Be Very Afraid of These Markets?

Katherine Burton and Katia Porzecanski of Bloomberg report, Paul Tudor Jones Says U.S. Stocks Should ‘Terrify’ Janet Yellen:

Billionaire investor Paul Tudor Jones has a message for Janet Yellen and investors: Be very afraid.

The legendary macro trader says that years of low interest rates have bloated stock valuations to a level not seen since 2000, right before the Nasdaq tumbled 75 percent over two-plus years. That measure -- the value of the stock market relative to the size of the economy -- should be “terrifying” to a central banker, Jones said earlier this month at a closed-door Goldman Sachs Asset Management conference, according to people who heard him.

Jones is voicing what many hedge fund and other money managers are privately warning investors: Stocks are trading at unsustainable levels. A few traders are more explicit, predicting a sizable market tumble by the end of the year.

Last week, Guggenheim Partner’s Scott Minerd said he expected a "significant correction" this summer or early fall. Philip Yang, a macro manager who has run Willowbridge Associates since 1988, sees a stock plunge of between 20 and 40 percent, according to people familiar with his thinking.

Even Larry Fink, whose BlackRock Inc. oversees $5.4 trillion mostly betting on rising markets, acknowledged this week that stocks could fall between 5 and 10 percent if corporate earnings disappoint.

Caution Flags

Their views aren’t widespread. They’ve seen the carnage suffered by a few money managers who have been waving caution flags for awhile now, as the eight-year equity rally marched on.

But the nervousness feels a bit more urgent now. U.S. stocks sit about 2 percent below the all-time high set on March 1. The S&P 500 index is trading at about 22 times earnings, the highest multiple in almost a decade, goosed by a post-election surge.

Managers expecting the worst each have a pet harbinger of doom. Seth Klarman, who runs the $30 billion Baupost Group, told investors in a letter last week that corporate insiders have been heavy sellers of their company shares. To him, that’s “a sign that those who know their companies the best believe valuations have become full or excessive."

He also noted that margin debt -- the money clients borrow from their brokers to purchase shares -- hit a record $528 billion in February, a signal to some that enthusiasm for stocks may be overheating. Baupost was a small net seller in the first quarter, according to the letter.

Another multi-billion-dollar hedge fund manager, who asked not to be named, said that rising interest rates in the U.S. mean fewer companies will be able to borrow money to pay dividends and buy back shares. About 30 percent of the jump in the S&P 500 between the third quarter of 2009 and the end of last year was fueled by buybacks, according to data compiled by Bloomberg. The manager says he has been shorting the market, expecting as much as a 10 percent correction in U.S. equities this year.

China Slowdown

Other worried investors, like Guggenheim’s Minerd, cite as potential triggers President Donald Trump’s struggle to enact policies, including a tax overhaul, as well as geopolitical risks.

Yang’s prediction of a dive rests on things like a severe slowdown in China or a greater-than-expected rise in inflation that could lead to bigger rate hikes, people said. Yang didn’t return calls and emails seeking a comment.

Even billionaire Leon Cooperman -- long a stock bull -- wrote to investors in his Omega Advisors that he thinks U.S. shares might stand still until August or September, in part because of flagging confidence in the so-called Trump reflation trade. But he said that they will eventually resume their climb and end the year moderately higher.

Likely Culprit

While Jones, who runs the $10 billion Tudor Investment hedge fund, is spooked, he says it’s not quite time to short. He predicts that the Nasdaq, which has already rallied almost 10 percent this year, could edge higher if nationalist candidate Marine Le Pen loses France’s presidential election next month as expected. Jones tripled his money in 1987 in large part by correctly calling that October’s market crash.

While the billionaire didn’t say when a market turn might come, or what the magnitude of the fall might be, he did pinpoint a likely culprit.

Just as portfolio insurance caused the 1987 rout, he says, the new danger zone is the half-trillion dollars in risk parity funds. These funds aim to systematically spread risk equally across different asset classes by putting more money in lower volatility securities and less in those whose prices move more dramatically.

