— Mar 1, 2018


Over the course of 2017 global equity markets displayed historically low volatility. Prior to its Christmas run up the FTSE100 spent the year trading within an unusually narrow range of +/- 3.2%, compared to the more typical +/-15.5% (over the last 5 years). This lack of volatility is the exception not the norm.

As has been seen before many times this calmness eventually led to a storm and global stock markets faced a swift downturn at the end of January, reversing the run up since late last year. The stock market decline is mostly welcome for several reasons:

Firstly and most importantly: equity valuations had become frothy. Their return to more reasonable (though still not cheap) valuations required either that earnings growth would be substantially faster than expected (a low probability) or their value falls. We experienced the latter.

Secondly, we have been holding significant portions of clients portfolios as cash. For clarity this is in no way because of an expectation on our part that markets would fall in January. That is beyond our or indeed anyone else’s sight. We can never predict market falls, but we can state with a degree of confidence when an asset is moderately overvalued and that owning it is likely to deliver a lower risk-adjusted returns than usual. Equities were becoming more expensive so we had gradually sold down part of our exposure to them. They were cheaper after the market had fallen by near 10% so we were comfortable reversing this process and using some of the cash to buy equities back – though we retain an unusually large cash portion.

Thirdly, market shakeouts clear out some of the deadwood – this is a welcome and curative process. The lack of equity market volatility had led to the growth of some investment products that provided exposure to volatility. They didn’t invest in the companies that make up stock markets but bought an instrument that tracked the volatility of stock markets. As is often the case some even cleverer types created variants of these volatility instruments that included leverage and the ability to short the exposure (in this case market liquidity). As has been said before: if you combine ignorance with leverage you get some pretty interesting results.

When the markets started tumbling at the end of January many of these instruments imploded with some of them losing over 90% of their value over two days of trading. There followed the usual cries from the protagonists behind them along the lines of “we never thought that this could happen”. The high frequency with which “investments” such as these implode suggests that neither their creators nor their investors are keen students of history. The CEO of Credit Suisse defended the 90% collapse in his own banks volatility product saying “it worked well for a long time, until it didn’t”. This is no basis for successful long term investing.

At BLACKWOOD we rigorously avoid investing in such complex products, not because we do not understand them, but because we understand them too well. Seeing them disappear is welcome.

There remains considerable momentum in US earnings growth but this is well understood and priced-in. It appears probable that the recent volatility will persist at least in the short term.