The S&P 500 racked up another fine quarter with an 8.55% return which brought the gains for the first half of the year to 15.25%. It has been easy to fill in the blanks with ostensible reasons for the continued appreciation: Strong economic growth, easy financial conditions, receding threat of Covid-19, etc. Still, it is hard to imagine the abyss the market was staring into just sixteen months ago.
This paradoxical combination of frightening crashes and eye-watering rebounds has come to dominate market behavior over the last several years. This pattern also differs noticeably from the past when markets traced out the business cycle more closely. The challenge for investors is to find a mental model that can help navigate this unfamiliar territory.
We’re not in Kansas any more
As value investors are well aware, valuation does not make a great timing tool, but it is closely associated with future returns and therefore has proved useful for long-term positioning. Since the financial crisis, however, not only has value underperformed consistently, but other investment tools have lost effectiveness as well. John Hussman recently described:
“In market cycles across a century of market history, there was always a ‘limit’ to speculation
– points where overvalued, overbought, overbullish syndromes were so extreme that an air pocket, or panic, or crash would regularly follow. Quantitative easing made those ‘limits’ utterly unreliable …”
So, if past guidelines to speculative limits have become ineffective, what guidelines should investors turn to? As it turns out, authors Tim Lee, Jamie Lee, and Kevin Coldiron pursued a similar course of inquiry in their book, The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis. For example, they wanted to know …
“Why have stock markets, over the past 25 years, experienced huge rises and crashes? Why did the US stock market, in particular, quadruple over the years following the 2007–2009 global financial crisis even though US economic performance was at best so-so?”
The rise of carry
Good questions indeed. The answer that best fits the evidence is the market has become one giant carry trade. In order to appreciate that conclusion and understand the implications, however, it helps to be clear about what a carry trade is …
“Carry trades make money when ‘nothing happens.’ In other words, they are financial transactions that produce a regular stream of income or accounting profits, but they subject the owner to the risk of a sudden loss when a particular event occurs or when underlying asset values change substantially. The ‘carry’ is the income stream or accounting profits the trader earns over the life of the transaction. In this sense carry trades are closely related to selling insurance, an activity that provides a steady premium income but exposes the seller to occasional large losses.”
As it happens, carry is “a naturally occurring phenomenon” and “is not in itself wholly bad”. As the authors fairly note, “The return that carry traders earn is, at least in part, compensation for providing liquidity to markets and for assuming risk.”
One of the unique elements of carry trades over the last twenty years or so, however, is the increasingly active role of central banks. By dampening volatility, central banks have reduced the risk to traders and speculators putting on carry trades. That course of monetary policy has “helped carry returns become supernormal returns” and has “supercharged” the phenomenon of carry in the process.
Characteristics of carry
When we examine the characteristics of carry trades, it is easy to see their stamp on market behavior. Critical features include: “leverage, liquidity provision, short exposure to volatility, and a ‘sawtooth’ return pattern of small, steady profits punctuated by occasional large losses.”
Perhaps the “sawtooth” pattern of returns is most notable – and pernicious – for investors. Just when markets seem fairly calm and safe, something comes from out of nowhere to throw markets into a spin. Likewise, just as soon as it looks like markets are going to completely seize up, the skies magically clear and it is smooth sailing again. This kind of progression of bubbles and crashes is what the authors refer to as a “carry regime.”
One of the fascinating characteristics of a carry regime is “a progressive de-anchoring of the structure of market prices from fundamental economic reality”. In other words, stock prices become driven by financial market structure more than business and economic fundamentals. This is exactly why valuation has been ineffective and why other conventional market metrics have also performed poorly. The carry regime is a financial phenomenon, not an economic one.
Another aspect of the current carry regime is that it is based in US markets. This is due primarily to the fact there is “greater liquidity and breadth of financial instruments in the US markets” and as such, place the S&P 500 index “at the center of the global carry trade”. This helps explain why the carry regime outside the US is “more fragile” and why emerging markets get hit so hard when things turn south.
