LTCMA Mark-to-Market: COVID-19 – New cycle, new starting point
As investors navigate current market uncertainty, some of our most senior portfolio managers and strategists share the lessons they’ve learned from previous crises—and how they may apply today.
Lessons in risk-taking from the summer of 1998
Jeffrey Geller - Chief Investment Officer, Multi-Asset Solutions
By the summer of 1998, I had been running hedging and arbitrage strategies for institutional clients for almost 20 years. I thought that the decisions I had made during the 1987 crash would be the defining moment of my career. Little did I know what lay ahead.
"After 42 years in the business, I sometimes feel like I’ve seen everything. But I’ve never seen anything like the current crisis”
That summer, cracks began to appear in Russian debt markets and other emerging markets. Options going out six months to a year, which I would typically be buying for hedging purposes, were trading incredibly cheap in terms of the forecast for risk. I snapped them up for clients that wanted to hedge. Meanwhile, in the arbitrage strategies that I ran, spreads were exceptionally narrow. On a risk-reward basis, these relationships made no sense, and I believed they were unsustainable. I slashed arbitrage risk across portfolios.
Then came the September demise of hedge fund Long-Term Capital Management, whose portfolio positioning (including ungodly amounts of leverage) had been driving markets. The fund’s unraveling created an extraordinary opportunity. I sold longer-dated volatility on equity indices for three times what I had paid earlier that summer, and at a premium even to levels reached around the 1987 crash. In addition, the internet craze was in full swing, enabling a successful arbitrage play: buying the calls on an internet stock and shorting the stock against it.
Looking back, the decisions I made in 1998 seem straightforward, but at the time they felt scary. Rather than a defining moment, they could have spelled the end of my career if my positioning had gone the wrong way. And that lesson has stayed with me.
After 42 years in the business, I sometimes feel like I’ve seen everything. But I’ve never seen anything like the current crisis, unleashed by a global pandemic. No one knows how long or deep the downturn will be. Given that uncertainty, it’s a time for balanced risk-taking.
The 1987 crash underscores the value of long-term investing
Dr. David Kelley, CFA - Chief Global Strategist, Head of Global Market Insights Strategy
In the fall of 1987, I was teaching an economics course at Michigan State University. On Monday, October 19, an excited student ran into my office to tell me that the Dow Jones Industrial Average had fallen by 508 points, which at the time was 22.6%. I explained to him why that couldn’t have happened – but of course it had, in the single biggest daily percentage decline in U.S. history.
In retrospect, the 1987 crash taught us a great deal.
“The 1987 crash was without an obvious fundamental cause or significant economic consequence."
First, it was a crash without an obvious fundamental cause. The stock market had been rising strongly for almost five years without a significant correction, and valuations were above average levels. However, the economy was growing steadily and geopolitical tensions were not particularly abnormal. Some have pointed to a falling dollar as a cause for the crash, but it is hard to argue that changes in exchange rates could justify wiping out over 20% of the value of U.S. companies.
Second, it was a crash without significant economic consequence. Consumer spending held up well in the months after the 1987 crash, and the economy continued to grow steadily until the mild recession of 1990.
Third, the crash serves as the single biggest reminder that stock market returns are not normally distributed. The standard deviation of daily returns in the year before the crash was just 25 index points. As has often been the case before and since, the decline in the market was exacerbated by trades designed to de-risk portfolios by dumping stocks or stock index futures as the market declined.
Finally, the crash underscores the value of long-term investing. If my student, instead of racing into my office that afternoon, had run off to a stockbroker, invested his money and achieved the average return of the S&P 500 since then, he would have made 10.9% annually, including dividends. However, if on that afternoon he had arrived in tears to tell me that he had put his savings into the market the Friday before the Black Monday crash, he would still have made an annual 10.0% over the subsequent years.
Lessons from the 2000 tech boom/bust
Lee Spelman, CFA - Head of U.S. Equity
I loved being a technology investor in the late 1990s – it was such an exciting time. The internet, just emerging, unleashed fantastic possibilities. You could buy things online! Work from home! Connect with your friends! The “old” analog economy was ceding ground to the “new” digital economy. Just putting “dot-com” in a corporate name made the valuation soar, occasionally past 100 times earnings (if there were no earnings, often “eyeballs” on a website sufficed).