Because risk-parity funds have been scooping up equities of late as volatility hit historic lows, some market participants, Jones included, believe they’ll be forced to dump them quickly in a stock tumble, exacerbating any decline.

“Risk parity,” Jones told the Goldman audience, “will be the hammer on the downside.”

Is Tudor Jones right to worry about risk parity strategies? First, for those of you who don't know about risk parity, I draw your attention to this CME paper authored by people working at the Clifton Group, Understanding Risk Parity.

It states the following:

In its simplest form, risk parity seeks to balance the contribution to total portfolio risk from each asset class that composes a diversified portfolio. A traditional 60% equity / 40% fixed income portfolio, which is the base of many investors’ portfolios, is not diversified. Approximately 90% of the risk in this traditional portfolio is concentrated in equities, due to the fact that historically equities have been three times more volatile than fixed income securities. Risk parity seeks to avoid this concentration of risk through the construction of a more diverse, risk balanced portfolio.

The authors then go on to highlight common criticisms of risk parity:

Like all investment strategies, risk parity has its detractors. One common criticism is that this strategy requires leveraging low-risk assets, primarily bonds. Risk parity allocations create an overweight to bonds in order to equalize the contribution to risk from all asset classes. Levered bond strategies performed well over the last several years as interest rates declined sharply since the onset of the financial crises in 2007. Risk parity critics note that given today’s interest rate environment, investors should have tempered expectations for the performance of their bond holdings in the future.

These critics may miss the objective of a risk parity approach, which is to have equal contributions to risk from all asset classes in the portfolio. The purpose of seeking equal contributions to risk from varied asset classes is to limit the potential economic impact to any one asset class in the portfolio. By equally weighting risk across a broad array of other asset classes such as equity, real estate, credit spreads, commodities, and inflation bonds, risk parity is not dependent solely on bonds as the source of diversification or return. It is important to note that a rise in interest rates would impact a risk parity strategy in different ways, depending on why interest rates were rising.

A gradual rise in interest rates as a result of a period of economic stability and prosperity would be positive for a risk parity approach. Although bonds may underperform in this environment, growth assets such as equities, real estate, and credit spreads would likely exhibit above average performance. If interest rates rise in response to increases in inflation expectations, a risk parity approach should benefit from exposure to inflation sensitive asset classes such as commodities and inflation linked bonds. In summary, because diversification is central to a risk parity strategy, there will likely always be some asset classes in the portfolio performing below expectations. However, at the same time other asset classes may well be performing above average.

The goal of the strategy is to allow the investor to collect the average risk premium across all asset classes over time in the most efficient manner possible and thus realize a superior risk-adjusted return.

Another criticism leveled at risk parity is that it often employs leverage. Risk parity strategies target a total level of portfolio volatility commensurate with an investor’s risk and return objective. To achieve this objective, a risk parity strategy may employ economic leverage in the form of futures contracts and financial leverage in the form of repurchase agreements and over-the-counter swaps. At a 10% risk target, it is not uncommon for a risk parity manager to have 200% cumulative exposure. This amount of leverage is required to equalize the risk contribution from low-risk assets like nominal and inflation linked bonds.

Leverage by itself is not a problem. Anyone who has used a mortgage to finance the purchase of a home has been exposed to leverage. What is critical is how that leverage is managed. It is here that the diversification prevalent within the portfolio and the operational and implementation experience of the manager are important. Diversification must be considered not only at the total portfolio level, but also among the various asset classes that are levered within the portfolio and therefore may require daily liquidity. Proven operational experience in managing leverage is key to risk parity managers. This experience should include having systems in place to monitor leverage levels on a real-time basis and developed plans for managing the strategy through challenging market environments. Assuming the diversification and experience criteria are met, the amount of leverage employed in a risk parity strategy should not create excessive risk to the investor.

Now, risk parity strategies have become very popular as rates plunge to historic lows and equities reach high valuations. In Canada, two of the best pensions -- HOOPP and OTPP -- do their own risk parity strategy internally instead of farming it out to an external manager. In order to do this properly, they too have invested heavily in systems and their portfolio managers are very experienced in managing leverage across asset classes (also, unlike other Canadian funds, their investment policy allows them to take on the leverage required to do this strategy internally).

