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Early Cycle: Disconnects and Volatility

By Ben Viemeister, CFA
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In this article we examine the interplay of markets, the economy, and volatility.

Layoffs. Bankruptcies. Vacancies. Despite persistent negative economic news, financial markets have rallied. This disconnect can cause confusion. How can these two dynamics take place at the same time? Confusion can lead to fear. In fact, one measure of individual investors’ fear of a market crash remains near a cycle high. What follows is an examination of the disconnect between the markets and the economy, and what implications it may have on Osborne Partners’ investment strategy.

Employment is a prime example of the disconnect between the markets and the economy. April 2020 saw unemployment spike to around 15%, the highest level since data began in 1948. It remains elevated. Layoff news is frequent, unfortunately, with numerous well-known companies announcing layoffs in late September. But as the chart below shows, unemployment peaks after equities bottom; over the three previous cycles shown in the chart, unemployment peaked around 11 months after equities had bottomed and started to rally.  Every recovery cycle has a period where unemployment is high even as equities rally.

In addition to equities’ relationship with unemployment, other asset classes exhibit a similar dynamic of market recoveries happening even as fundamental headlines are negative. In real estate, commercial real estate assets have historically bottomed around two years before vacancy rates peaked; residential real estate assets in the past have bottomed around a year before mortgage delinquencies peaked.  In corporate credit, high yield credit spreads, which reflect how much yield investors demand over Treasuries to take on the risk of default, peak and start to improve before actual defaults and bankruptcies peak; for example last cycle, spreads peaked over a year before bankruptcies peaked.  All these examples are reminders that economic indicators like unemployment, bankruptcies, delinquencies, and vacancies, look backward. Markets look forward.  A few forward-looking factors generally impact the pricing of financial assets: growth expectations, interest rate assumptions, and compensation for expected risk (i.e. risk premium).

Shifts in these forward-looking factors create price volatility in markets. This is especially the case early in economic recoveries like today. Uncertainty remains elevated about the recovery’s trajectory as recoveries are often jagged not straight lines. The disconnect between the economy and markets often is most evident at this point in the economic cycle. Common uncertainties include: How sustainable is stimulus? How resilient is the consumer in the face of weak labor markets? How confident are businesses to invest and grow despite weak demand and a hazy outlook? And in this cycle: What is the path of the Coronavirus? How will the election end? Not until questions like these are answered does volatility dissipate.

The phenomenon of elevated uncertainty amid disconnects between the economy and markets early in a recovery cycle are shown in the following graph. Early economic recoveries in the early 1990s, early 2000s and 2009 – 2012, saw the volatility index, a measure of the market’s expectation for volatility in the S&P 500 based on the options market, remain elevated with sharp swings. Volatility declined as the recovery matured. Today’s early recovery is no different: at the end of the third quarter of 2020, volatility remained elevated, at around one standard deviation above normal.

Every early recovery exhibits a disconnect between the market and the economy. Every early recovery, however, has unique characteristics. This cycle, the intensity of the disconnect is arguably greater than past recoveries given the swiftness and severity of the COVID-induced recession that saw record unemployment in April, a record decline in US gross domestic product in the second quarter, and record monetary and fiscal stimulus. Exacerbating this cycle’s disconnect is the market’s extrapolation of recent strength in ecommerce, software, and other tech-related companies. This, along with the stimulus, has buoyed equity markets, even as the economy deals with the fallout of the recession. All is not negative however. Positive unique factors this recovery cycle are that consumer and financial system balance sheets were stronger and there was less investment excess going into this recession versus past recessions. These factors create a stronger base on which the recovery cycle can build.

The uniqueness and inherent uncertainty of early recoveries, along with the disconnects that can appear, creates investment opportunity. Osborne Partners’ portfolio management strategy is positioned well to benefit. Osborne Partners applies a diversified, style agnostic approach across global asset classes. When this is combined with the flexibility to deviate from benchmarks, the odds of capturing opportunities can improve. Osborne Partners continuously reassesses asset-specific risk-reward and possesses a willingness to sell assets that no longer provide attractive risk-adjusted return. Pairing this with a disciplined approach to deploying cash can make portfolios more resilient during market declines and more dynamic in capitalizing on periods of uncertainty.

Today’s elevated volatility and disconnect between the market and the economy are consistent with past early economic cycle recoveries. The uneven path of all recoveries and uniqueness of today’s recovery should present attractive opportunities for Osborne Partners’ diversified, flexible, disciplined, and dynamic investment strategy.

Ben Viemeister, CFA

Ben is an Investment Analyst at OPCM and has over 10 years of experience. Ben is a member of the OPCM Investment Management Team, and is responsible for research coverage in all asset classes. Ben is a member of CFA Society San Francisco and CFA Institute. Ben graduated summa cum laude from Lynchburg College with a B.A. in Economics and is a CFA Charterholder.
The opinions expressed herein are strictly those of Osborne Partners Capital Management, LLC ("OPCM") as of the date of the material and is subject to change. None of the data presented herein constitutes a recommendation or solicitation to invest in any particular investment strategy and should not be relied upon in making an investment decision. There is no guarantee that the investment strategies presented herein will work under all market conditions and investors should evaluate their ability to invest for the long-term. Each investor should select asset classes for investment based on his/her own goals, time horizon and risk tolerance. The information contained in this report is for informational purposes only and should not be deemed investment advice. Although information has been obtained from and is based upon sources OPCM believes to be reliable, we do not guarantee its accuracy and the information may be incomplete or condensed. Past performance is not indicative of future results. Inherent in any investment is the possibility of loss.