“Stocks are worth their future cash flows – there is no substitute.”
Tech stocks doubled and then doubled again. It seemed everyone from taxi drivers to doctors wanted to be a day trader. Most crises are rooted in fear; this one was driven by greed.
The market peaked in March of 2000. It wasn’t a big bang, and no single event caused the unraveling. High profile bankruptcies and 9/11 were contributing factors, but overall it was a slow, steady erosion, ultimately culminating in a peak-to-trough drop of 78% for the tech-heavy Nasdaq. It took 15 years for the index to reach its prior peak.
Some lessons from that era have stayed with me:
- It’s easy to get caught up in the hype: We all want to believe in innovation and growth.
- Change happens more slowly than you expect, but then it flies. The internet did change everything, but it took longer than people forecast. We needed the convergence of mobility, big data and the cloud for the change to fully accelerate.
- Stocks are worth their future cash flows – there is no substitute.
- Stocks can go down much further than you ever thought possible, even after they have already plummeted.
- You can’t set it and forget it. Most of the tech leaders of the dot-com era never recovered. New leaders emerged.
From all these lessons, I draw one conclusion. Active and engaged stock selection is key to long-term investing success.
Lessons in leverage from 2000-02 credit markets
Lisa Coleman - Head of Global Investment Grade Corporate Credit
When volatility started to pick up in U.S. credit markets in 2000, I had recently started a new job managing global credit portfolios at an asset management firm. Markets were focused on increased corporate leverage and the specter of rating downgrades. When I look back on the 2000-02 period, I see clear similarities to the current environment – “leverage” and “fallen angels” are hardly unfamiliar concepts these days - but also important differences.
“We may be living with a lower quality investment universe for quite some time to come.”
Several factors were specific to the earlier era. First were the effects of the 1990s deregulation of the telecom industry (leading to significant overcapacity) and the California electricity market. Elements of this deregulation helped set the stage for instances of corporate malfeasance, which resulted in the collapse of Enron and Worldcom. (I remember one stressful weekend following our decision to sell Enron based on our mounting concerns about the company’s operations. We decided to hold off on selling the euro-denominated debt, expecting a higher price on Monday. Indeed, we did sell at close to par, and weeks before the company collapsed.) Another defining event of that era was the shock of 9/11. In the end, the 2001-02 period saw an unprecedented number of fallen angels as the economy slipped into recession.
U.S. corporations entered that recession with stretched balance sheets, but after leverage peaked in 2002 it then came down steadily. And here’s where I see a key divergence from the current cycle. Companies entered the 2020 recession with higher leverage than at the 2002 peak, and they will likely emerge into the next cycle with even more debt on their balance sheets.
We do not expect a V-shaped recovery, and in a less than robust economic environment companies may remain considerably more leveraged than in past cycles. At the same time, though, the Federal Reserve will, for the first time, buy bonds of certain fallen angels (companies with investment grade ratings as of March 22), thus providing a market backstop. On balance, we may be living with a lower quality investment universe for quite some time to come.
2000–02: The pain of bear market rallies
Katy Thorneycroft - Portfolio Manager, Multi-Asset Solutions
In 1999, as the tech boom roared, I was fresh out of university, a newly minted portfolio manager on the European behavioral finance equities team. Having studied the various principles of valuation, I was interested to see that a discounted cash flow could easily justify any share price as long as your forecasts were optimistic enough and your terminal value was suitably extravagant.
“A bear market rally can make you a hero or … something else altogether."
As the cycle neared its peak, I was concentrating on mid and small cap companies. Looking back, I see that I was very lucky to be working for an experienced portfolio manager who had seen several bear markets in his time. He kept me focused on corporate cash flows and balance sheets.
Two lessons from the 2000-02 bear market have stayed with me. First, bear market rallies can be brutal. In 2001, I recall, the FTSE fell by 15% overall, but there was a 20% rally in the final months of the year. We won’t know for some time whether the recent rally this year is in fact a bear market episode. Depending on how you are positioned, a bear market rally can make you a hero or … something else altogether. In my early years in the business, I learned that it helps to keep true to your investment framework while remaining humble enough to shift course when the evidence changes.
