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IN THE OLD SCHOOLYARD GAME, the kid who flinches ahead of a feigned punch is punished with a real one.
For the better part of two years, flinching has been a popular investment tactic among professional and individual investors alike, and the continuing rally in risky assets has consistently laid gloves on their performance—at least their relative performance.
Vadim Zlotnikov, chief market strategist at Sanford C. Bernstein, has been noting the abiding interest in investment tactics and instruments that are sold as risk shields, purporting to protect against so-called "tail risks," or unlikely but devastating market events much like those that occurred in 2008.
These risk-avoiding hiding places include the obvious— high-grade bonds and gold—but also stretch to tactical asset allocation strategies and owning "volatility" as an asset class, through such things as futures on the CBOE Market Volatility Index, or VIX.
Zlotnikov pointed out a few months ago that investors "will go to great pains to avoid repeating the most recently made mistakes, but have few qualms about repeating mistakes from long ago. Today, this shows up as investors' extrapolating of the historically highest volatility" of 2008 into 2009.
Gordon Fowler Jr., CEO and chief investment officer at wealth manager Glenmede, made a similar point, suggesting last month that "protection against extreme outcomes…has become unprecedentedly expensive."
This is the muscle memory of the crisis still animating investor behavior. The iPath S&P 500 VIX Short-Term Futures exchange-traded note (ticker: VXX), which profits from rising volatility, has more than $1.4 billion in assets, despite having launched in January 2009 and the fund having lost almost 90% since inception. For more than a year, prices on the relatively newly tradable futures on the VIX—which measures the options market's implied forecast of stock index jumpiness—have shown a steep premium in more distant contracts. This means traders have consistently bet on a surge in market turmoil a month or three or six hence.
Dean Curnutt of Macro Risk Advisors and Paul Britton of Capstone Holdings, speaking at a Bloomberg hedge-fund conference last Thursday, agreed that one reason for the steady premium in these instruments and others is a dearth of risk capital on Wall Street that would typically take the other side by effectively "writing" insurance to hedgers. This is a fair point and speaks in part to a structural change, but doesn't as much disprove the idea of broad risk aversion as help support it.
Just last week, BofA Merrill Lynch introduced a Global Financial Stress Index, "a comprehensive, cross-market gauge of risk, hedging demand and investment flows. The index is designed to help investors identify market risks earlier and more accurately than commonly used risk indicators, such as the VIX index," according to its news release.
The index might well do just that, perhaps even better than well-established indicators such as the Bloomberg Financial Conditions Index. (It certainly does the job in back tests, of course.) Yet the fact that, to the research folks at the No. 2 U.S. brokerage house, this seemed a propitious time to initiate an early-warning system for financial upheaval says plenty about the mindset of investors.
NONE OF THIS SAYS VERY MUCH about the near-term state of play in the markets, though the fact that the stock market rose 3% through Thursday and gave up hardly any of it despite a moderately disappointing employment report Friday. must have troubled the risk-averse.
Part of that can be pinned on another drop in the dollar Friday and the heads-I-win/tails-you-lose logic that says good economic data are good, and bad economic data are good because they will keep money easier for longer.
As noted last week, those investors who are actively engaged in the market are feeling pretty good about it, and there's a comfortable consensus that December is a slam dunk for seasonal and psychological reasons. A market intent on confounding the crowd, as it did with its strength since September, might decide to turn nasty or at least flat-line for a while.
But the market action is hinting that, whatever happy talk people are mouthing, they may not all be positioned along the lines of their words. CarpenterAnalytix.com notes that macro futures hedge funds have been fighting the market rally with net short positions.
And the tape itself isn't showing very much vulnerability yet, with cyclical leadership intact. And it's not simply the hopes and prayers of Fed money-printing at work, either. Since Treasury yields bottomed (and fixation on Fed bond buying arguably peaked) on Oct. 7, payroll processors Automatic Data Processing (ADP) and Paychex (PAYX) have handily outperformed the S&P 500. These jobs-sensitive names had every excuse to pull back Friday, but refused.
Could it be that this is one of those times, with lots of liquidity and supportive economic data, when the market's game is as simple as checkers rather than as intricate as chess?
WHAT'S WORKING IN THIS MARKET are the shares of industry-leading companies geared toward the cyclical global recovery in capital goods and the long-term rise of the emerging-markets consumer.
That's another way of saying that what's working in this market is Johnson Controls.
The company, whose business is split between auto components (batteries, seats and interiors) and building management (temperature and other facility control systems) has seen its shares (JCI) zoom higher by about 40% since Barron's ran a bullish cover story on it less than four months ago ("Totally in Control," Aug. 16).
This impressive ride has come as Johnson Controls—a $26 billion-market-value blue chip with roots stretching to the 19th century—logged another impressive quarter of earnings outperformance, showed tremendous growth in automotive sales in Asia, achieved higher margins across the company and gained market share in each business.
With such great recent stock performance and good fundamental results, stockholders might ask whether all the happy news is reflected in JCI's price of 39.19. Here the old trading rule of letting one's winners run probably makes sense.
Johnson Controls merely trades on a par with its diversified-industrial peers, the stock now at 15.7 times forecasts for $2.49 in earnings in the current fiscal year ending next September. Yet JCI's growth prospects are decidedly better than average. Robert W. Baird analyst David Leiker figures the company has room for 5% to 10% revenue growth and 15% to 20% earnings growth "over the next several years."
Aside from the energy-saving building-systems work JCI offers commercial real-estate owners, there is underappreciated strength and endurance to the current upswing in auto sales, both in North America and globally. Here, demand is pent up. Car inventories are about as low as ever recorded, the Big Three are healthy, used-car prices are near record highs, total volume of cars on the road has declined for two straight years for the first time ever, and the sales pace of new cars versus the driving-age population is as low as it's been since the early '80s.
The emerging-markets car-sales story hardly needs elaboration, with China handily exceeding U.S. annual-car sales right now, yet with penetration of car ownership at one-sixth the level.
JCI has recently pared its already manageable debt levels, raised its dividend and embarked on promising tuck-in acquisitions. All in all, investors in JCI ought to hang on for the ride.
E-mail: michael.santoli@barrons.com
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