August Swoon: Emotions create opportunities for systematic investors

August 30^th 2024
By Derek Bilney

In the unpredictable landscape of equity markets, the volatility experienced in early August 2024 serves as a reminder of the inherent fluctuations within equity markets. This period underscores the notion that while higher risk is associated with the potential for stronger returns over time, volatility is often transient, with markets capable of swift recoveries following corrections.

Key insights for equity investors:

• Periods of elevated volatility is the price that equity investors pay for the potential for higher long-term investment returns.
• The unpredictability and brief nature of volatility spikes highlight the challenges and risks of market timing.
• There can be an opportunity cost in holding lower-returning defensive assets missing longer term equity trends.
• Macquarie Systematic Investments’ portfolios have a strong track record of outperforming in both positive and negative markets due to the effective targeting of different investment styles and a risk-aware approach to portfolio construction.

Recent market dynamics:

Figure 1 shows the S&P/ASX 200 Price benchmark against the S&P/ASX 200 VIX (with the scale reversed). The ASX 200 VIX, a real-time index, reflects the market’s expected volatility in the S&P/ASX 200 benchmark by analysing the implied pricing of volatility in ‘put’ and ‘call’ options.

Although the calculation is complex, the interpretation is simple: equity markets periodically experience short-term periods of? volatility spikes that quickly revert. These spikes often coincide with market downturns.

Figure 1: S&P/ASX 200 vs S&P/ASX VIX (reverse scale)

Prior to the recent downturn, volatility levels were at near-historic lows. So, what triggered the increase in early August?

As always with sharp moves in equity markets, there are typically several factors – many of which are only clear in hindsight:

1. Weak US employment report: Previously, markets interpreted ‘bad’ economic news as a precursor to ‘good’ news, expecting Federal Reserve interest rate cuts. However, a weak set of employment numbers, alongside other lacklustre economic data, suggested that the US economy was rapidly sliding into a recession. This shift in perception meant ‘bad’ news was seen as detrimental across the board – harming the economy, corporate profits and equity markets, leading to a sharp decline.
   
   
2. Concentrated US market: The US market’s recent gains were largely driven by the ‘Magnificent 7’, closely tied to the AI-thematic. However, earnings reports indicated that the anticipated benefits from AI-investment would take time to emerge, disappointing some investors that were expecting immediate results. Companies that had lifted the market contributed to its fall.
   
   
3. Unwinding of Japanese carry trade: Across the Pacific, the Japanese Central Bank’s decision to raise official interest rates led to the unwinding of the global ‘carry trade’, where investors borrow at very low interest rates in Japan to invest higher-yielding assets elsewhere. While the scale of the carry trade is difficult to quantify, the market consensus is that the unwind has stabilised, with supportive comments from the Japanese Central Bank providing reassurance.
   
   
4. Rebalancing of volatility-based strategies: Certain investment strategies adjust their holdings according to relative volatility levels. An increase in equity volatility triggers selling to maintain a portfolio's volatility balance. Unfortunately, this can exacerbate volatility and lead to more selling. However, when the cycle ends, the process can reverse.
   
   
5. US Election uncertainty: The race for the presidency has grown increasingly competitive, diverging from initial expectations. A spike in the odds of a Trump victory post-assassination attempt coincided with a peak in the US market.

The swoon in markets ended on August 5 and markets have essentially clawed back their losses, closing in on record levels. Volatility continues to retrace.

Message for investors

The events of early August provide a number of timely lessons for investors:

• Markets rarely go up in a straight line – there are always ups and downs. However, equities have historically delivered strong long-term performance relative to most other asset classes.
• Timing exit/re-entry points is challenging and often less effective than remaining invested (“time in the market, not timing the market”).
• Central banks have scope to cut rates if economic conditions unexpectedly deteriorate which should reassure investors and support the economy.

There is significant ‘cautious’ cash on the sidelines, ready to capitalise on market dips. Should the US cut rates, defensive assets may become less attractive, potentially reviving the TINA trade – “there is no alternative” – favouring riskier assets like equities.

Opportunities for systematic investors

The Macquarie Systematic Investments process has a strong track record in delivering portfolios that have historically outperformed the benchmark in more volatile market conditions.¹ Our pool of approximately 70 investment signals reflects different investment styles – including signals that are typically associated with Quality-based investing that are typically more defensive. As a result, our portfolios are designed to maintain robust active performance in both turbulent and buoyant market conditions, contributing to overall consistent longer-term outperformance against relevant benchmarks.

Swings in market sentiment are often accentuated by investor emotions such as greed and fear. A systematic investment approach is designed to dispassionately navigate through periods of market stress, taking advantage of evolving opportunities in the context of a highly diversified, risk-aware portfolio.

Author

1. The downside capture of the Macquarie Australian Shares Fund and Macquarie Australian Small Companies Fund for the five years to 31 July 2024 were 93.6% and 82.2% respectively. Past performance is not a reliable indicator of future performance. Current performance can be obtained here macquarie.com/mam/au-performance.