Editorial and Market Update
Volatility has defined the last financial quarter, as market uncertainty continues to pose a challenge to investors. Weak economic performance from China and low oil prices have continued to rouse negative sentiment in the market. The TSX closed out the quarter at -7.86 within 3 months. At 1 Year, the TSX performance is -8.38%. The US market did not fare much better with the S&P500 at -6.44% within the last 3 months, and a yearly performance of -0.61%. Bonds dropped -0.23% and -1.90% for 3 and 6 months respectively. Typically, the bond market provides some insurance against stock market volatility, but recent shifts in that sector have led to a decrease in stability overall.
What is at the root of this volatility? The first cause we can point to is China. As the second largest economy, China has a large influence on the world’s economic health. While their middle class has grown, the Chinese have focused on transitioning from an export-based economy to a consumer-driven one. This switch is far from complete as the Chinese are still extremely dependent on their capacity to export. This has proven difficult with a currency tied to the US Dollar. As the USD grew in strength, the RMB was thought by some to be overvalued against the rest of the world. As a result, Chinese exports became less attractive for other countries. To address the problem this summer, the Chinese intentionally devalued their RMB 2% against the USD. It may take a while before the results of this move are evident in China’s economic performance.
In an attempt to aid their precarious economy, the Chinese government aggressively encouraged the public to invest in their stock market. This introduced a new way for people to create wealth. The rationale was that if the markets go up, people would “cash in” and eventually have more to spend on a consumptive lifestyle, thus fueling a consumer-driven economy. The problem with this model is that markets do not continuously go up. What likely started as a normal market correction this summer turned into panic selling.
As of August 26, the Shanghai index had dropped 43% from its peak in June. Massive over-leveraging caused losses to mount quickly and the resulting market instability rocked the global equity markets. Chinese authorities made the decision to intervene and stop the losses. Many criticized their methods as they ceased trading on at least 50% of securities, arrested short sellers, and promised to funnel money into the equity markets. Media outlets even reported that Chinese officials had forced students to recite chants praising the stock market. To investors outside of China, this kind of market manipulation distorts transparency and lacks integrity. The global credibility that China has worked so hard to build over the past number of years is damaged by the Chinese government’s intervention. Skepticism towards the Chinese economic situation and the legitimacy of their valuations has risen dramatically and created significant market uncertainty for investors.
All countries rely on for growth from somewhere, and China has played a key role in global GDP over the past decade. There is significant concern that the Chinese economy is actually weaker than they are reporting. Singapore, often a leading indicator for the economic health of Asia, and China specifically, has experienced a significant slowdown. Reporting GDP at -4%, the next quarter’s numbers will indicate if they are in recession or not. In addition, the Baltic Dry Index (recording rates of sea freight) is near a 10-year low, which indicates the slowing of export activity from Asia.
The second notable cause of market volatility is low oil prices. Much has been written on the topic already, but there are a few new factors worth considering. The Russian geopolitical story continues to develop with their recent military move into Syria. This decision has the power to influence commodity pricesin the medium to long term. Instability in the Middle East tends to cause market uncertainty, as markets anticipate less supply because of conflict in the supply-rich zones. This fear drives commodity prices up. With a broader escalation in the Middle East, the highly commoditydependent Russians may benefit from instability throughout the region.
Historically, the USD and the price of commodities have an inverse relationship, since most commodities are priced in USD and investors recognize the high price they will pay for the commodity when the USD is strong. This relationship recently played out after the Fed made a decision not to raise interest rates. Immediately, we saw a drop in the US Dollar, followed by an increase in the price of oil. A decreased US Dollar would not only help commodity prices to rise, it would also allow the country to be more successful in exports. For these reasons, many believe that a high US dollar is not preferable.
There are different ways a country can attempt to pull down their currency without direct manipulation (like China). Historically, some countries have entered into negotiations to pull down their currency value to avoid a trade war, as in the 1985 Plaza Accord. A negotiated agreement today would likely be far more complex and require participation from many more countries.
