May 9, 2014
By Steve Blumenthal
“Man. Because he sacrifices his health in order to make money. Then he sacrifices money to recuperate his health. And then he is so anxious about the future that he does not enjoy the present: the result being that he does not live in the present or the future: he lives as if he is never going to die, and then dies having never really lived.” The Dalai Lama (when asked what surprised him most about humanity).
I’m sure, like me, you are running at a very fast pace. Sometimes there seems to be an endless list of to-dos that all needed to get done yesterday. In just that way, I found myself a bit offside the other day. I expressed this with my good friend and partner, Steve Kitching, yesterday at his office.
Steve K. reached for his phone and shared the above quote with me. I read it and paused in thought. “Anxious about the future” – what advisor, what money manager and what investor doesn’t feel that? I certainly feel that way sometimes. As we talked, I walked around his conference room and by chance (maybe not by chance) saw a book titled Tail Risk Hedging – Creating Robust Portfolios for Volatile Markets.
I grabbed a copy and finished the book late last night. It is outstanding. I’ve been advising that equity exposure be inexpensively hedged. This book shows you how. The simple message is we as advisors and money managers can gain important long-term equity exposure while protecting against the systemic risk that exists. What is meant by Tail Risk? Tail risk simply means sharp declines – significant market loss (crash or crisis-like events similar to 2000, 2008, Flash Crashes, 1998 Asian, Long Term Capital Management, recession corrections, etc).
I do believe we advisors can help our clients (and frankly ourselves) ease our “anxiety about the future”. This week let’s take a concerning look at the current leverage (margin and derivative risk) that exists in the system, further the discussion on protecting your portfolios’ equity exposure and conclude with a look at the most recent sentiment and market trend charts in Trade Signals.
Included in this week’s On My Radar:
- Margin Debt 1990-2014 – Alarming
- Tail Risk Hedging – Creating Robust Portfolios for Volatile Markets
- Trade Signals – The Weight of Evidence
Margin Debt – Alarming
There have been three major peaks in the last 14 years. In March 2000, margin debt hit $278.5 billion or 2.66% of GDP. In April 2000, the stock market declined and margin calls went out. The unwind of leverage caused forced selling to take hold and the market disconnected – the S&P 500 Index lost 50% over the next two years. The NASDAQ, where a vast majority of money had gravitated to, lost over 75%.
Margin debt again peaked in July 2007 – this time at $381.4 billion or 2.60% of GDP. In August of that year, margin debt declined. Momentum stocks got hit first. Margin calls went out and another epic unwind began. The S&P 500 Index lost over 50%.
In February 2014, margin debt peaked at $465.7 billion or 2.73% of GDP. Momentum stocks have declined. Margin debt has reversed and is now in decline. Here’s the chart:
Source: http://www.zerohedge.com/contributed/2014-05-02/last-two-times-happened-stock-market-crashed
Systemic risk becomes elevated when leverage is involved. Selling begets more selling, margin calls kick in and a negative feedback loop ensues. Liquidity providers step aside and gains that had taken years to achieve disappear seemingly overnight. “Buy the dip” turns into “what was I thinking”.
While margin debt is clearly one concern, perhaps a greater concern is total market derivative exposure as expressed in this next chart.
As it relates to the expansion of leverage, keep an eye on credit risk. This from Carlyle Group conference call last week…
- “given recent geopolitical and macroeconomic events we are surprised at how well credit markets have been in 2014. The world continues to be awash in liquidity and investors are chasing yield seemingly regardless of risk. Leverage levels in the United States are increasing and rose by almost a full third over the past year while spreads between IG and HY are ~250 basis points below the 20 year average. Thus, the market is not assigning a significant premium to riskier assets. We continually ask whether the fundamentals in the global credit markets are healthy and sustainable. Frankly, we don’t think so. What does this mean for global investments? On the positive side we are locking in low interest rates for new investments and continuing to refinance existing debt. At the same time historically low interest rates and a high appetite for risk are pushing up leverage levels and contributing to rising asset prices. This is good news if you are a seller, but bad news if you are a buyer. Given these dynamics good deal judgment is paramount”. (Emphasis mine)
The bottom line is that risk exists, it is elevated with margin/derivative debt and downside events happen. Investors need long-term equity portfolio exposure to be successful. To get it without some form of risk protection, in my view, is imprudent. Especially when it is relatively easy to do.
This leads us nicely into the best book I have read on the subject and one I believe you will find quite helpful.
Tail Risk Hedging – Creating Robust Portfolios for Volatile Markets by Vineer Bhansali from PIMCO
The book is about using a tail-hedging overlay at relatively low and finite cost and the investor may achieve three objectives:
- He can hold his investments in other skilled managers (funds, stocks or ETFs) while hedging out the common market tail risk exposure,
- he can tune up or down the market exposure according to his needs and the opportunity sets with liquid instruments and,
- he has more predictability about the distribution of returns,: that is, he could plan his investment strategy ahead of the day-to-day implementation noise.