But most pensions and large investors aren't able to do risk parity internally so they farm it out to big hedge funds like Bridgewater or AQR, two well-known risk parity titans.

How do risk parity strategies perform? Let's have a look at the Salient Risk Parity Index which is a quantitatively driven global asset allocation index that seeks to weight risk equally across four asset classes — equities, rates, commodities and credit. The Index is calculated daily, rebalanced monthly, and targets a 10% volatility level.

Below, you can see the annual returns which can be found here along with monthly and weekly returns (click on image):

As you can see, it's not always smooth sailing for risk parity strategies. In 2008, this index was down 17%, which was a lot better than what stocks did that year, but in 2015 it was down 12%, considerably underpeforming the stock market.

Incidentally, risk parity woes contributed to Bridgewater's lackluster performance in 2015, but last year risk parity performed well and so did Ray Dalio's behemoth fund, earning $4.9 billion for its clients, all due to its All-Weather (risk parity) portfolio which outperformed its flagship Pure Alpha portfolio.

But if you listen to Paul Tudor Jones's warning, you'd think risk parity strategies are doomed and they can heavily influence all risk assets, especially stocks.

Here is where I tune off. Why? Because he over-exaggerates their effects on the market, which is why the quants are firing back at his claims:

For AQR Capital Management LLC, a giant in the risk parity field, the concerns are overblown, with any selling forced by the strategy having an “utterly trivial” impact on the $23 trillion U.S. equity market.

“There are scenarios in which risk parity funds sell equities, but the possible magnitude of that is very small,” said Michael Mendelson, a risk-parity portfolio manager at AQR.“Some reports have grossly exaggerated the potential impact.”

Jones, who oversees $10 billion in his Greenwich, Connecticut-based Tudor Investment hedge fund, is the latest active asset manager to whip up fears surrounding the automated strategies that were a favorite target of bank researchers during the selloffs in August 2015 and early 2016. The strategy has less than $150 billion invested in it, according to data provider eVestment, most of at AQR and Bridgewater Associates’ All Weather Fund.

That’s significantly lower than the roughly $500 billion Jones estimated. And of that total, only around a third is investing in equities, Mendelson said. That compares to the nearly $2 trillion in market value that evaporated from U.S. equities during the last stock market correction.

“Even on a sharp move in the stock market, the positioning changes would be utterly trivial and would have about zero impact,” Mendelson said.

Cash Fleeing

Risk parity bases its allocations to different asset classes on risk rather than capital, as in the typical 60-40 stock-bond fund. So, for example, U.S. Treasures and international government bonds often play a larger role in risk parity funds than in other asset pools, while stocks usually take up a smaller slice.

In addition, money has fled risk parity funds in seven of the past nine quarters, for net outflows of more than $16 billion among funds tracked by eVestment.

But even in the scenario that Jones lays out, the funds wouldn’t dump their stock holdings for a variety of reasons, according to Edward Qian, who’s credited with coining the term risk parity. Because of the safer asset concentration, the strategy performs relatively better when stocks tumble and wouldn’t need to sell as much as a traditional 60-40 portfolio, Qian said.

“They’re always focused on the equity portion of risk parity, saying that equities might have a terrible time and other scary fear mongering things,” Qian said. “Even if someone has a stop loss or equity reduction program, it can’t be a significant player in those time periods.”

In short, while risk parity strategies are intellectually appealing and have positive performance attributes, they really aren't as popular as people think. A lot of pensions aren't sold on the idea of risk parity and a lot of them cannot undertake this strategy, at least not in-house which is why they farm it out to big shops.

In order to draw inference on risk parity strategies, you need to see total assets under management of these strategies as a percentage of total stock and bond market capitalization, which is still peanuts.

Sure, at the margin, when risk parity strategies get whacked it can cause problems in markets for a brief period, but I'm not sold on the idea that "risk parity will be the hammer on the downside."