Second, I learned that investors may overlook valuations for a period of time, but it’s rarely a permanent condition. Value stocks had been somewhat out of fashion in the later stages of the late 1990s bull market. But once the bear market ended in 2003 and the stage was set for a reacceleration of growth, investors had the luxury of being more price sensitive. Again, only time will tell, but if the next cycle delivers higher levels of nominal growth, it could provide a tailwind for long-beleaguered value stocks.
1987 crash: Bank training grad sees first black swan event
Patrik Jakobson - Portfolio Manager, Multi-Asset Solutions
I was a few weeks out of the training program at J.P. Morgan when the stock market crashed on October 19, 1987, Black Monday. My desk in the old headquarters at 23 Wall Street looked out on the floor of the New York Stock Exchange. “What have I gotten myself into?” I asked myself.
“By definition, black swan events are low probability occurrences. But over the past 30-plus years, they seem to arrive with some regularity.”
At the time, the double-dip recessions of the early 1980s were fresh in people’s minds and a downturn seemed inevitable. But the stock market regained its previous highs in less than a year and a U.S. recession did not arrive for several years, not until 1990.
Coming into Black Monday, stocks were overvalued and investors were complacent. Portfolio insurance “guaranteed” downside protection – until it didn’t. Portfolio insurance clearly exacerbated the 1987 sell-off. And certainly there is an element of commonality in subsequent crises, with financial markets or financial engineering as a causal or contributing factor.
In the normal course of things, it’s hard to think about left tail or black swan events. By definition, they are low probability occurrences. But looking back over the past 30-plus years, these events seem to arrive with some regularity: the Asian financial crisis and Long-Term Capital Management, the dot-com bust, the global financial crisis, the sovereign debt crisis. Each had a slightly different contour, but each was a left tail event.
My younger colleagues find it difficult to imagine, but in October 1987 we worked without computers or cellphones. Trading was manual and slow. Today, in the midst of a global pandemic, J.P. Morgan Asset Management is, in essence, remotely run. That is remarkable – and a reminder to me of the fundamental resilience of the economy and markets through all manner of crises.
Sovereign debt crisis: The importance of a big-picture view
Karen Ward - Chief Market Strategist, EMEA, Global Market Insights Strategy
For the countries bound together in Europe’s monetary union, the financial crisis did not end in 2009. Indeed, for many it was just beginning. As government debt spiraled, investors soon shifted their attention from the question of whether banks would go bust to whether sovereigns would default. As a sell-side economist during the sovereign debt crisis (which ran from roughly 2010–12), I had to form a view on whether the end result would be a breakup of the eurozone.
“I understood that the eurozone was first and foremost a political union. The crisis was more about political commitment than economics.”
While every crisis is different, the analytical toolkit we use is essentially the same. From my perspective, crises are much like impressionist art. Get too close to the canvas and the art is impossible to fathom. But if you step back a few paces, it all becomes much clearer.
In a crisis, it’s essential to consider the big picture. As an economist – and a student of history – I understood that the eurozone was first and foremost a political union. In turn, the crisis was more about political commitment than economics. Because I didn’t doubt Germany’s commitment to the project, I expected compromises would ultimately be made, and they were. This was far more important than understanding the minutiae of the various bailout packages.
And I learned that it is important to step back physically as well as mentally. In the sovereign crisis, policymakers made key decisions late on a Sunday night or in the early hours of Monday morning following a eurogroup meeting. Staying awake to cover the press conference followed by a whole day of client meetings was physically as well as mentally draining. Finding a way to recuperate is essential for making clear, rational decisions.
Finally, while it’s important to have a clear view, it’s equally important to challenge that view. Team culture is critical here. Healthy debate is essential at all times, but never more so than in a crisis, when both the emotions and the stakes run high.