Another method used to lower the value of a currency is for countriesto “talk it down” by publicly discussing some of the problems in the economy. In the case of the US, they could highlight the fact that although employment has grown, wages have remained stagnant and the participation rate has dropped to 60%. Despite the years of QE, money is stuck in the financial and banking system rather than being lent out to businesses. Some businesses that do have liquidity are spending it on share buyback programs, which drive stock markets higher, rather than hiring or buying equipment (ex., Hewlett Packard Co. and Bebe Stores Inc.). Remember, a rising stock market does not necessarily mean the economy is healthy.
Perhaps, more than ever before, this quarter’s volatility reminds investors to ensure that their portfolios accurately reflect their risk profile. If the investor does not have the time to wait out volatility, then some may argue that they have no business investing in traditional equities. Investors who honestly assess their financial situation, while evaluating their emotional ability to accept volatility, will stand a better chance of satisfying their investment goals.
On Humility & Diligence
You know the two governing emotions of the markets, Greed and Fear, but equally important are the two determinative character traits of investment: Diligence and Humility, along with their corresponding vices: Sloth and Over-Confidence. Undoubtedly, there are many other important virtues and skills involved in investment, but these two come up over and again in investment tales of triumph and defeat.
Diligence refers to the unceasing activity of pursuing one’s goals and the constant reorientation to right priorities. That does not mean “Just do something, even if it’s wrong,” as the old adage goes, rather, it means careful consideration and analysis before acting. At Covenant, we believe that diligence involves long research that sometimes results in passing up interesting, but ultimately not ideal, opportunities. Diligence involves monitoring an industry, firm, security, or macroeconomic trend for months or years before using that information to trigger a trade. This understanding drives us to work hard to ensure the trustworthiness and continued competence of our strategic partners where a less diligent investor may be content to “let it ride”. As a strategy, this may not look as exciting from the outside, but it is precisely the kind of preparation needed to strike fast when great opportunities arise.
A lack of diligence ruins an investor bit by bit like rust, but it is often the other vice - Over-Confidence, a particular manifestation of pride, that leads to the most spectacular failures in finance. On the importance of humility, John Chrysostom, the Early Church Father, once said,
“Humility is the root, mother, nurse, foundation, and bond of all virtue.”
However, we must not confuse humility with polite pretensions of modesty. Speaking of weightier matters, C. S. Lewis said,
“Perfect humility dispenses with modesty.”
To speak with competence and ambition without falling prey to over-confidence istricky. It is even more difficult to act with conviction and diligence without acting out of undue confidence.
Over-confidence ruins an investor by either lack of activity or by surplus:
To explain a lack of activity, look to many of the large banks and pension funds whose notoriously bad trade in the 2007-2008 crisis was the insuring of sub-prime credit. While trusting enormous research departments and credit analysts, they failed to put in the work necessary to assess the risk, while a few small diligent firms were able to determine that they should bet heavily against these same risks.
Going back to the previous crisis of the dot-com bubble, we see a perfect example of over-confidence by surplus of activity. The iconic loser in 2000 was the day-trader with an ego inflated by years of immoderate bullishness that rewarded even the most naïve long strategies. The convergence of a heroic industry to bet on, and the technology to do it, resulted in a furious churn of activity that ruined the vast majority of individual day-traders as the NASDAQ dropped precipitously. For some time afterward, exploring the psychology of these losing strategies driven by overconfidence was a favourite topic in academic finance.
Speaking of popular academic theory: Bernard Mandeville’s 18th century theory that “private vices” result in “public benefits” has waxed and waned in popularity over the years. Our understanding is that public benefits that come from the exercise of vice are most often misunderstood public detriments. Nearly as often, the nature of private vice and true virtue are misconstrued. Virtue, though it is thought to be selfevident, is a concept that requires that we have our senses constantly trained to discern good and evil (Hebrews 5:14).
Team Updates
We are pleased to have welcomed two new team members over the past quarter. Dora and Jennifer both come to Covenant with many years of experience in the industry. Dora has taken on the role of Administrative Assistant, while Jennifer has joined as Stephen’s Executive Assistant. She will be supporting Stephen in all areas of Compliance, Scheduling and Operations.
After working as Stephen’s assistant for the past four years, Elyse recently moved into a new role in Business Development. Her role will focus on providing information to outside dealers while also aiding the team with marketing resources. We are excited to add this new position, as it strengthens our team and allows us to continue to provide clients with excellent service.