This is pure nonsense from a "legendary investor" who has been underperforming and cutting fees to keep investors onboard.

Is Janet Yellen afraid of Paul Tudor Jones and risk parity? Of course not, the Fed can crush macro gods like Tudor Jones, Ray Dalio and George Soros like little bugs, and it has a lot more arsenal in its war chest than what most investors think.

Are there reasons to be afraid of these markets? You bet. My chief concern -- and that of the Fed -- remains global deflation. This is why I'm highly skeptical of the reflation trade everyone is buying hook line and sinker, especially now that the next economic shoe is dropping and the Fed is considering to shrink its balance sheet, which ironically will only exacerbate global deflation.

Large investors are also preparing for the next downturn by rushing into alternative assets but investing in these strategies has been mixed and if deflation does strike, it's safe to assume there's nowhere to hide except good old US long bonds (TLT) which from a risk-reward perspective, remains my top recommendation this year and probably next year too (click on image):

But things move very quickly in these high frequency, Twitter infested schizoid markets. We shall see what happens after the French elections this weekend and if the Trump Administration is able to pass tax cuts and its infrastructure spending program (if so, US long bonds could get hit again but I would use that pullback to buy more).

All this to say stop listening to the dire warnings of legendary investors. Unless you're privy to their trading books, you have no idea how they're positioned and performing and whether they want to send out false signals to scare people off.

My rule of thumb is to look at what they're actually buying and selling every quarter but don't base any investment decision on what top fund managers are buying or warning of. More often than not, you'll get badly burned.

These markets are ruthless, unrelenting and just brutal.  Everyone from top traders to lowly retail investors is finding it hard to make money. But one thing is for sure, there is a major beta bubble going on in public markets and you need to be well diversified to mitigate against downside risks.

In the meantime, everyone is dancing to the music worried about what happens when the music stops. This is why I hate these markets and why I'm an ardent defender of large, well-governed defined-benefit plans which ensure people can retire in dignity and security (read Mauldin's latest, Angst in America, Part 4: Disappearing Pensions and my recent comment on America's growing retirement angst).

One final note, my recent comment on Canada's real estate mania has proven to be extremely popular.  I'm increasingly concerned about Canada's $1.1 trillion shadow banking system which is now half as large as banks, and you can see the dominoes are beginning to fall as Home Capital (HMC.TO) melted down yesterday on the stock market the same day Ontario was trying to hammer housing (read Garth Turner's latest, Cold Comfort).

Still, Home Capital's stock is bouncing up today (wouldn't touch it with a ten-foot pole!) and I was surprised to see the Royal Bank is the latest Canadian firm to explore a sale of bonds backed by uninsured residential mortgages after that bank's CEO warned of a frothy Canadian housing market.

Also, Ted Carmichael discusses Toronto's real estate boom, stating that while say that house prices will never decline, the city's history clearly demonstrates that there is a good chance that, like its two predecessors, this boom will end badly.

To my former BCA Research colleague, Steve Poloz, who is now the Governor of the Bank of Canada, all I have to say is "be very afraid of Canada's housing bubble."

On that note, where are the contributions to this blog? I work very hard every single day to provide all of you with great insights on pensions, markets and the economy and I'm getting tired of asking for handouts. Be polite, please take the time to donate or subscribe to this blog on the top right-hand side to show your support. I thank every single one of you, especially those on a fixed income, who support my efforts.

Below, risk parity has been one of the trendiest investment strategies in the world since the financial crisis. This FT Markets clip explains what exactly it is and why institutional investors like it.

Also, Guggenheim Partner’s Scott Minerd says he expects a "significant correction" this summer or early fall. Highly likely but who knows if "sell in May and go away" proves to be right this year? Stay tuned, quant hedge funds might ramp this market up even more before they pull the plug.

Update: One astute global macro trader told me "it's more vol control strategies that de-lever quickly as vol rises." In particular, he sees more risk from vol targeting annuities, not risk parity strategies and thinks that US equities have further upside as positioning and sentiment is too cautious. Like I said, stay tuned, we'll see what happens next week and in the second half of the year.