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Dec 02, 2015

A Silver Lining in the Dark Cloud of Volatility

Bill Miller

There was an interesting paper called “Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking?” that studied the risk attitudes and behavior of people who lived through the Depression. The authors found that the impact of the Great Depression on peoples’ financial behavior was long-lasting. They were much more conservative than most, had higher savings rates, and most didn’t want to take much risk as they were always fearful of another calamity happening. The impact diminished gradually over time but had a significant effect on investor behavior. It also worked the other way: people who experienced high rates of return in stock markets were more likely to take risk and to have a higher percentage of their assets invested in stocks. Broadly speaking, the financial environment one experienced with other members of one’s birth cohort imprinted sufficiently to affect one’s future asset allocations and views on risk.

These findings are consistent with investor behavior observed since the 2008 financial crisis. The stock market has tripled since the lows in 2009, yet investor allocations to equities remain low by historical standards while those allocated to “safe” bonds are elevated. The scars from the 2008 experience remain, and investors continue to be reluctant to move toward more normal allocations to equities. That means perceived risk is much higher than the real risk in stocks in my opinion, and I think that creates an environment that one can invest in profitably in equities. I continue to believe treasury bonds offer no value except as a hedge against deflation.

A series of changes arising mostly from the 2008 crisis has, I believe, also impacted market structure and offers potential opportunities to the enterprising investor. There are four such changes: the rise of so called risk parity products, algorithmic trading, including high frequency trading, the demise of the specialist system, and Dodd Frank. One could probably also throw in the increased emphasis on risk management at the institutional and portfolio level.

All of these combine to increase the amount of trading based solely on market price action and volatility relative to that based on fundamental factors. Estimates are that as much as 70% of equity trading is now price reaction based. Put differently, as much as 70% of what goes on in the market is noise and contains no information of fundamental value.

We saw this in action in the third quarter of this year as volatility exploded for no apparent reason. On August 24, the stock market came unglued with highly liquid stocks such as Apple, GE, and JPMorgan dropping 15 to 20% at the open from the previous day’s close on absolutely no news whatsoever. Less liquid names, such as private equity firm KKR, dropped over 50%. These declines subsequently reversed, but that day’s decline marked an unsettled period where stocks had their first 10% correction in several years. The third quarter was also the worst quarter for stocks in several years. This was followed by an October that was the best month for stocks in a similar period.

I do not believe we have seen the last of this kind of volatility unless the regulatory authorities move to undo some of the factors mentioned previously, which they show no sign of doing. This non-fundamentally based volatility presents an opportunity for monetization by investors who focus on long term fundamentals and not daily price action.

With the demise of the specialist system, there is no institutional requirement for liquidity providers to make an orderly market or to maintain bids. Dodd Frank effectively removed the big banks from proprietary trading (which had nothing to do with the crisis anyway), which also decreased liquidity. Risk parity strategies have grown dramatically since the crisis, but differ little from the old portfolio insurance products that were a prime culprit in the 1987 stock market crash. They have the effect of selling as prices go down and volatility goes up, and buying when prices are rising and volatility falling. And have you ever met a risk manager who believes you should own more of an asset whose price is falling?

The combination of all these suggests that both stocks and the market are more likely to diverge sharply from fundamental value in the short term and that the opportunity to profit from this divergence is greater than it was prior to 2008. The divergence from intrinsic value is likely to be more pronounced in falling stocks and markets than in rising ones due to what Richard Thaler dubbed myopic loss aversion: people react much more to losing money than to the opportunity to make it.

If this is correct, the opportunity set for patient, long term, contrarian value strategies is expanding as the market’s time horizon shortens. In our strategies, we took advantage of the dislocations in the third quarter and expect to see more opportunities to monetize non-fundamentally based volatility in the quarters to come.

The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results. It shall not be assumed that other strategy investments will be profitable or will equal the performance of the securities mentioned.

©2015 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.