The New Volatility

Recent declines in MLPs and High Yield indicate an increasingly nervous retail investor base. Individuals who made decisions almost solely on the basis of yield lack the foundation of knowledge that enables sound judgements during times of stress. Bouts of panic selling resulted. This selling occurred in the face of an economy that remains sound and good corporate fundamentals for MLPs and most high yield issuers (at least outside of oil and gas producers). More savvy observers that recognize this fundamental strength are, paraphrasing FDR, afraid of the fear itself.

Many observers express a concern that the reforms made to the banking system after the 2008 Financial Crisis created conditions for a future new collapse. With banks now severely restricted from making risky loans and trading in the securities market, the continued stability of corporate lending now lies almost exclusively with hedge fund, mutual fund and ETF investors. In 1978 banks supplied approximately 50% of all US private sector credit [1] while in recent years that ratio has fallen near 20%. Many worry that the short term, return-chasing mindset that unfortunately characterizes all too many participants in the financial markets will result in a continuing cycle of value-destroying credit booms and busts.

This view seems nostalgic. The banking sector historically proved itself at least equally adept at making bad decisions based on short-term thinking as individual investors. The goal of the post-2008 reforms was to eliminate some of the “heads I win, tails you lose” conflicts inherent in banks able to gamble with a leveraged mix of shareholder equity and taxpayer-guaranteed debt. The current environment where the end investor directly bears the loss or gain of their decisions meets the goals of these reforms.  Junk bond ETFs – a recent financial innovation we and others have been wary of – so far appear to have performed up to promise, offering liquidity to investors without disrupting the access to credit for issuers.

The recent volatility in high yield bonds began with the hundreds of billions of debt issued by lower tier oil and gas producers. This debt at its peak comprised over 15% of the junk bond market. It appears that a third or so of these issues will default and investors will generally recover very little in the reorganizations. As concerns spread from the energy sector to high yield bonds as a whole, several funds with either leverage or liquidity issues ran into difficulty. Most notably was the Third Avenue Focused Credit Fund – a fund which we recommended to clients several years ago but terminated in 2013. Our primary concern with Third Avenue was a lack of confidence in the new corporate management. The fund concentrated its investments in distressed issues with poor liquidity. Poor performance combined with redemption requests forced the fund to suspend trading in order to facilitate an orderly liquidation. Our current high yield manager had no exposure to energy prior to the oil price crash and does not invest in distressed situations.

This volatility feels painful because we have become accustomed to a benign financial market environment. Who remembers the nearly 20% decline in the S&P 500 in 2011 when a European collapse appeared eminent? Like then, the memory of 2008 still serves to reign in risk-taking before it becomes a systemic issue that puts the economic expansion at risk. The silver lining of the subpar recovery from 2008 is that very few excesses have been created. In 2008, a spike in oil prices and slowdown in housing shattered the brittle, overleveraged financial sector and ignited the worst economic collapse since the Great Depression. The instigators of the Financial Crisis profited handsomely, leaving the wreckage to taxpayers and ordinary business owners. Today, we have mostly unlevered investors risking their own money and suffering the consequences of their own bad decisions. Cyclical sectors cycle without their financial contagion disrupting the broad economy. Volatility in financial markets cannot be eliminated as it is the manifestation of markets attempting to price new information. The goal is to limit its impact on the real economy and so far, this appears to be the case.

Rather than 2008, this market bears a much greater resemblance to 1998 with its similar collapse in emerging markets and commodity prices against a backdrop of relatively stable US growth. Too many investors took the wrong lesson in 1998 – shedding underperforming asset classes and concentrating their portfolios on the large cap US growth stocks that continued to perform. They drove these stocks into a record equity bubble which collapsed shortly thereafter and set up a lost decade of equity returns where the S&P returned, on an annualized basis, -1.0% from 2000-2009. Large cap stocks, the best performing major asset class over the past five years, appear to us to be priced for 4-5% returns after inflation. While not a new lost decade, if valuations revert to more historical levels, the next five years may well see negative returns for the S&P 500.

The real lesson of 2015 is that surviving volatility requires liquidity and an understanding of economic fundamentals. There will always be a certain level of cognitive dissonance surrounding holding long-term assets that are repriced hundreds of times each second. Purchase and sale decisions should be made from a multi-year outlook, not in reaction to short term price movements. When fundamental outlooks deteriorate then sell, if the outlook still harmonizes with the original investment thesis then one should hold. With MLPs and most high yield issues outside of energy, the outlook remains intact. Portfolios should maintain adequate liquidity in high quality fixed income instruments to several years of cash flow needs so that these intermittent periods of volatility do not result in forced sales at distressed prices.

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[1] World Bank Data cited at http://www.bloomberg.com/news/articles/2015-12-15/the-guy-who-warned-about-broken-libor-now-sees-fast-money-financing-as-the-new-risk