U.S. markets have seen a rough start to the new year and some investors are getting spooked. The brave hearts on the interest rate strategy team at the Royal Bank of Scotland just suggested that their clients sell all other asset classes and buy bonds with the proceeds.
(By the way, if you don’t see the irony in an interest rate strategist recommending everyone to buy bonds, you should really attend IOI 102 — An Introduction to Behavioral and Structural Biases).
Top on the list of issues roiling the market at the start of 2016 are that:
- The Chinese economy is collapsing and
- The price of oil is collapsing
I have written about China extensively (here and here), so I will not belabor my previously made points except to say that if the Chinese economy is collapsing, someone failed to inform the Chinese. China imported a record amount of crude oil in 2015 and the most recent trade figures show that imports fell less than expected and exports grew at a decent clip. It’s tough to base an argument using official Chinese statistics while keeping a straight face, but a decent piece of anecdotal evidence is this: Beijing would not be plagued with nearly as bad pollution if the economy was grinding to a halt.* My favorite quote about declines in the Shanghai market comes from Tim Summers, senior consulting fellow on Asia at Chatham House (as reported by Bloomberg):
“The international reaction [to the Shanghai market fall] has probably been bigger than it should have been, given that China’s equity markets are not very related to the real economy nor yet very connected to international markets.”
As for oil, I am not an expert in this field, but I’ve long been suspicious about the resilience of oil prices based on the most oft-repeated supply / demand themes. The price of oil may well go down to under $20 / bbl. If it does, the U.S. economy will have to deal with a lot of bad debt in the energy sector and this may have an effect on banks that are not too big to fail; even if it stays at $30 / bbl, there will be a lot of energy sector defaults. It’s hard to imagine, though, that market participants have not noticed this until now. I think it is also fair to say that compared to the mortgage debt markets in the mid-aughts, the energy debt market is far more discrete. Some blocks will topple, but it seems a stretch to think that it will be the Jenga game of 2008-2009.
What I would like to suggest is that the rough start to 2016 is due to political uncertainty here in the U.S. of A.
In 2012, I was working as Morningstar’s Market Strategist and the media meme at the time was that markets were volatile because it was an election year. The excerpt from my January 2012 report tells the surprising story of what I found:
To gauge volatility, I decided to look at two separate statistics: standard deviation of daily returns (the favored measure of risk in financial economics) and intraday range (a slightly more nuanced definition of risk preferred by some). I analyzed S&P 500 data starting in January 1950 through the close of business on Dec. 30, 2011. This gave me 15 election cycles (1952-2008) of end-of-day data and 12 election cycles of intraday data (1964-2008). For all of the data, I compared the statistical measure of interest (i.e., intraday volatility, standard deviation of returns, and returns) during the months January through October in an election year to the statistical measure of interest in nonelection years.
My results were as follows:
Average daily return: 0.02%
Standard deviation of daily returns: 0.86%
Percentage range of intraday prices1 : 1.48%
Average daily return: 0.04%
Standard deviation of daily returns: 0.90%
Percentage range of intraday prices: 1.47%
The appropriate statistical test to gauge whether each of the election year statistics differed from the nonelection year statistics (two-tailed z-Test) showed that they did not. However, because of my small sample sizes, statistical significance for each of the tests was low (lowest for daily return, highest for standard deviation of daily return), which brings doubt to the quality of the results. Despite the low level of statistical confidence, seeing these results made me think that there was good evidence that the belief that volatility increases in election years is probably just an urban legend.
So it seems that political races have no statistical effect upon market volatility. Why then, can I claim that present volatility is due to political issues? The answer comes in an academic paper, Elections, Partisan Politics and Stock Market Performance, written by D. Leblang and B. Mukherjee that I found while doing my 2012 research. In addition to finding that markets tended to display much less volatility when left-leaning parties were expected to win, the professors found that during election cycles characterized by greater political uncertainty, stock markets exhibited greater volatility.
The primary season is upon us and out of the three or four lead contenders, only one (Clinton) is a centerist candidate. Donald Trump is on the far end of the nationalist populist spectrum, so much so that his comments at various rallies would have had him arrested under hate speech statutes in most of Europe. Ted Cruz is perhaps a more careful speaker, but is arguably not much closer to the center than Trump. On the other end of the spectrum, Bernie Sanders would make a stupendous candidate for office in any number of Scandinavian countries, but is much further left than many in the U.S.
It is becoming more and more obvious that the Republican party will have a hard time nominating a center-right candidate. At the same time, recent polls show that the Democratic party’s centrist candidate, Clinton, is losing her lead over Sanders in both Iowa and New Hampshire.
No matter what your political leanings, if you are an American, you’ll likely find it easier to imagine a country ruled by Hillary Clinton than one ruled by Trump or Sanders. U.S. equity market participants are confused too, and with such a broad political spectrum showing strongly in this year’s presidential race, this confusion is likely to be manifested as volatility.
As an intelligent option investor, one can always structure option-based hedges (this is the subject of one of the sessions of our IOI 101 course), but unless the value of the market differs significantly from its price (which I personally think is unlikely, though some of my partners here at IOI might disagree), any option hedge will be a form of short-term speculation. Even after hedging portfolios in the hundreds of millions of dollars, I do not believe I have much of an advantage when it comes to this type of a speculative bet, but I am very happy to teach you how to structure your hedge in the most intelligent, cost-effective way possible if you have more confidence in that area!
* According to this scientific paper, industrialization’s effects are also exacerbated by geography: “Beijing’s geological conditions also make it highly susceptible to air pollution. Beijing sits on a plain flanked by hills and escarpments that can trap pollution on days with little wind (Wong, 2013). Conversely, strong northwestern winds carry dust from the Gobi desert to Beijing in the spring and lead to low visibility and high concentrations of PM10, particulate matter with diameter of 10 micrometers that are considered highly harmful to human health (Zhang R. et al., 2005). Domestic heating in this heavily populated city usually starts in mid-November and ends in the following March, and it is the major source of pollutant sulfur dioxide in the winter season (He et al., 2001).”
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