Just how volatile have the markets been the last two months? Would you be surprised to know that August and September 2011 rank amongst the top 5 most volatile periods in the last 50 years? I was. I knew things were bumpy but I didn’t realize they were Top 5 bumpy.
Volatile markets with high correlation can be the bane of the stock picker’s existence (Correlation article) because it is difficult to monetize idiosyncratic value when everything is moving wildly in the same direction. Many of the clients I’ve spoken to over the last couple of months have reduced exposure by lowering gross and net exposure. In fact, I was recently working with a client and developed a heuristic method to suggest gross exposure based on a few general factors:
A portfolio manager uses this rubric by defining the minimum and maximum gross exposure for their portfolio, defines a combination of external and internal factors to determine exposure, then creates Risk-On and Risk-Off parameters for each factor. The external factors like volatility, correlation, and S&P PE Multiple help highlight when the markets are difficult for fundamental portfolio managers to navigate. The counterbalance is the internal factors (Portfolio RAR and Downside Risk) that highlight the current opportunities derived from the firm’s investment process. Is the Portfolio Risk-Adjusted Return high and is the Portfolio Downside Risk low? If so, a portfolio manager may be willing to wade into the chop of the market to harvest the opportunities.
As volatile as this market is today, it doesn’t come close to the bouncy house in a tornado we went through in Oct 08-May 09 (6.4% average intraday change versus 3.0% today). Additionally, the direction of the market was pointedly up or down during ‘08/’09 (mostly down) versus the current market which is more mean-reverting. This creates an environment for Capitalizing on the Random Walk. If you look at the oscillation in the example below, you will see that while a stock increases in value, the position size increases (because the total number of shares stayed constant) but the Risk-Adjusted Return falls. The dynamic of increasing exposure when return falls is counter to sound portfolio management. Continuing the example the stock falls to $27 then rises back to $30, no trading has occurred and the resultant trading profit is $0.
But for fundamental investors that have a sense of long-term value, the gyrations create opportunity. See in the example below that as the price rises, the risk-adjusted return falls, and the position is reduced. The counter occurs as the stock decreases. In both examples, the beginning and ending share count is identical but “Capitalizing on the Random Walk” below creates 50bps of additional return net of commission. This is one stock out of dozens in the portfolio that have moved like this over the past two months.
Taking advantage of market volatility certainly isn’t top of the list when describing value investors but if expected return changes then the disciplined investor should react. A firm should create a disciplined method to highlight disparities between position size and risk-adjusted return. This is critical to Capitalizing on the Random Walk.
Here are a few quotes that lend credence to the strategy:
“When the facts change, I change my mind. What do you do, sir?” – John Maynard Keynes
“Our trading models tend to buy stocks that are recently out of favor and sell those recently in favor. Thus, to some extent, our actions have the effect of dampening extreme moves in either direction, and, as a result, reducing volatility in those stocks.” – James Simons, Renaissance Technologies (testimony to Congress 11/13/08)
“We as a firm are always going to buy too soon and sell too soon. And I’m very at peace with that.” – Seth Klarman, Baupost Group
“When JP Morgan was asked how he had become so rich? He replied, “I sold too early.” – JP Morgan, famous financier
“The riskiest moment is when you’re right. That’s when you’re in the most trouble, because you tend to overstay the good decisions.” – Peter Bernstein, legendary investor
“Make a rule: Whenever an investment doubles in price, find out who has the most negative view of it and give this devil’s advocate a full hearing.” – Jason Zweig, author of Your Money and Your Brain