Professor Ron Bewley

Chief Investment Officer
Commonwealth Bank of Australia

Learning from the past

1st October 2009

If you, like I, went through all that pain in the GFC being not just in equities but geared then I am sure you will want to be the better for it going forward. All pain and no gain would be a sorry state of affairs.
Nobody made all the right calls although some claim they did and others had it claimed for them. Earlier this year Nouriel Roubini was hailed as the NYU professor who got it right. He did write a book about how the financial system would collapse and said that the ensuing depression would last a generation or more. A few months later he changed his mind – growth by September this year – not quite a generation! Presumably Roubini wasn’t geared as his US market charged up 50% – think of all of the lost opportunities. Professor Shiller (Yale) and Professor Krugman (2008 Nobel Laureate) also did an about-face around that time. Of course I am not criticising them for changing their minds – commentators must when they have cause to. What I am stressing is that no one is infallible and so investors need their own risk system in place to cope with our constantly shifting environment.

Every man and his dog is looking for a pull-back but cash seemingly jumps in before a significant fall takes hold. There is reportedly about 18% cash in super funds – but for how long. The sidelines are too crowded for my liking. It reminds me of the “super bubble” of 2007 when people could put $1m each into a super fund before July 1, 2007 and then $450k each straight after. What happened then is we had four big bubbles and the last one ending in November 2007 certainly burst.

While I do not subscribe to W-, U- or L-shaped recoveries (more time should be spent thinking about the market than cute ways to get media attention) I do feel that life has certainly not got back to normal yet. Volatility is much higher than before 2007/08. Volatility is a measure of how much the market might vary over a year even if we know the trend. For example, if volatility is expected to be 10% and growth is expected to be 5%, then one standard deviation (volatility) either side of the trend is 5% ± 10% or a range of -5% to +15%.

Normality (bell-shaped curve) is a reasonable assumption over a year or so and we are thinking of small deviations either side of trend but serious risk analysis requires something a little more complex. This simplification is enough to get the point across.
We can say there is a 66% chance that the S&P/ASX200 will be in that range (5% ± 10%) - if our assumptions turn out to be correct. That means for a forecast of 5,000, the range is about 1,000 points wide and that only gives us a 2/3 chance of being correct!
 

Current volatility estimates

Current volatility estimates are more like 20 - 25%. If we expect volatility to stay the same and our expectation of capital growth is about 7% - the long-term average – we would expect the index in one year to move from today’s 4,700 (at the time of writing) to 5030 with arrange of 2,514 to 7,544 for a 95% chance. [Real statisticians would know there is more upside than down side in properly constructed intervals]. The point remains that for one year ahead there is a false sense of accuracy to a forecast that is say 5,478 – we have trouble getting the first digit (5) right!

This means that anyone with a margin loan should be aware that markets are not easy to predict and so you need to be ready for some evasive action. You might be asking if markets are too volatile? The answer is a resounding yes for those not prepared to do their homework. For those with the appropriate risk appetite and the rights rules and tools, the rewards can be quite good. Get them wrong and trouble awaits!

There are two other important measures of volatility for the savvy investor to comprehend. The first is cross-sectional volatility or the extent stock returns move together on a given day. We calculate this ‘harmony’ index by first taking the standard deviation of returns across the top 200 companies. If stock prices move together, investors are less alarmed. If there is major disharmony in the market – as there was during the GFC – investors do not know whether to rebalance portfolios or duck for cover. We discovered an interesting result two or three years ago that a change in the long-run level of disharmony is a precursor for a change in the usual sort of volatility we addressed at the beginning of this article. Figure 1 shows our measure of harmony with the ‘tram lines’ – or a range we use to benchmark harmony. Above this range for long and it is time to think very carefully.

Another type of volatility is ‘irrational volatility’ or fear. We measure fear by the excess volatility on a given day outside the open and close range. In an orderly market, one might expect a reasonably smooth transition from the open to the close. On February 4th last year the market fell over 200 points from high to low but the close was 13 points above the open. In hindsight we can see the alarm bells started to ring in mid 2007 and became deafening at the start of 2008. I remember announcing on Switzer (Sky Business Channel) July 1st 2009 that both fear and harmony were inside the tram lines for the first time since the start of the GFC – so a rally could begin and be sustainable. As it turns out the market rallied from about 3,700 to 4,700 over the next quarter. Partly luck but I never make any investment decisions without checking these two measures out.

So where to from here?

We believe the market is over-priced (using our exuberance measure) but harmony is pretty good and fear is reasonable. The combination of money coming off the side-lines and profit takers collecting after a great rally should dampen the swings but – with (usual) volatility about twice what it was from 1985 – 2007 expect the unexpected. Enter the market carefully, gear appropriately and, of course, take advice from a professional.
We didn’t develop the fear and harmony indexes until February 2008. Too late for some but we can’t change the past. What we think we must do is learn from wherever we can. 
 

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