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Lab coats and safety goggles

We recently came across an article on the BBC website, which prompted a wave of nostalgia. Titled ‘Whatever happened to kids’ chemistry sets?’, it described how they were the catalyst for lots of mischievous childhood adventures, including stink bombs, explosions in garden sheds, singed eyebrows and holes burnt into dining room tables. Most of us have been guilty of at least one of these; whilst some may have done all and more!

The two main themes of the article centred on how these sets inspired numerous subsequent Nobel Prize winners and - on a more rueful note – how Health & Safety concerns subsequently watered down their contents, to the point sales sharply declined. The latter was no bad thing, as early chemistry sets provided exposure to all sorts of dangerous substances. Potassium nitrate, used in gunpowder, fireworks and rocket fuel was commonly present, as were highly corrosive nitric and sulphuric acids. Calcium hypochlorite – a source of chlorine gas - was frequently a component and others contained Sodium ferrocyanide, which produces a Prussian blue dye, but is now classified as a poison! To think, ten year olds were free to make things go boom, build their own batteries and bend glass with alcohol lamps, no matter how poisonous, flammable or volatile the compounds they were dealing with.

We are pleased to have survived the dangers of our chemistry sets and gone on to study the subject at A-level. Thankfully flammable liquids and poisonous gases do not currently occupy our day-to-day thoughts. Things that might be volatile, however, most certainly do.

Ignoring the small rises in volatility we have experienced in recent weeks, prompted by Trump-related issues, many column inches have been committed to the ever more becalmed nature of developed financial markets, especially through 2017. Rightly or wrongly, the S&P 500 Volatility Index (VIX) is commonly used as the default proxy for representing global volatility and the following chart clearly demonstrates this is at, or very near, all time lows.

Source; Bloomberg

From an investor perspective, the fascination with this – admittedly fostered by the financial media – is that a low VIX level is generally a signal of complacency and should be taken as an early warning signal of falling prices ahead.

What should we be reading from this?

The horizontal dotted line on the aforementioned chart represents a VIX level of 28.5. According to Ned David Research (NDR), a reliable bear market signal occurs if this level is breached on the upside, having been below it for at least 6 consecutive months. On such occasions, these advancements on the VIX have historically resulted in a median fall in the S&P 500 of 22%.

The current signal is far from bearish and one could argue, rightly so. In the same piece, NDR advise that among the 46 equity markets making up the MSCI All Country World Index, 91% were trading (18/05/17) above their 200-day moving averages. This ‘market breadth’ is consistent with ‘economic breadth’, where 85% of Manufacturing PMIs have positive momentum and ‘earnings breadth’ where more than half of the markets have positive earnings growth.

In a piece of research, also published this May, Deutsche Bank have analysed the 1, 3, 5 and 10 year S&P 500 returns after volatility (as measured by the VIX) starts at particular levels. According to this analysis, ultra low volatility does not necessarily predict poor returns going forward, but returns are generally higher when volatility starts at a higher point than current levels, or when it is ultra high. The evidence suggests future returns from the level we are now may be sub-trend, but there is no particular evidence of an imminent problem based on historical data.

Should we be comforted by this? With so much being written about the dangers of complacency, does this suggest investors are not being complacent? As always, time will tell, but – despite the research we have presented – we remain watchful.

Why?

Returning to our chemistry sets, we learned of a process called sublimation; associated with certain substances which can change directly from being in a solid state to a vapour, without first becoming liquid. For example, Dry Ice (solid carbon dioxide) turns into a gas without ever being in liquid form. Put differently, becalmed, low energy molecules in a solid can quickly become volatile, high energy molecules in a gas and completely bypass the liquid phase, where an observer would be able to recognise things are changing.

This analogy could apply to the current state of markets, as we may move from a very low volatility environment to one that is ultra high, without a transition stage in between. Forecasting what could prompt this is not a valuable use of our time, but as we mentioned in our March edition of VFTD, there are some useful ‘rules of thumb’ to keep an eye on. Bob Farrell is a Wall Street veteran who draws on some 50 years of experience in crafting his investing rules. His 10 rules stem from having lived through dull markets, bull markets, bear markets, crashes and bubbles. Rule No.7 reads ‘Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.’

The first of the two charts that follow measures the percentage share of the S&P 500 market cap represented by the FAANGs – Facebook, Apple, Amazon, Netflix and Google. These five stocks continue to grow their share.

Source; Bloomberg, Gluskin Sheff

This second chart measures the proportion of the performance of the S&P 500 year-to-date contributed by the same 5 stocks.

Source; MAN GLG

We believe this is a warning sign for investors in US equities.

Implications for portfolios

The general lack of volatility across many asset classes, not just equities, means it is more important than ever to think about long-term investing. Returns from any investment can be decomposed into those that come from changes in price and those that come from the actual economic return in the form of coupons, dividends and profits. In an environment where prices are stable and there are few opportunities to buy truly cheap assets, the focus should be on the economic return that may be harvested. In our view, diversification is key and maintaining exposures to long term, super secular investment themes – whilst adjusting for risk avoidance using a mix of asset classes, investment styles and geographic allocations – is as applicable now as it has always been. As we regularly talk about, understanding how our underlying investments and portfolios might behave in certain market conditions, is much more important than the labels they are given. Volatility will return and we continue to manage portfolios in anticipation of this.

The basic principals taught to the users of those early chemistry sets are appropriate today. Experimentation can be dangerous and it is important to be respectful of volatile things, even if they seem inert in their current state.

Julia Warrander and Russell Waite

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