Materials Risk

“Sell in May and Go Away” is an investment advising investors to sell their investments in May, wait out the summer months by the beach before reinvesting in November.

In theory the existence of such a seasonal pattern should be quickly eroded as investors try and front run selling by other investors. In turn reducing the prevalence of the evidence to support the adage. Analysis by Rothko Research looking at major equity indices over a period of several decades finds mixed results.

That being said there is plenty of convincing evidence and arguments to suggest that 2020 could be one of those years where the adage holds true. Here I outline three reasons why this could be the case:

Follow the money

There is a strong historical relationship between money supply (as measured by M2) and annual changes in the S&P 500. As money supply grows (the result of easing by the Federal Reserve and increased demand for credit), risky assets tend to be bid up as too much money chases too few assets. But importantly it operates with a lag. Based on analysis by Nordea there is a lag of 252 trading days between a change in M2 and the impact of that liquidity on the S&P 500.

Right now (this week) the S&P 500 is likely to see liquidity dry up and go into reverse – perhaps moving lower by 25%-30%. Only later in 2020 or early 2021 is it likely to bottom. Historical trends suggest that the wall of liquidity unleashed by the Federal Reserve’s easing policies due to covid-19 will flood the US equity market making 2021 a potentially strong year for asset prices.

China and the US escalate their battle of words and deeds

Authority figures and PR executives have long known the value of deflecting attention. Directing the public’s anger to someone else, preferably someone or some country a long way overseas is the idea strategy to divert gaze from any embarrassing shortcomings.

What better idea then (ahead of the November Presidential election) to deflect attention from any domestic leadership shortcomings related to covid-19 than blaming someone else, especially the country where the virus is understood to have originated from, China.

According to US political commentator Karl Rove, “If the issue is who is tougher on China, this is going to be a Trump victory.”

The two countries are likely to clash economically and financially. First, over the doomed trade deal and second over the dollar yuan exchange rate. A sharp weakening in the yuan from current levels could set the stage for further economic conflict between the two countries and set off an exodus from risky assets.

Corona Wave 2.0

Many will now be familiar with the scale of the 1918 Spanish Flu, in particular the second more deadly wave of infection that hit during late 2018.

According to the US Centers for Disease Control and Prevention (CDC) the rapid spread of the coronavirus in Latin America (now experiencing their autumn/winter) raises the possibility of a second round later in 2020 just as the northern hemisphere enters winter.

The rebound in equity markets since late March is built, at least in part on investor expectations that the worst is now behind us, cases and deaths have peaked and the economy will gradually reopen.

Governments, companies and people may now be better prepared than they were a few months ago, but that doesn’t mean that a prolonged period of re-shuttering and re-opening of the economy won’t be enormously disruptive.

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Retail investors getting spooked

No fee trading platforms such as Robinhood have seen a spike in account applications over the past few months. The combination of boredom, government corona related payments and the abandonment of all sports (and associated betting) has led a flurry of new retail investors into the market.

No doubt sitting pretty at the moment, praising their trading skills and pondering doing it full-time. Beginners luck of course my turn sour when the s*** hits the fan. A change in fortunes could mean that markets quickly give up their gains as sentiment shifts to disappointment.

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As of today (Tuesday 19th May) it’s been a full three months since financial markets went into a spasm as evidence of spread of coronavirus across the globe began to emerge, and the uncertainty over the potential negative health and economic impacts became more acute.

After a tumultuous period it’s worth taking a look back and seeing how far we’ve come. No surprises to see gold prices notching up a healthy 14% increase since the start of the year – the yellow metal has put on a strong performance as economic and political uncertainty has soared and concern that the debasement of fiat was now on steroids.

No prizes for guessing that energy prices – oil, natural gas and fuel – would be down sharply. While US natural gas is down 17% year to date, the benchmark oil futures contracts are down around 50%.

Of course the year to date picture masks massive volatility. Many commodity markets (especially oil and precious metals) sold off sharply during the first couple weeks of March as investors eyed the drop in energy demand and sold off precious metals to meet margin calls elsewhere.

The ideal pandemic hedge has come from a citrus drink that until recently suffered years of declining sales as consumers worried about the impact of teeth decay. Orange juice appears to have regained its status as a natural product to boost their immune systems. Consumers have also resorted to juice as consumers – worried about shortages and being in public places – have stocked up rather than waste real fruit.

Adverse weather in Brazil (one of the major producers) has also supported prices. Despite the rebound in orange juice futures since the start of the year, prices remain 50% below the record high prices achieved in October 2016.

Table: 2020 commodity futures price change – year to date

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History is a guide to how things will turn out in the future. Nothing more. But right now everyone is trying to search back into the realms of history for a guide to how the future will unfold; whether its pandemics, hurricanes or just boring recessions. From this analysis they prescribe a V, U, W, L or even an I shaped recovery.

However, new forces like technological developments, disruption, demographic change, political instability and media trends give rise to an ever-changing environment, as well as to cycles that no longer necessarily resemble those of the past. That makes the job of those who dare to predict macro more challenging than ever.

The accelerating pace of change may mean that the old cycles begin to play out much more rapidly in the future. According to hedge fund manager Howard Marks (author of Mastering the Market Cycle: Getting the Odds on Your Side), that may make the job of economists, analysts and investors much more challenging in the future:

I realised recently that in my early decades in the investment business, change came so slowly that people tended to think of the environment as a fixed context in which cycles played out regularly and dependably. But starting about twenty years ago – keyed primarily by the acceleration in technological change – things began to change so rapidly that the fixed backdrop view may no longer be applicable.

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There could of course be a contradiction in Marks’ prediction of the challenges involved in prediction. As can be heard almost any time someone frets about the future, there is the issue of hindsight bias. Someone says, “Things are uncertain, not like it was in the past.” The first part of that statement is accurate; the second is not. The future is always uncertain, whether it is the future we face right now or the future that people faced a century ago.

If Marks is correct, then how should investors react to this new market? Well, when change is both inevitable and gaining speed, a person’s ability to adapt to the market environment based on what can be observed here, right now, in the present is far more valuable than trying to predict the future. Evolution and those best able to take advantage of commodity market trends both favour those individuals and organisations that can adapt the fastest and most effectively to that accelerated change.

Believing that we know and understand where we are now can lead us into the temptation that we can then extrapolate this to the future (back to the alphabet soup). For the successful, a delicate balancing act is required to guard against this inherent demand in our psyche and from others around us. According to Marks:

We can’t predict, but we can prepare… the key to dealing with the future lies in knowing where you are, even if you can’t know precisely where you’re going. Knowing where you are in a cycle and what that implies for the future is very different from predicting the timing, extent and shape of the next cyclical move.

The advice for traders and investors is that instead of attempting to second guess the future direction of economies and markets, devote yourself to specialised research in market niches. These are the inefficient markets in which it is possible to gain a “knowledge advantage” through the expenditure of time and effort.

Try to know the knowable.

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