INSIDE
A closer look at what was behind the recent flash crash
Central bank policy and currency markets are having an outsized influence on equity markets, more than many realized. The recent and unexpected meltdown and recovery was a bit of a wakeup call.
The benefits of risk-managed investing
Market flash crashes provide a great test of our risk processes and strategies. Our risk-managed approach of implementing downside protection on well over three-quarters of our positions has really helped us avoid the sell off while being well positioned to capture some strong risk-adjusted returns going forward.
Update on our strategic positioning
We are quite comfortable with our current positioning weighted heavily to structured notes in both the fixed income and equity space complemented by a hedged long U.S. equity, hedged U.S. small cap, Canadian oil and gas, and a strong weighting to those segments that will benefit from falling interest rates.
August 2024 – “Tomorrow, tomorrow’s wind will blow.”
Welcome to this month’s Market Strategy. This edition we take a closer look at what caused the huge spike in volatility sending global markets suddenly correcting before subsequently rebounding in short order. In particular, we examine what is called “the yen carry trade” and how central bank policy and currency markets have had an outsized influence on equity markets which has created some opportunities as well as some new risks.
Our risk-managed approach was put to the test and our downside protection on well over three-quarters of our positions really helped us avoid the sell off. For example, prior to the crash we also sold some of our U.S. dividend exposure and replaced it with a hedged put spread collar on the S&P 500 and did a similar trade on the Russell 2000. As a result, while many segments of the market corrected double digits, we calculate that our risk-managed balanced fund fell only 0.3 per cent giving back some of the 8.1 per cent gained year-to-date to the end of July.
This didn’t mean we were sitting idle though. Our contrarian nature had us adding those segments of the market that have nothing to do with the yen unwind but suffered losses even deeper than the tech sector, such as Canadian oil and gas, and other areas like Canadian utilities and banks that will benefit from accelerated rate cuts.
Ultimately the Bank of Japan caved last Wednesday and was willing to let its currency continue to depreciate in order to protect its equity market. That decision resulted in a steep recovery in global risk along with a rebound in those segments that sold off the hardest.
The lesson in all of this market drama is that there is value in being able to sleep at night—especially if it means not having to stay up to follow Japanese equity and currency markets.
Finally, we are honoured for our TriVest team to have received the Wealth Professional 5-Star Advisory Teams award. A special thank you to all of our clients out there who provided the review to Wealth Professional.
Hope you have a great summer, and keep investing wisely!
A closer look at what was behind the recent market volatility
The market volatility we’ve seen over the past two weeks has been quite astounding to watch. The Volatility index rocketed higher as investors sold equity positions across the board with more speculative assets like U.S. tech, and crypto getting hit the hardest.
It all started with some weaker U.S. economic data on Thursday, July 31 and Friday, August 1 following the Federal Open Market Committee (FOMC) meeting on Wednesday July 30. Traders reacted by taking the probability for a 50 basis point rate from 11 per cent up to 70 per cent while the Bank of Japan hiked 25 basis points.
This wasn’t about worries over a U.S. recession but rather a massive liquidity squeeze as investors have been borrowing in yen and investing in U.S. assets like big tech. With the Bank of Japan hiking rates and the expectation of a larger rate drop by the U.S. Federal Reserve (Fed), it caused a portion of the U.S. $4 trillion yen carry trade to unwind and quickly.
Don’t kid yourself, this has been a powerful liquidity trade. For example, we calculate that the yen has depreciated nearly 35 per cent against the U.S. dollar since its January 2021 highs to its mid-July 2024 lows while the Nasdaq was up nearly 50 per cent over the same period.
Interestingly, we noticed a lot of panicking among those in the more speculative assets such as tech with calls for the U.S. Federal Reserve to do an emergency rate cut. Wharton’s Jeremy Siegel led the charge as only three days into this unwind and he was calling for a 150-basis point cut.
However, given the current situation we find it astounding that they would make such a demand but perhaps it’s out of habit of getting bailed out by the Fed many times over the past decade.
