As noted in a Dec. 15 Bloomberg article, “VIX Note Volume Proving Prescient as Volatility Surges,” the VIX, “a measure of trader anxiety that has spent most of the year hovering about 25 percent below its historical average, jumped 78 percent as oil’s impact rippled through financial markets.”
In other words, there is a lot of fear in the market. Though it was sparked by a huge drop in oil, today’s geopolitical backdrop provides additional sources of fear that further increase investor angst. This heightened fear in the markets has been reflected in falling asset prices — especially assets that are risky, such as junk bonds and emerging markets.
How does this growing market fear relate to short-term traders? They are focused on what asset prices will do tomorrow. On the other hand, long-term investors are more concerned about what all of these current events mean in the longer term. This overlap between short-term traders, who are seeking to front-run changes in asset prices, and long term investors, who are trying to stay focused on the bigger picture and who engage in a more disciplined approach to asset allocation, is often where the disconnect occurs.
For investors to understand how they should react to news and price movements, it helps to make a distinction between risk and volatility. Though the two concepts are often considered one and the same, nothing is further from the truth.
The way in which volatility and risk are interconnected has mostly to do with the investor’s time frame. If money is set aside for an emergency or near-term expenditure, then of course, the greater the volatility, the greater the risk. However, if the investor is able to stay invested for a longer period of time, then volatility is much less of a risk factor than it is a test of one’s nerves to hold fast and keep the long-term view in mind.
Looking to the 1997 Asian Crisis
The primary historical analogy that is being drawn between what is happening today and what has happened before is the Asian financial crisis of 1997, which was followed by Russia’s currency devaluation and subsequent defaulting on its debt in 1998. Today’s slump in oil prices, the strengthening of the dollar that has pushed many currencies down, and now Russia moving toward what looks like a default, all seem eerily reminiscent of what happened in 1997-1998.
Some analysts believe that the markets are about to experience the same kind of pain in the near future that it felt back then. Others argue that there are some major mitigating circumstances this time around. In particular, Bloomberg points out that, similarities aside, today (as opposed to 1997-1998) within the developing countries, exchange rates are more flexible, foreign reserves are much higher, much of the debt is denominated in local currencies and interest rates are much lower — all of which bode well as the emerging markets encounter a strengthening dollar, plummeting oil prices and the possibility of the Fed moving interest rates higher in 2015.
From the perspective of the short-term trader, this recent volatility and what it portends for the near future is of great concern. Once the fear of financial contagion sets in, it tends to spread rapidly, keeping prices volatile until fear begins to dissipate. From the perspective of the long-term investor, this “fear of contagion” is relevant only if it represents a long-term change in how market cycles tend to play out. Looking back to the Asian and Russian 1997-1998 crisis, it is informative as to what might be expected this time around.
In the case of the Asian crisis, the situation was extremely bad for the currency and asset prices of Asian (particularly Southeast Asian) countries. Later, as the price of oil went to $11 a barrel, this contagion spread to Mexico and Russia. Though the collapse of the Long-Term Capital Management (LTCM) hedge fund (caused by the Russian default) threatened to spread the contagion to the developed markets, that never happened thanks to quick action on the part of Fed Chairman Alan Greenspan, who orchestrated the buyout of LTCM.
Three years after the Asian crisis, the IMF reported that, “the financial crises that erupted in Asia beginning in mid-1997 are now behind us and the economies are recovering strongly … this rebound did not happen spontaneously, but came about as a result of steadfast policy implementation by the affected countries and large-scale financial support from the international community.” Russia also climbed out of its financial hole after oil prices began climbing in 1999-2000 and even ran large trade surpluses in 1999 and 2000.
Even if the differences between EM then and EM now are set aside, one can still look back on the 1997 Asian and subsequent 1998 Russian crisis as a time when developing markets were going through a crisis/adjustment period, as all major economies will do from time to time. Move forward post-crisis, and EM experienced explosive price appreciation between 2003 and 2007.
A Global ‘Invisible Hand’
Now the market cycle seems to be back to where it was in 1997-1998, though with stronger structural protections in place as well as a more solid economic footing than before. The Russians are saber-rattling but, unless they want an all-out war — which few believe they do — it ends there and the market and geopolitics get rebalanced.
Short-term traders are less concerned with the bigger picture than they are with trying to do their best to come out ahead on tomorrow’s trade. The long-term investor focuses with a wider set of lenses so as to be able to realize the benefit of being able to take a longer-term perspective.
To use Adam Smith’s term, globalization seems to have an “invisible hand” at work in the world economies. As the global economy continues to evolve, it becomes increasingly interconnected. Consequently, for the world’s different financial markets to be individually successful, they need for their major counterparts to experience success (often at different times) as well. This is evident as one studies the historical ebb and flow of the various economies. Today the U.S. is on top, with a strong dollar, low interest rates, low inflation and a growing economy. However, as the 1973-1974, 2000-2001 and 2008-2009 bear markets attest, these fortunes can change very quickly. Thus, there is an ongoing rebalancing that is continually taking place across the global markets — an “invisible hand.”
The trends we are seeing today — a strengthening dollar, plummeting oil prices and slowing growth in many of the EM countries — seem to favor less risky assets. That may be true over the short term, but we know that trends move in cycles and that no one knows when they will begin to reverse — as they always have in modern times. Hence the strong case for diversification and the periodic rebalancing of portfolios.
This message may be meaningless to the short-term trader who is focused on volatility, but it is very meaningful to long-term investors (e.g., DC investors) who are much less concerned about short-term volatility and, instead, are focused on long-term risks.
If long-term investors focus on following the advice of short–term traders who are trying to front-run asset prices, they most certainly will be whipsawed in the process. There is only one way to avoid falling prey to short-term traders: ignore their advice about how to respond to volatility.