How to Find Profit in Volatile Markets - Spear's Magazine

How to Find Profit in Volatile Markets

Ready, Set, Go! Stop! Go!
 
 
It’s been a volatile summer in our financial steeplechase, says Charles MacKinnon. Only by holding steady and keeping your nerve do you have a hope
 

WE ARE ALL looking forward to the Olympics, and when the starting gun goes off on the 100 metres sprint there will be a huge surge of excitement to see if Usain Bolt can delight us again.

For those of us managing money, the starting gun that just went off was the S&P downgrade of the USA’s credit rating in early August. Rather like the bang of the starting pistol, it was no real surprise — we all knew it could happen, but it was a shock when it did. Sadly, it was followed with a very different sort of excitement as the runners in the global economy rushed to reposition themselves in the new race they found themselves in.

The volatility that we are now experiencing is a consequence of the necessary rearrangement of assets between holders who have different needs and obligations, much as runners in longer distances jostle for line and position.

One very large group can be loosely defined as pension and insurance funds. For them, it is of paramount importance that they can deliver on the promise that they have made to their policyholders. This means that these investors must react to any threat to capital value — and so a downgrade means that they are obliged to take action. This helps to exacerbate volatility as they will all tend to do the same thing at once, even though they know that by acting together, they are making the problem worse. High volatility creates more high volatility.

Another huge part of the market is individuals and funds depositing cash. This group is even more credit-sensitive than the pension investors — any bad credit event will cause a significant and instantaneous reaction. For example, US money market funds have effectively withdrawn all their cash from short-term deposits at European banks, causing a massive liquidity squeeze and huge volatility in short-term rates and in banks’ funding costs.

The third large group of asset holders can be loosely defined as active managers in both bonds and equities. They are trying to make money, on an absolute or relative basis, and for them, volatility is meat and drink.

The fact that these three very, very large pools of assets are changing their mix can and will continue to generate significant dislocations in markets. Volatility is here to stay, and we, as investors, must find a way to profit from it. These are the simple rules that we try to follow:

Decide what you want to own and decide at what price you would sell and at what price you would buy, and in what size.

Write these prices down, and only review the document at pre-determined regular intervals — such as quarterly, weekly or monthly.

Execute the buys and sells as per the document mindlessly. Do not kid yourself that ‘things have changed’.
Do not trade based on the colour of the screen.

 
 
THIS IS SIMPLE to write and tough to do. The really important rule is the first one because here you are making a choice based on today’s information that you will exercise at some point in a different future. Other people will have different views from you and, most importantly, will be subject to different pressures.

These basic rules give you the structure to withstand periods of intense market volatility. The key point to remember is that different market participants will have different drivers to their actions. The summer stock price movements of large companies had nothing to do with changes in fundamentals, which take years to change, not hours. A fund liquidating its position due to a cash call is a more likely culprit. For example, Nestlé traded up and down 12 per cent, Unilever 11 per cent, Amazon 32 per cent, Colgate 16 per cent and so forth.

Looking forward into the last quarter of 2011, we feel surprisingly encouraged. The next few months will hopefully see some resolution for investors with the levels of volatility returning to more normal levels, in part for the simple reason that investors need to regroup. But we should beware, as the calm that may settle will be a false dawn, as the underlying causes of volatility have not gone away.

For what it’s worth, in the near term we think that markets are more likely to rally from here (S&P 500 at 1,162) than fall, but this should be seen in the context that we think markets will trade in a broad range for the next five to ten years of 800–1,600, with the lows still several years away.

While we freely acknowledge there is the possibility of a shallow recession in the G7, we think this should be seen as part of the normal business cycle. Many large, well capitalised companies are trading at historically low P/E ratios, and have dividend yields that are higher than their own bond yields. Growth economies around the world are still growing, albeit a bit slower. Money is cheap to borrow for well-managed businesses, meaning they will make bigger profits in the future. Above all, however, you must know what you own and why you own it.



 

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