If U.S. Federal Reserve Chairman Powell was more dovish and indicated a 50-basis point potential drop in September and/or went 25 basis points on their July 30 Wednesday meeting, imagine the impact that would have had on the markets accelerating the depth and size of the yen carry trade unwind. Then think about what would happen if the Fed took Siegel’s advice.
There are a couple of important take aways for investors here.
Markets don’t always go up, and as Charlie Bilello of Creative Planning said, “suffering through drawdowns is the price of admission for long-term investors, without which there would be no reward.” This is especially the case for younger investors who are early in their savings and can take advantage of price sales in the market by averaging in.
For those older investors, corrections like these are a fantastic “gut-check” as to your ability to emotionally withstand corrections to your portfolio especially if it’s important for you to keep pace with the hottest market segments.
We have taken a different approach by focusing on risk-managed returns by implementing downside protection on well over three-quarters of our positions. This means that while we will not fully track high growth segments of the market it also means we won’t move to the downside. For example, while many of these segments corrected double digits, we estimate that our risk-managed balanced fund fell only 0.3 per cent at the lows of the meltdown giving back some of the 8.1 per cent gained year-to-date to the end of July.
This didn’t mean we were sitting idle though as our contrarian nature also had us adding those segments of the market that have nothing to do with the yen unwind but suffered losses even deeper than the tech sector such as Canadian oil and gas, and other areas like Canadian utilities and banks that will benefit from accelerated rate cuts.
The good news in the end was that the Bank of Japan caved last Wednesday and indicated no further rate hikes as long as markets are unstable resulting in a steep recovery in global risk, and in those segments that sold off the hardest—for now. It is almost as if the correction never happened, but it did, and there is a lesson or two to be gained from it.
The power of choosing your own path when investing
Nothing is more powerful than greed and envy when it comes to money. Greed is relatively easy to understand, but in order for envy to be a driving force, you need to have a baseline or reference point to compare to something else that is better than your present situation. Or as Warren Buffett once said, “It is not greed that drives the world but envy.”
Those in the sales industry know this all too well. For example, a common tactic among realtors is to purposely show their clients a few not-so-desirable homes first and then follow it up at the end with more attractive homes they think their clients would want to buy.
We’ve seen investment advisers deploying a similar anchoring or benchmarking tactic, such as comparing their tech-heavy portfolio’s performance this year against lacklustre indexes such as those in Canada and Europe or even the equal-weight S&P 500 as a means to secure new business.
You don’t own Nvidia Corp.? Don’t worry, they say, you didn’t miss out since market pundit Tom Lee recently said it has the potential to be a 10-bagger over the next 10 years, giving it a market value greater than the entire U.S. economy.
Exchange-traded funds (ETFs) and other fund launches often feed into this and correspond with the hottest market segment, knowing full well there is an excellent correlation between fund flows and recent performance.
I’m sure we’re not alone in noticing that the most-traded and fastest-growing ETFs happen to be those focused on the Nasdaq or semiconductors. Feel like you missed out? It’s OK, play catch-up by owning the leveraged version of the index, which we’re all too happy to provide, fund providers say.
The problem with envy is that you’re never going to be happy because there is always going to be someone or something better out there. It could even prove to be destructive if you take greater and greater risks to try to beat everyone else.
This is why we’re a huge fan of investing based on your own goals and objectives and designing strategies around achieving them while minimizing the risk. Suddenly, it isn’t about beating everyone else, but doing your own thing.
Let’s give you an example of one such strategy we’ve deployed that suits this approach.
There has been a lot of market talk around the sustainability of the recent rotation out of U.S. large caps into U.S. small caps, which will benefit from an improvement in the broader economic outlook of the U.S. economy. Unfortunately, this rally resulted in a structured note paying us a nice 10.3 per cent coupon on the iShares Russell 2000 ETF being called away, leaving us with funds to redeploy.
