Apparently Hope Is A Strategy

Did anyone see this coming?


YTD Total Returns as of 10/31/2019

From what we can tell, few investors expected such a broad and decisive show of strength from all corners of the financial markets. We have certainly been among the more cautious. As we wrote last quarter, uncertainty and volatility tend to go hand-in-hand in our experience, and we’ve just explained how greater uncertainty lowers the expected value of assets over time. So, when we see an environment in which these natural relationships between uncertainty, asset values and volatility break down to an unprecedented degree, it seems likely we haven’t seen the end of this market’s story just yet.

But who is driving these markets higher? Apparently, no one knows. Financial news services are full of quotes from every strategist and fund manager they interview calling this market “ridiculous,” “exhausting,” or something similarly exasperated. Some stories even cite social media posts, just to prove that even people who aren’t professional investors are incredulous when it comes to unexpected moves in the markets. Apparently, everyone is surprised, and no one seems to want to admit they are among the investors perpetuating a bull market that few saw as inevitable and many argue is unsustainable.

Which leads us to wonder: Are the investors buying in the current environment truly optimistic about the market’s prospects for gains? It would be easy for us to write about how this behavior makes no sense, but the hard reality for those who see themselves as risk managers is that this makes perfect sense. After all, more than a few (including us) have warned about growing downside risks at the start of each year since 2011. And, in some years, some warnings came true, if only temporarily. We just experienced one such event in late 2018 as bank loan investors seemed to finally realize the inherent risks in this asset class. Until it didn’t. Prior to this decline, the loan market experienced unprecedented growth due to historically loose monetary policy, increased demand from risk-seeking investors and the benefit of floating rate debt if interest rates increased. Today, with lower interest rates and a potential recession looming on the horizon, the loan market hasn’t learned many lessons from the fundamental fears from last year and sits at an all-time high.

This is not an isolated observation, limited to any one asset class. Time and time again, fear in the market has been met almost immediately by fear of missing out. Some skeptical investors who reduced risk in their portfolios have not been rewarded for doing so, and others have been conditioned to bet against their own views to maintain or add risk. For this latter group, market declines are expected due to fundamental weakness, and market gains are lucky… and now predictable after years of negative sentiments being offset by positive markets. In year one, they complained about less risk-minded investors getting lucky. Nine years since 2011, this has become a market in which “getting lucky” buying dips is the expected outcome and the most prevalent strategy.

However, we think this year holds a particular risk to this strategy of luck. Wall Street has a tendency to react to its own missed or exceeded expectations in the last quarter of the year. If traders, especially those managing proprietary portfolios at banks and hedge funds, are more profitable than anticipated in a given year, they find themselves in line to get unexpectedly generous bonuses, which are usually determined based on a trader’s profits and often formulaically so. Naturally, the psychology that tends to take over is one of paycheck preservation. Why risk giving back gains from a bull market they didn’t expect if the market declines to where they thought it would go anyway? In response to this mismatch between expectations and reality, traders often sell their “risk-on” positions and lock in gains to make sure their profits are preserved through bonus day. The bigger the difference between market sentiment and performance, the more likely this is to happen.

To be clear, we aren’t predicting a large market decline between now and the end of the year. We are simply highlighting one of many risks which investors face every day. And we find it hard to believe that investors are truly bullish right now given the many uncertainties and risks permeating the marketplace. In our view, betting against one’s instincts is a lose-lose situation: If expectations are met, losses follow; gains depend on the investor being wrong. It’s up to them (or their clients) to decide if this strategy of luck and investing counter to their fundamental views is truly repeatable or if recent history has just lulled them into a false sense of security.

We have posed questions for our readers in the discussions above which we cannot answer for you. It is incumbent upon investors to decide for themselves whether their portfolios are appropriately aligned with their goals. But we can offer fixed income strategies which aim to help investors simplify their efforts through a considered and careful focus on volatility and risk-adjusted performance using a repeatable investment process rooted in fundamentals and corporate sustainability. If we do this well and we do it consistently, we believe we can offer our clients something to rely on other than luck in these uncertain times. So that is what we will continue to do.


By Venk Reddy
Originally published in Q3 2019 letter

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Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.

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