Finally, carry is about power in an important sense. When markets go down, it is only those with strong balance sheets or close government connections that survive. When volatility spiked in the financial crisis, all of the major banks (except Lehman Brothers) got backstopped by the Fed. When volatility spiked in February 2018 in the Volmageddon event, retail investors in the XIV ETF got wiped out.
“Long term, this leads to three critical outcomes. First, it makes prospering in financial markets less about competence and more about insider status, as insiders with weak balance sheets are able to survive carry crashes thanks to central bank action. Second, it reinforces wealth inequality by truncating losses for already wealthy investors who do not necessarily need, but nevertheless benefit from, action to suppress volatility. Last, the distinction between economic recessions and financial market downturns becomes increasingly blurry. Recessions no longer cause severe asset price declines, or bear markets; they are a function of the asset price declines.”
To sum up then, carry trades are naturally occurring phenomena but have become supercharged due to central bank interventions that artificially moderate volatility. Insofar as central banks stay the course on interventions, a carry regime develops which is comprised of a running series of carry bubbles and carry crashes. Because the drivers are financial, conventional economic and market-based metrics and decision tools lose effectiveness.
Adapting
One of the adaptations some investors have made is to “Buy the dip”. While this strategy is painfully simplistic, it has also been amazingly effective. While such robotic behavior may not seem worthy of earning excess returns, in a carry regime buying the dip provides liquidity and therefore does earn excess returns.
There are two problems with managing through carry regimes though. One is carry crashes can occur suddenly and without warning. The authors describe, “In the world of extreme carry, high financial asset prices do not guarantee that the economy is ‘good for now.’ The carry crash can occur suddenly—at the point when leverage has reached too great an extreme to be sustainable …”
Another problem is carry regimes can last longer than one might guess, although they can’t last forever. Part of the reason is “The carry regime in itself is fundamentally deflationary over the long run, primarily because it exists in an economic environment of very high, and burdensome, debt levels.” Relatedly, a carry regime directs the course of the economy by “creating a pattern of economic growth driven by consumption and capital allocation driven by speculation, as opposed to a more healthy economy driven by the investment of the economy’s savings in future growth potential.” In other words, it is parasitic.
Over the long run, then, the carry regime de-anchors stocks from fundamentals, facilitates debt accumulation, weakens growth, and increases economic risk. It is destined to end. But what will cause it to end and what will follow in its stead?
When push comes to shove and central bankers are eventually forced to make a decision between tanking the economy by withdrawing monetary support or throwing the machinery into full inflationary gear, the authors assume the latter will happen. In their words, “governments together would implement extreme measures that would be outside the bounds of current law but would be deemed imperative to ‘save the world’.” Certainly, this could include direct monetization of government spending.
Conclusion
In summary, the carry regime provides remarkable explanatory power to market behavior over the last twenty years or so. For example, it helps explain the sawtooth progression of bubbles followed by crashes and it helps explain why the value style has underperformed.
For as long as the carry regime persists, the easiest path to success is to buy the dips. It is important to note in doing so, however, one must both have the wherewithal to survive any carry crashes along the way and to be on the lookout for the ultimate end of the carry regime.
It is also useful to highlight the potential this environment has to wrong-foot all kinds of investors. While many investors will be comfortable riding out the carry crashes of the sawtooth pattern to ever-higher market highs, that will all come collapsing down once the carry regime fails. Others may prefer to buy the dips of the sawtooth. But they need a regular supply of capital to do so and even then, will be just as vulnerable to the final denouement of the carry regime.
Still other investors will prefer to sit out the carry regime or to remain underinvested through it. This strategy is notable for avoiding much of the potential for permanent losses of capital but requires a great deal of patience. Further, since the carry regime will most likely end with inflation, appropriately sizing inflation hedges is an ongoing challenge.
At the end of the day, the carry regime does not provide the kind of markets most of us would prefer to invest in, but we still need to contend with it nonetheless. At least by understanding its characteristics and developing an appropriate mental model, you can have a fighting chance to make the most of the market exposure you accept.