So, we bought the ETF outright, paired with an at-the-money put through to January 2025 and made it costless by selling an out-of-the-money put and call with the same strike date. As a result, the payoff profile is such that our new position on the Russell 2000 will have a capped upside of eight per cent over the next six months and full downside protection on the first 13 per cent in case we get it wrong and the U.S. economy stalls.
An eight per cent return over six months may not be sexy for those chasing tech stocks, but it more than meets the goals and objectives for all our clients.
Our tactical positioning
Currently, within our TWC Risk-Managed Balanced Growth fund, we’re running about 8 per cent cash and money market paying about 5 per cent in interest, 3.4 per cent in U.S. floating rate bonds paying nearly 6 per cent, 4 per cent in a 1.2 times 20-Year Treasury note with 20 per cent downside protection (our recession hedge), 21 per cent in fixed income structured notes with 100 per cent principal protection and yields ranging from 7.0 to 8.5 per cent and about 3 per cent equity tracking principal protected notes.
We also have a 30 per cent weighting to equity structured notes, generating some fantastic yields with embedded downside protection ranging from 25 to 50 per cent. Some of the yearly autocallables we’ve written over the past year to two years have been getting called away, locking in some strong double-digit returns along with some monthly contingents that have been generating 8 to 12 per cent annual returns with most outperforming their underlying equity indices.
We have replaced a lot of our yearly autocallables with monthly contingents as we like them from a risk standpoint in a market that appears to be a bit shaky with more downside.
For example, we did one on the Canadian pipes paying an annualized 11.52 per cent out monthly with 25 per cent downside and one on $BNS, $BCE, $EMA, $ENB, $TC, $T that is paying an annualized 10.23 per cent out monthly with 30 per cent downside. We did a 100 per cent principal protected note on Canadian Blue Chips that will pay a 40 per coupon if the index is between 0 to 40 per cent over the next 42 months, and track one-for-one any index returns above that.
We also implemented a put spread collar trade on the IWM ETF representing the Russell 2000 through to January 2025. It will have a capped upside return of 8.5 per cent with full protection on the first 15 per cent of a correction. Finally, we replaced our U.S. dividend exposure with the Simplify Hedged equity ETF (HEQT) which is an ETF that ladders the put spread collar trade into the next forward 3 months offering decent capped upside and downside protection.
As a result, nearly our entire U.S. equity exposure has decent downside protection in case things get rocky over the next few months especially heading into the U.S. election. In total, about 85 per cent of our total strategy portfolio has embedded downside protection with decent upside return potential at a time when things are getting more volatile in global markets.
In the media
BNN Bloomberg: Martin shares our thoughts on the market volatility we’ve seen over the past few trading days, what was behind it and the importance of understanding the relationship between risk and return. Watch Here
Financial Post: While equity market volatility has picked up considerably, most of Main Street in Canada are suffering the effects of a seriously weakening economy. Martin’s piece on why we’re worried about the collapsing Canadian economy and some ways to protect yourself. Read Here
BNN Bloomberg: Martin shares our thoughts on $BCE, some ways we’re positioning around it as a trade, the market sell off after sleeping on yesterday’s FOMC, and some hedged strategies we’ve been deploying via $IWM and $HEQT. Watch Here
Unusual Whales: This episode of the Unusual Whales Pod was recorded Live on July 31, 2024 prior to and after the FOMC interest rate decision. Our panel of experts cover all topics from gold and commodities, to international inflation sentiment, as well as the overall outlook in the markets for the latter half of 2024. Listen Here
Financial Post: Martin zeroes in on the biggest risk to your wealth and happiness—envy. And some strategies we’ve been deploying to minimize this from impacting your portfolio. Read Here
BNN Bloomberg: Stocks rise as investors look beyond Biden’s exit. Laura Lau, CIO of Brompton Group, Martin Pelletier, senior portfolio manager for Trivest Wealth at Wellington-Altus Private Counsel, David Doyle, head of economics at Macquarie Group, join BNN Bloomberg to discuss investing strategies amid uncertainty. Watch Here
BNN Bloomberg: Part I – Portfolio manager Martin Pelletier predicts strong Q2 U.S. stock season straying away from tech. Watch Here Part II – Some strategies we’re deploying heading into the second half of 2024. Watch Here
Financial Post: Martin’s column on the dangers of FOMO chasing the S&P 500 as there isn’t always safety in the herd. So perhaps it’s worth considering investing based on your own goals and objectives and not trying to keep up with or beat everyone else? Read Here
BNN Bloomberg: Martin’s thoughts on this market environment, some of the risks of an overly concentrated U.S. equity market, the falling CAD, bonds, and some ways we’re positioning. Watch Here
UPCOMING EVENT: We’re thrilled to have Martin join us. With over 20 years of experience in the investment industry and an admirable track record as a Senior Portfolio Manager at Wellington-Altus Private Counsel, Martin’s expertise will be invaluable to the event. His impressive credentials and media presence make him a standout in the field. Welcome aboard, Martin!
