 in September, which, while above the average of June (12.65), remains significantly below the 25-year average of 19.95.

What we have seen in September is significantly below long-term average volatility. However, because it is significantly above recent lows, it feels more volatile than it is. This is the playbook for the next few years as FED support wanes for markets and risk asset markets, particularly equities, bonds and currencies, revert to more normalised trading patterns. You need to adjust to the “new normal” of volatility.

I’ll finish today with a simple chart of the US S&P500, the world’s biggest and most important equity index. The chart accurately summarises all the above, but you can see in recent times (since June) that volatility has increased and the two-year technical uptrend is being challenged. This chart needs constant watching as if the technical uptrend breaks a full-blown US equities correction (to around 1810 on the S&P500), with associated volatility, will be the result.

100% of Charlie Aitken’s fees for writing for the Switzer Super Report are donated to The Sydney Children’s Hospital Foundation.

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.

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