The issue is easily defined: Convergences reduce volatility. Divergences increase volatility. That defines the yin and yang of markets. Or others might call it the Sturm und Drang of markets. We call it a merger of metaphors.
“Yin and yang” (Chinese philosophy, origin estimated 4th century BC) describes how opposite or contrary forces are actually complementary, interconnected, and interdependent in the natural world, and how they give rise to each other as they interrelate. The Global Interdependence Center (www.interdependence.org) has been a leading think tank on these relationships in the markets for 40 years.
The phrase Sturm und Drang (literally, “storm and stress” – German origin, 18th century) is usually applicable to literature and music. It describes elements in which individual subjectivity and, in particular, extremes of emotion are given free expression in reaction to the perceived constraints of rationalism.
Let’s merge the two concepts and then discuss the divergences at work in markets today. Rationalism in markets is fact-driven, data-dependent, and mathematical. Numbers have no emotions. Estimates are assertions or forecasts made within a numerical system. Fear and greed, on the other hand are the traditionally defined emotions of markets. Fear and greed are the Sturm und Drang of modern-day markets.
Convergence and divergence are elements that may be identified factually and rationally. Seen in perspective, they provide the yin and yang of interdependency and hence guide a market agent to better understand volatility. Volatility is an outcome revealed in markets: volatility is not causality; it is result. The yin and yang of data flows and interdependency do, however, influence the Sturm und Drang of human behavior. That is the source of volatility. It is the Sturm und Drang that activates market uncertainty and drastic market shifts. We can measure the VOL factually and rationally. The measurement of VOL and the rate of change in VOL reveal crucial information about irrational market forces at work. At Cumberland, we measure VOL daily and do so in many ways.
Now to markets.
Our work suggests there will be no recession this year in the US. Slow growth, low inflation, and low interest rates will persist. The recent higher VOL has made that outcome more likely. So our expectations are still positive for the longer-term bull market in US stocks and still positive for the high-grade bond sector. Hence we are still positioned accordingly. The stock side has suffered, as one would expect. The bond side has rallied strongly, as one would expect. Yin and yang. The complementary balancing of these two sectors has long confirmed the seminal work of Franco Modigliani, conducted about a half century ago. Much of this work is revealed in the jointly authored books of Modigliani, who was at MIT, and Frank Fabozzi, who was at Yale. (On a personal note, one of the great honors of my life was to have made a small speck of a contribution to a Fabozzi book. I recall it vividly even though it was many years ago.)
Markets today face intense divergences. They are replacing convergences that reached their peak in 2008–2009. The world coalesced in the face of the financial crisis and risk of a great depression. In 2008, the Sturm und Drang of markets was narrowed and sharpened into intense fear. There was no room for greed. By 2009, the world began it scale its way out of that dark, frightening economic nadir. Everywhere, new, often radical, policy initiatives coalesced into determined action. Fear remained but began to morph to a better, more rational outlook as the initiatives started to thaw a frozen global market. Sturm und Drang convincingly shifted to the optimistic while the yin and yang of financial failure and recovery confirmed their interdependency. Those trends have been in place ever since the turn.
New divergences are now causing these post-financial-crisis trends to be questioned. And it is the guesses we make about these divergences that affect the Sturm und Drang of today’s market agents, who must try to steer their portfolios through this storm of uncertainty.
In the storm it is hard to step back and calculatingly appraise the indissoluble yin and yang of markets. Example: from time to time, markets need corrections in prices. That is how they find a solid platform for the next movement up. Similarly, credit needs to be extended in excess before it can be corrected and a more stable platform created for the next round of credit expansion. Yin and yang hold true in geopolitics as well. Antagonists may either need to negotiate intensely or duke it out until one side is exhausted. That is how a new platform for peace comes into being. Yin and yang are a constant whole, even as the Sturm und Drang of human emotion causes market agents to feel besieged by the world they confront.
Let’s observe some of the divergences at work.
1. Monetary policy converged to create stimulus worldwide as agents combined to fight a financial crisis. That was then (2008–9). Now we see divergence at work (2015–16). Example: The European Central Bank may lower its present negative rates to an even more negative level. Meanwhile, the Federal Reserve is on a path to attempt to raise rates. The size of these two monetary blocks dwarfs all others. And what was a convergence of policy between the Bernanke Fed and the Trichet ECB is now a divergence of policy between the Yellen Fed and the Draghi ECB. In my personal view, this monetary divergence is the single biggest force at work on markets. The divergence is widened by policy positions and changes in those positions occurring in Japan, England, China, and elsewhere. We expect further divergence in 2016.