What we’re reading
U.S. tech layoffs. In 2024, tech companies have laid off +126,032 people. See Here
U.S. earnings season. This has been the most volatile earnings season since the Global Financial Crisis according to Goldman Sachs. See Here
Goldman bull or bear? Compared to the previous bull market correction, the current S&P 500 drawdown has been sharper, tracking the average bear market. See Here
Yen carry trade unwind is only about halfway finished, JPMorgan warns. ”We think that the carry trade unwind within the speculative investing community is maybe somewhere between 50% and 60% complete.” Read Here
Markets must navigate well beyond one bounce. The selloff’s damage to the tectonic plates of global finance won’t be clear for weeks. Read Here
Warren Buffett’s Berkshire Hathaway sold nearly half its stake in Apple. Isn’t this an interesting development especially considering how much cash he is already sitting on. Read Here Also, did Buffett learn from his positioning in Coke? Watch Here
What if Generative AI turned out to be a Dud? “I just wrote a great piece for WIRED predicting that the AI bubble will collapse in 2025, and now I wish I hadn’t. Clearly, I got the year wrong. It’s going to be days or weeks from now, not months.” Read Here
Commodities once again a hated trade. Hedge funds turn bearish on commodities for the first time in more than 8 years. See Here
“’Quite striking’ oil markets haven’t pre-emptively priced in Mideast tension.” Daniel Yergin, S&P Global vice chairman and ‘The New Map’ author, joins ‘Squawk Box’ to discuss the state of the energy sector, impact of Middle East tensions on oil supplies, and more. Read Here
Aramco CEO says oil demand is strong and recent selloff was overreaction. Saudi oil giant sees demand “north of 106 million b/d” in 2025 and “robust” oil use points to “fairly healthy” market: CEO Read Here
A bit of a bias here? A closer look at how the EIA has consistently underestimated oil and gasoline demand in their reporting. Read Here
What career risk looks like. If you diverge too far from what others are doing and miss out on the rally you face redemptions and getting fired. If you participate in the correction, you have the excuse that everyone else is doing poorly as well. This is how our industry works. See Here
On the Positive
Words. Words have power. Words can be our power. Words can unite or divide. Words can spit venom or can mend a broken soul. Words matter. Watch Here
Effort does not change the person. You truly win the love of others not by the practice of techniques but by being a certain kind of person. And that is never achieved through effort and techniques. And so, it is with spirituality and holiness. Not what you do is what brings it to you. This is not a commodity that one can buy or a prize that one can win. What matters is what you are, what you become. Read Here
Now that’s winning. He sacrificed becoming a world champion to help his brother cross the finish line! This is a precious moment that will never be forgotten in a lifetime. Watch Here
Quantum computing. The next decade is going to be amazing. Watch Here
Martin Pelletier is an investment pro columnist for the Financial Post. His columns can be read here every Monday afternoon as well as his active Twitter feed.
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