Market Overview Q217: Shaping up for a New Investment Environment

Hiking on short, flat, well-marked paths is not a good way to get in shape for much more challenging hikes. It takes a series of longer hikes to build stamina, elevation gain to build strength, and some poorly marked trails or wilderness areas to build orienteering skills. In fact, it is quite common to train or run drills in order to get in better shape for upcoming challenges.

The notion of what constitutes "challenging", however, is subject to considerable interpretation - especially when it comes to markets. Helpfully, Andrew Lo's new book, Adaptive Markets: Financial Evolution at the Speed of Thought, provides a fresh perspective from which to evaluate conditions. The bad news for investors is that there is likely to be some "difficult hiking" ahead. The good news is that Lo's theory provides some useful "exercises" to help prepare for it.

Undoubtedly, the "path" for a lot of investors has been pretty easy for many years. The long, cyclical decline in interest rates beginning in 1982 created an extremely benign environment for credit creation and for the appreciation of risk assets. People who invested or managed assets during this period enjoyed an environment almost bizarrely conducive to their activity. As As Bill Gross himself reflected: "You did not, as President Obama averred, 'build that,' you did not create that wave. You rode it."

Despite the rude interruption by the financial crisis in 2008, investors were quick to return to "riding the wave", albeit this time on the liquidity provided by central banks. The widespread regime of accommodative monetary policy sent a strong signal to market participants that the Fed has your back. When stocks go down, the central bankers will come in to save the day. This response to the crisis has been strong enough to encourage investors to continue increasing risk exposures despite an economic backdrop featuring the weakest recovery in post-World War II history.

According to the assessment of Mohamed El-Erian in the Financial Times : "Central banks have been big buyers of financial assets during an unusually long period of prolonged reliance on unconventional monetary policies, the market impact of which has been amplified by the predictability of their purchase activities. All this liquidity has floated stocks higher, and kept them there despite an unusual degree of economic and political fluidity. In the process, asset prices have been decoupled from underlying economic and political fundamentals."

This leaves both investors and central bankers in an awkward spot now, however. Although the Fed has started increasing rates and is signaling more to come, the major indexes continued to press higher last quarter. While it is true that much of the gains were driven by a narrow group of large tech firms and that even those stocks lost momentum at the end of the quarter, the "decoupling" process has continued. What does this all mean?

In trying to disentangle the Fed's intent, Albert Edwards provides some useful context. As he notes, "the BIS [Bank of International Settlements] is really very concerned that policy makers are making exactly the same mistakes they did in the run-up to the 2008 financial crisis." While there is no shortage of entities offering advice to central banks, BIS recommendations carry some serious weight because it was one of very few institutions to correctly anticipate the problems of the financial crisis. One can make out more than just a hint of a warning in the comments of Claudio Borio, the Chief Economist at the BIS, when he noted, "The end may come to resemble more closely a financial boom gone wrong, just as the latest recession showed, with a vengeance. A strategy of gradualism is no panacea, as it may encourage further risk-taking."