From the crucible of the 2008 crisis, the expansion and evolution of real assets
Pulkit Sharma, CFA, CAIA - Head of Alternatives Investment Strategy and Solutions
“Build it and they will come” was the motto of real estate investing across global markets leading up to the 2008 crisis. Working in the Middle East, I witnessed the development boom that produced some of the world’s largest structures. Although the global financial crisis was not directly connected to emerging markets, it exposed vulnerabilities that led to a prolonged real estate bust as development projects were stalled or scrapped altogether.
“Financial crises produce winners and losers. The real asset winners had contractual cash flows and strong counterparties.”
In the U.S., unlike the dot-com crash where real estate values were unscathed, the 2008 mortgage meltdown created ripple effects across private and public real estate. Cracks first appeared in real estate credit markets, which impacted public and then private real estate. Transaction volumes decreased, and a heightened need for liquidity led to an increase in private fund redemption queues as investors sought to withdraw capital wherever available.
Financial crises produce winners and losers. The winners had exposures to inelastic demand sectors, contractual cash flows and strong counterparties. Low leverage private core debt and primary markets core real estate equity fared better than higher leverage debt, public and noncore private real estate. This period also saw the emergence of infrastructure as an asset class. Its similar, albeit noncorrelated and more defensive, return profile relative to real estate made it a suitable complement.
Each crisis reshapes the industry it impacts, and the global financial crisis sparked a wave of innovation and opportunities for the next decade. These included the rise of infill logistics, renewable energy and globalization of real estate, and the emergence of regulation-driven asset classes such as transport leasing and mezzanine real estate. Over the long term, the safe haven characteristics of high quality cash flows of real estate and infrastructure will remain important sources of income and diversification, and investors should be on the lookout for new sources of sustainable innovation to further expand and evolve their exposure to real assets.
Quant chaos in the summer of 2007
Ted Dimig - Head of U.S. Advisory and Core Beta Solutions, Multi-Asset Solutions
In the summer of 2007, I was a client portfolio manager at J.P. Morgan, leading our behavioral finance/quantitative equities product team. In those days, quants ruled, investment performance was strong and we had just launched our first long-short product. Then everything changed, seemingly overnight. The first two weeks of August – the lead-up to the global financial crisis, as it later became clear – delivered broad-scale liquidations.
“My main takeaway from this difficult period? Plainly put, there is never just one cockroach.”
Overly levered quant strategies’ returns plunged (a 5+ standard deviation event) and as a result experienced sizable redemptions. What had been up was now down. Our first instinct was to think that this was a temporary blip and we should thus stay disciplined. But we quickly understood that chaos now ruled the quant world, and investors did not like chaos. While the quants would ultimately reemerge stronger in the wake of this experience, in the subsequent two years, it is estimated, nearly 80% of quant strategy assets were liquidated.
My main takeaway from this difficult period? Plainly put, “There is never just one cockroach.” What was happening in the quant space proved to be an early warning sign of the financial stresses across much of the global economy. In other words, it was one of the first but by no means the only cockroach. As a crisis emerges, it’s human nature to find patterns that resemble prior episodes. But in reality, each crisis is different. Today I push myself to take a multi-faceted view of the market and economic environment and try to focus on what’s different from the past. While a historical perspective is helpful, too narrow a focus can turn into tunnel vision. Then you miss the fact that there are a lot more cockroaches that warrant investigation.
Learning the limitations of quant models in the 2008 financial crisis
Katherine Santiago - Head of Quantitative Research, Multi-Asset Solutions
I began my finance career in 2004, so the 2008 global financial crisis was my first experience with live market disruptions. As a quant investor, I could see that implementation decisions such as improper risk sizing and leverage overwhelmed otherwise “correct” portfolio views and positions. I learned that the true power of a robust investment process is its ability to manage through cycles of underperformance, recalibrate to new information and risk, and establish better positioning for the next market phase.
“Understanding the limitations and biases of your models can help you navigate your response to severe dislocations.”
Understanding the limitations and biases of your models and processes can help you navigate your response to severe dislocations. Models based more heavily on valuations may be significantly early in signaling a market peak, whereas those based on technicals may take longer to register a turning point. Depending on the model, an investor can evaluate the necessary speed of a response and decide whether to lean into the downturn or rebound of an event.