There is much more in the book that this short piece cannot do justice. “Managing, mitigating and even exploiting the risk of bad times are the most important concerns in investments. Bhansali puts tail risk hedging and tail risk management under a microscope – pricing, implementation and showing how we can fine-tune our risk exposures, which are all crucial ways in how we can better weather our bad times.” Andrew Ang, Columbia University.
My good friend, Christopher Geczy, Ph.D., Academic Director, Wharton Wealth Management Initiative and Adj. Associate Professor of Finance, The Wharton School adds, “This book is critical and accessible reading for fiduciaries, financial consultants and investors interested in both theoretical foundations and practical considerations for how to frame hedging downside risk in portfolios. It is a tremendous resource for any involved in asset allocation today.”
The book is about how tail risk hedging works, how it is implemented and how it can lead to higher returns with very little cost over a market cycle.
It is my hope that you find it helpful. Vineer does an excellent job at explaining hedging and how you might implement a strategy.
Trade Signals – The Weight of Evidence
A look at the most recent investor sentiment and market trend charts. Sentiment is nearing extreme optimism again and both the equity market and fixed income cyclical trends, while aged, remain bullish.
Click here for a link to Wednesday’s Trade Signals.
Conclusion
We are nearing a tipping point. Just when, from what level, how steep – who knows. An inventive Fed can continue to be even more inventive. Here are a few quotes from Mohamad El-Erian:
- “Undeniably, central banks have consequentially influenced how markets function, value securities, and allocate capital. And the deeper they have been pulled into this hyperactive involvement, the less obvious the route of exit. Indeed, it is far from clear how and when central banks will eventually be able to extricate themselves from what has become an intense influence on risk position, liquidity, and price setting behaviors.
- The bottom line is a simple but consequential one. If investors wish to continue to generate superior long-term returns, they will have to work harder, smarter, and somewhat differently.
- To succeed, investors will need to construct global portfolios with more agile alpha and beta engines, more forward-looking differentiation, and more resilient sizing of positions.
- Equally important, they will also need to limit their vulnerability to severe downturns that threaten to suddenly erase hard-gained returns and, judging from the insights of behavioral finance, also increase the probability of subsequent portfolio mistakes.”
If you don’t know Mohamed El-Erian, he is the former CEO and Co-CIO of Pimco, former President and CEO of Harvard Management Company, the entity that manages Harvard’s endowment and one super smart and balanced human being. That doesn’t make him right; it just makes his opinion worth consideration. I personally would rather trade with him than against him. Source: Forward to Tail Risk Hedging.
Mohamed concluded, “Whether your emphasis is on return generation, risk mitigation, or (hopefully) both, you will find Vineer’s book informative and actionable. Simply put, it is a must-read for those investors seeking to excel consistently in what has become (and will remain) a highly fluid world.”
I honestly find myself getting so caught up in this business – sometimes too much. It is frankly intoxicating to me and I’m sure you as well. A giant chess match with a billion players and constantly moving parts. Risk simply exists and in that existence creates opportunity – unless one is sitting unprotected in the path of the avalanche of selling.
It has been my experience, 32 years of success with some important hard knocks along the way, that investment risk is most elevated when it feels the safest and nearly non-existent when it feels most extreme (individuals in panic). Today, investors seem to me to be far too complacent. Risk is elevated.
We as fiduciaries, financial consultants and individual investors can create portfolios that focus on growth coupled with tail risk protection. Further we can enhance the portfolio structure to manage downside risk. Building core exposure to tactical and trend strategies may help. The tools exist. That’s good news.
I frequently escape to a place of meditation. A form of prayer for me, a place of creation and often it is a place I go to try to unwind and find my way back into balance. Unwind – I though about this as my friend shared the Dalai Lama’s quote. Am I so “anxious about the future” that I don’t enjoy the present?
I believe clients want their money in the hands of excellent stewards, creative thinkers, with experienced management and with someone who really cares about their future well-being. No small task we both signed up for.
It’s been a long time since I last read a Dalai Lama quote and the timing of finding the Tail Risk book in my buddies conference room was somewhat serendipitous. I’ve really been worried about the systemic risk in the system – a 2008 like event, in my view, is on the horizon. Talk about “worrying about future”. So I left my friends office in a better place. Reminded that there is considerable peace in knowing I can gain important equity exposure with inexpensive downside tail risk protection in place. I do believe such structure may help your clients be less “anxious about the future”.
Here’s a toast to “Living in the Present”.
I was in Washington, DC yesterday presenting at the Bloomberg ETF Master Class co-hosted by Bloomberg and Wolverine Execution Services. One advisor is shorting the Russian ETF and going long a US Energy ETF. The number of investment tools at your disposal is amazing. I’m off to Chicago next week attending Envestnet’s annual conference May 14 – 16. I love Chicago and am really looking forward to learning more about all things Envestnet.
Please let me know if you’ll be attending – stop by our booth.
Have a great weekend!
With warm regards,
Steve
Steve Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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