The Dow Jones Industrial Average (INDU) has hit its all-time high, set in 2007. The US stock market has rallied significantly despite the debt ceiling issue and fiscal concerns.
But this five-year stock market ride from 2007 to 2012 has been anything but smooth. Beside the market being cut about half in value through the financial crisis, we have faced a host of macroeconomic shocks.
These include the debt ceiling debates, the housing crash, the fiscal cliff, the Japanese tsunami, the flash crash and the Euro debt crisis. I would point to four factors which I believe created greater instability in the financial markets in recent years.
High Frequency Trading – This age of supercomputers and super quick flash trading has created a few advantages for investors. Online trading is now more cost effective and faster than it has ever been before for investors.
There are some quantitative investors, including hedge fund managers, who create lightning fast trading programs which are designed to exploit market movements that may only last for a fraction of a second. At times, these traders may create more efficiency in the marketplace.
For example, if a stock trades out of whack temporarily with its fundamentals or technicals, these programs may create liquidity by buying back (or selling) the shares within milliseconds. Thus they would push back the shares to a more reasonable (according to a program’s algorithms) price point.
There are however, times when these trading programs could become destabilizing. An example would be if these programs were looking to exploit a selloff or downward momentum in the market. One of the largest quantitative trading hedge funds (Renaissance Technologies) for example has used a strategy that, in my opinion, seems intuitively destabilizing at times.
I believe these programs are too quick for a human being to effectively control. Consequently, if there are glitches such as the Flash Crash, human beings appear less able to understand and remedy the situation than they have in the past.
It seems as though the market makers and regulators are acting at a slower speed than some of the big quantitative traders. For this reason, while there are benefits to flash trading, I believe there are likely to be more of these glitches in the future.
Globalization -- We are in a more globalized marketplace than ever before. Investors around the world are accessing similar investments in similar ways. People have global investment portfolios and access to similar exchange-traded funds (ETFs), index funds, and mutual funds.
When there is a big selloff in the market, it appears to me that investors tend to dump their shares at the same time. Several decades ago having a global portfolio was not nearly as common.
Climate Change - I cannot pretend to be an expert on weather or climate issues. However, in my opinion, we seem to have experienced a period of more volatile weather patterns in recent years.
After two major hurricanes in the northeast in the last couple of years, more of our clients are buying generators. These are people who have lived here for decades and never thought about buying a generator in the past.
Fiscal Challenges -- We have some serious fiscal issues to deal with here in the US and in various parts of the developed world. There is a high percentage of debt to GDP here in the US and in many European countries.To make matters worse, in the US we are continuing to run an annual deficit.
The debt ceiling debates and fiscal cliff issues are simply an expression of our ongoing debt issue. During the late-90s Asian Financial Crisis, it was the emerging markets and the developing world that struggled with indebtedness.
I would expect that maintaining a portfolio which can thrive in volatile time periods would be very helpful in today’s environment. I also expect that one should be prepared for periods of inflation as a potential symptom of ongoing intervention from central banks around the world.
In an investment portfolio, some stock, real estate, and commodity investments would be helpful in my opinion, as they tend to keep up with inflation over time. During a selloff, it is helpful to invest in some assets that are not very correlated to the stock market.
At times, various kinds of bonds and alternative investments are not highly correlated with the stock market. With interest rates historically low, it is important for investors to be very strategic in the way that they invest in bonds so that they are not too vulnerable to interest rate risk.
I believe that emerging market investments that are denominated in non-US dollars are a great way to take advantage of the global fiscal imbalances that I have described. In my opinion, the Wisdom Tree Small Emerging Market ETF (DGS) and the Wisdom Tree Emerging Local Debt (ELD) are a couple of our investment choices in that area.
The investments discussed are held in client accounts as of February 28, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.
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