From a quant investing perspective, our reliance on data is a humbling element of any market dislocation. In 2008, so many of our data series, such as Libor or other liquidity measures, which had worked reliably in prior periods, began to fail as liquidity and market stresses impacted not only market prices but the financial system itself. This meant that our models had difficulty interpreting the reality of current market conditions and thus could not predict where markets were headed. Being able to understand your data, its limitations and their exact impact on your models is essential to navigating these types of market events. In the current crisis, economic data will be equally challenged to keep up with the fast pace of the economy’s sudden stop and the pace (as yet unknown) of the economy’s eventual restart. Finding new sources of data to help interpret economic activity can be useful, but investors need to think carefully before jumping into anything new and untested.
Past crises reinforce the lesson - It’s not (essentially) different this time
Anthony Werley - Chief Investment Officer, Endowments & Foundations Group
On October 19, 1987, when the Dow Jones Industrial Average fell 22.6%, the biggest single-day percentage decline in U.S. history, I was working as the head of an equity sales and trading desk in the Boston office of a bulge-bracket investment banking firm. We handled dozens of convertible bond trades that day that were priced 25% or more below the previous day’s close. Even then, those prices were only that day’s clearing bid, as talk of further steep declines in markets ahead made every trade a risky proposition. As investment professionals seeing the carnage in markets, we were convinced something important was afoot that would change markets for a long time.
“I am repeatedly amazed by how resilient economies and markets are.”
The next 32 years included other frightening market episodes: the 1998 crisis precipitated by the collapse of the Russian ruble and hedge fund Long-Term Capital Management, the 2000 technology stock bust and the economic and market meltdown of the global financial crisis. Looking back, a pattern seems to emerge: Shock around a completely unexpected (but still probable) event lends itself to wide-ranging explanations of possible outcomes that eventually narrow as events evolve and policymakers address the crisis as best they can.
Although the 1987 crash turned out to have no significant economic impact, financial market participants, including investors and managers, learned valuable lessons. “Portfolio insurance,” at the time the latest technique to hedge portfolios, was discredited – and then resurfaced in other forms over the subsequent decades. And in some ways, large investor redemptions during the 1987 crash paved the way for the market’s bull run in the 1990s.
The current crisis will have significant repercussions over the next couple of years, especially since a serious public health crisis is unfolding along with an important economic and market event. But I am repeatedly amazed by how resilient economies and markets are. The events of 2020 are likely to accelerate changes that are already underway but not radically alter their basic course.
From bear markets to new opportunities
John Bilton, CFA - Head of Global MultiAsset Strategy, Multi-Asset Solutions
In 2008, I watched the global financial crisis unfold from the vantage point of a derivatives desk. What has always struck me about the acute phase of a market dislocation is how eerily quiet dealing floors become – in stark contrast to images in the media. Asset markets may be doing somersaults, but often trading is paralyzed and the most frantic activity occurs behind office doors as the scale of the impact is assessed.
“From bear markets are forged new economic expansions, new bull markets and new investment opportunities.”
Derivatives are often associated with hedging, but the complexity of some instruments compromised their effectiveness – for instance, increased counterparty risk following the collapse of Lehman Brothers impaired the value of some hedges by far more than price action in the underlying asset. Ultimately, in any market dislocation cash is the most prized asset. Hedges are important – but they need to be simple, liquid and effective, since converting them back into cash is critical.
In a bear market, the initial shock, where cash is in high demand, passes fairly quickly. A more drawn-out phase then begins. Benjamin Graham noted that markets are “voting machines in the short run and weighing machines in the long run.” The initial shock may be analogous to investors “voting” on whether sufficient cash is available, and what follows is a weighing or calibration of the long-run impact on growth and valuations.
In the recent turmoil, central banks moved swiftly to flood markets with cash, and it is comforting that the initial dislocation phase is calming down – even if the trajectory of the economy remains uncertain. Price discovery is now possible, and the weighing phase can get underway. As the veteran of now four recessions and six major market dislocations, I can clearly see that from bear markets are forged new economic expansions, new bull markets and new investment opportunities.