May Day or mayday | MBMG Investment Advisory Report and Outlook May 2023
Waiter, there’s a bear in my free lunch…
It has become customary for our May updates to discuss the well-worn market
aphorism, “Sell in May. Go away. And don’t return until St Leger’s Day”.
However, this year, we prefer to focus on our theme that post-pandemic markets
are marching to a new, discordant, arhythmic beat.
“Diversification is the only free lunch in investing” –Harry Markowitz 1
The shutdown and re-opening of developed western economies and capital markets during the pandemic disrupted financial and economic behaviours.
The usual market trends were replaced by a bullwhip effect or series of amplifying waves, like the ones shown in the diagram on the right.
The unclear current state of economies and investment markets is a consequence of this disruption, alternating between indications of resilience and weakness.
This has led to increasingly polarised positive and negative interpretations of these data.2 This effect is also exacerbated by market reactions to these data.
Good news = bad news, bad news = good news.
Upbeat data might usually be viewed as a positive indicator for corporate earnings and for asset prices. However, we have seen positive data increasingly greeted with negative market reactions. This is because these have sometimes been interpreted as providing justification and encouragement for policymakers to continue tightening monetary policy (i.e. raising interest rates), in response to the potentially inflationary consequences of stronger data.
Policymakers such as the FOMC (the policy making committee of the Fed) need little or no encouragement to pursue this agenda.3
Weaker data has received a positive response from market participants on the basis that policymakers might not raise interest rates further or might even cut rates.
This applies up to a certain point.
It doesn’t apply when the news is so negative that the potential damage to corporate earnings outweighs the expected benefits of rate cuts.
In this case, then bad news = bad news.
The ideal situation for investors is data that are soft but not too soft.
This reminds us of the fairy tale of Goldilocks and the three bears. Goldilocks tried the bed of each of the bears until she found one that was ‘just right’.4
We get very worried when investing strategies sound like fairy tales.
Other issues also worry us today.
Measures of equity market volatility have subsided from the extreme levels of the pandemic, but they are still high by historic standards.5
Relationships between different asset classes that have been in place for many years are breaking down.
This has serious implications for cross asset volatility and correlation.
The classic form of diversification is the 60/40 portfolio, invested 60% in stocks and 40% in government treasury bonds. The theory behind this has been described as “60% in equities for the good times, 40% in bonds for the bad (and for the yield)”.
Stocks should provide higher returns in the long run but are more volatile and more prone to significant corrections. When stocks fall in price, ‘safer’ government bonds should help to cushion that.
At least, that is the theory.
“In theory there is no difference between theory and practice; in practice there is.” – Yogi Berra (baseball coach)
1 While in his mid-20s, Markowitz wrote a post-graduate dissertation, heavily reliant on statistical analysis that helped mathematically formulate the concept of diversification and resulted in Markowitz being one of the shared recipients of The Sveriges Riksbank Prize in Economic Sciences [sic] decades later in 1990. It also spawned the statistical modelling that emanated from universities such as Chicago that still influence the pricing of derivatives such as options and underpinned the blow-up of hedge fund, Long-Term Capital Management, giving rise to modern American capital market bail outs, although these had progressed far from Markowitz’ work, including his ‘efficient frontier’, an ambitious, if not unrealistic attempt to mathematically formulate the optimal asset allocation for each level of risk. Markowitz claimed “I was awarded for portfolio theory, which in brief says ‘Don’t put all your eggs in one basket.’ But there’s a trade-off between return on the average in the long run and variability of return. So I worked on the mathematics of risk-return trade-off.”
2 The ‘bull-bear indicator of market sentiment is almost exactly at its long-term average or neutral point at the time of writing.
3 Read here https://mbmg.substack.com/p/-jerome-powell-demolition-man or https://mbmg.substack.com/p/mbmg-update-inflatiophobia to see why we call Fed Chair Powell ‘demolition man’.
4 We explained to CNBC’s viewers in 2018 that Goldilocks was originally a bleak morality tale. “In the first three versions of the Goldilocks story, Goldilocks actually died horribly, and we think that could well happen again [to stocks].” At the time, we were worried about a pullback in bullish sentiment. Within 2018, we saw the Dow Jones fall back below 22,000. Two years later it fell back below 19,000, before the bull-run of 2020- 21 started.
5 MBMG | Advisory The measure of volatility in the S&P500 stock index, known as the VIX, has fallen to its lowest level since late 2021 and well below its peak in the first quarter of 2020, although it remains elevated by pre-pandemic standards
Disclaimer: The above information has not been independently verified. This investment brief is given for information only and does not represent an investment proposal, recommendation or advice to invest in the shares or business of the subject company. Additional information shall be made available to interested parties subject to the execution of the requisite confidentiality undertakings. The financial information, actual and/or forecast, provide herein is based on management representation.