2. Iran and Saudi Arabia are embroiled in a huge divergence, as manifest in the growing intensity of the Sunni-Shia schism and in the geopolitical risk profiles of the two countries and their respective spheres of influence. It is a divergence that is also demonstrated by their oil price policies and their budget constraints. The outcome is unpredictable, so risk is increasing and fear is growing. The yin and yang and Sturm und Drang of the Shia-Sunni schism are centuries old. History gives us lessons to learn from if we want to take the time to study them. But our Western impatience gets in the way; hence we make policy error after policy error. This is the outlook: more policy errors and further reactive policymaking will be followed by more violence until one or both sides are exhausted. Will the struggle be a Thirty Years’ War model, or a Hundred Years’ War model? No one knows.
3. US energy policy is undergoing a divergence. After 40 years of an export ban, the policy change is about to add large volumes to energy output as the new oil and natural gas export industry grows from its incipient stage to maturity. That process will take several decades. The world sees this new America as the most secure and dependable global source of oil and LNG. That is why global buyers are executing 20-year contracts with our American companies. Markets are focused on the present spot price of oil or on the weather. So we have a clash between the yin and yang of American energy turning positive while the Sturm und Drang of spot prices is most fearfully intensified. We believe clarity will be regained in 2016. At the conclusion of this phase of high VOL in the energy patch, the US will be positioned to establish a positive growth industry. That is already our destiny. By the way, all this happened because of the yin and yang of economic forces that developed the new energy production techniques. It came about in spite of politicians, not because of them. Remember the fear of “peak oil?” That history reflected the tug of war between Sturm und Drang on one side and the yin and yang at work always and everywhere in any dynamic enterprise.
4. American politics are in the midst of a divergence, too. The electorate is rejecting the two mainstream political parties. That is why Sanders on the left and Trump on the right are doing so well. Voters are saying “enough!” of the conventional Democrats and Republicans. It took years to get this level of Sturm und Drang. The road was paved by Ross Perot and John Anderson and others who failed in their challenges to the entrenched two-party system. But now voters are rejecting the despised American political class in greater numbers and with greater fervor. Politicians (read congressional representatives and senators) are about as popular as scorpions. Nothing new here, though, if one steps back and looks at the yin and yang of American political history. But emotions are running high now, and outcomes are unpredictable. The country may actually have a civics lesson coming with regard to the functioning of our Electoral College. We got a small lesson of that sort in the “hanging chad” affair of 2000. A larger one will unfold if this presidential race comes down to a contested political convention for one party or the other, or a contested election decision that must be made in the Electoral College. The possibilities are fascinating and uncertain. Imagine if political divergence leads to a call for a constitutional convention to rewrite the rules by which this nation was launched in the late 18th century. Wow, what a year this may be for America.
5. The last divergence we will mention is in credit and banking. We have written about high-yield debt and the use of foreign debt and other instruments by mutual funds. Our position remains the same: it is incumbent on the investor or agent to read the details carefully. We used the Nuveen high-yield funds as an example because they were in the Morningstar list. Investors would be wise to examine those reports. For us, this is an easy one. We avoid Nuveen and others of the same ilk. We are wary of mutual funds. Some of them are paying larger platforms for shelf space. They use a portion of their management fees for this payment and do so because they claim they are covering marketing and administrative costs. As long as the total management fee is disclosed to the mutual fund shareholder, the mutual fund manager may pay a portion of it for marketing; but at Cumberland we avoid this process. We do not engage in it and will not do so. Again, we recommend that investors read the documents very carefully and then ask their agents if there is such a payment to be made.
In sum, market agents are enduring a tug of war between the emotional forces pulling at them and the rational forces that spring from an appreciation of yin and yang. To see yin and yang at work, one must step back from the daily tugs and the spot prices. One must seek the trends and then place them in perspective.
One of those trends is very clear to us: America is still the safest and most desirable place in the world for the accumulation and disposition of capital. Our currency is the world’s favorite for good reasons. Ownership enjoys better legal governance in the US than in most other places. And our institutional strengths allow us to change governance without tanks in the streets. All of that is a positive for our markets, and particularly so, given the state of divergences in the world.
We think higher-grade credit is still cheap. We think American corporations are being repriced in the stock market and are desirable for entry. Certain foreign markets are also going through this repricing and are once again becoming attractive. 2016 will be a high-VOL year, but VOL is bidirectional. Violent downside moves are alarming, but they set the base for strong upside ones. Bidirectional VOL is the yin and yang of markets; Sturm und Drang drives the intensity of VOL.
Happy start of 2016.
David R. Kotok, Chairman and Chief Investment Officer