Volatility is making a comeback. I often joke that investors never get upset about upside volatility, but if they are wise they should. Risk is risk, and while it is exciting to take risks when they work out, eventually one will experience the downside.
This last quarter has worked out pretty much like we thought it would. The crisis in Europe once again grabbed headlines and the markets gave up much of the gains from the first quarter. We were well-positioned in all of our strategies for the downturn and, as expected, outperformed. Then a funny thing happened: On the last day of the quarter the market went up by 2.5 percent. That is some upside volatility. What caused it? Some believe it was a positive reaction to the news that the EU is going forward with creating a banking union, so banks can be bailed out directly by the EU instead of by the individual countries. Others, more cynical but probably more accurate, believe a lot of traders needed to cover their short positions before client statements went out and/or they left town for their 4th of July vacations.
Regardless of the reason, that one day made the entire quarter look significantly different. In our case we went from significant outperformance to being roughly in line with the market, as we had outperformed on the downside but underperformed on the huge up day. It is frustrating that one day can be so important from a client visibility standpoint. By tradition and regulation investment managers report on a calendar quarter basis, but is that three month period any more valid than the three month period that ended a day earlier? The frustration leads to a phenomenon known as “window dressing.” Knowing that clients get to see what they are doing at the end of every quarter, some managers will make trades to make their portfolio look better. They may sell controversial holdings, which are likely their best ideas, in order to not offend. They may purchase big winners to make their clients believe they owned them all along. If a manager gets a big lead on the market half way through a quarter they may become a quasi-index fund for the remainder of the quarter in an effort to “book” their relative performance.
We don’t engage in these practices, and for the record I don’t believe window dressing is as widespread as the rumor mills insinuate. However, there are some who do it, and anyone who has been in this business for a number of years understands the temptation. The problem is two-fold. First, a manager who conducts himself in this manner is putting his own interest before that of his clients. Risk to the client is losing money; risk to the money manager is underperforming the market. A manager who gets ahead of the market and then changes his portfolio to “book” that relative gain is reducing his risk, but in all likelihood increasing the risk of the client.
Secondly, it is just a day. The unfortunate timing that gives days like this seemingly greater importance is illusory. The reality is that markets go neither up nor down in straight lines; we often have big up days in down markets and vice versa. Regardless of which story you believe – that the market rebounded because of EU action or that it was all window dressing – both effects are temporary and will be undone within a week or two.
In the case of window dressing it should be obvious why it is undone. We are now in July and three months away from most managers having to come clean to their clients, so they can once again position their portfolios as they wish versus what they wish to show their clients.
In the case of Europe my prediction may be a little more controversial. However, nothing has really changed. The latest moves to assist the banks will put off catastrophe a while longer, but once again the proverbial can has just been kicked down the road. In the interim Europe’s recession is still here, and investors and economists are just beginning to understand the severity of the situation. China’s economy is slowing as is ours, when we were already not far from recession.
The reason this crisis is important to investors is that we invest in companies that must operate their businesses in the economies that are impacted by an overwhelming amount of debt. The economies are slowing, therefore earnings will be slowing, and therefore the companies we invest in will be worth less. This dynamic has not changed. Watch for earnings reports, as they are not likely to be very encouraging.
We will get through this crisis, but it is not going to end neatly on one day at the end of a quarter. It will be a process that takes time. Recovery will most likely be marked by a market slowly climbing a wall of worry, not 2.5 percent jumps of temporary euphoria.
Warm Regards,
Chuck Osborne, CFA
Managing Director
