Is a crash coming?
Increasing numbers of experts are beginning to express concern amid high stock valuations, historic market concentration, and the increasing prominence of circular financing among AI-related firms, whose capex is driving much US economic growth.
While the US economy has been fairly resilient to date, growth is clearly moderating, and the jobs market is showing signs of strain.
The US government shutdown has put blinkers on the US Federal Reserve just when it is back in rate-cutting mode, despite inflation running well above target.
Tariffs are beginning to creep into consumer prices.
Strangely, none of this seems to be perturbing financial markets.
Stocks are soaring, credit spreads are at historic tights, and private markets are enjoying a continuous flow of capital.
Clearly, this has some worried.
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The Bank of England recently warned of a sudden correction in global markets given the extended valuation of AI stocks, and highlighted the risks of a sharp repricing of US dollar assets if the US Fed succumbs to pressure from President Donald Trump and cedes independence.
Jamie Dimon, chief executive of JPMorgan Chase, puts the chances of a serious market correction at 30 per cent, having earlier expressed concern about unsustainable government spending and borrowing.
“You are going to see a crack in the bond market,” he said in May. “I’m telling you this is going to happen. And you are going to panic.”
Gold breezily surpassing $4,000 an ounce suggests there is ‘FOMO’ aplenty – and a hint of a debasement trade – but also a lack of confidence in government debt.
And while US retail sales have held up so far, US consumer confidence in September declined along with job openings, and popular Google search trends suggest more problems lurking under the surface.
What kind of market regime are we currently in?
Comparisons to the past are, some argue, more difficult to make this time.
Perhaps the effects of AI and innovation in everything from wearables to healthcare render the valuation frameworks of the past obsolete.
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Yet if we simply narrow the focus to equity valuations, there are similarities with elements of the Nifty 50 crash in 1972.
Fifty stocks that were viewed to be magnificent then, with valuations to be similarly ignored, collapsed and continued to fall for two years.
The crash in 2000 followed massive speculation in profit-free internet-based companies with dotcom attached to their name.
Today, we note that Anguilla is making a small fortune from owning the AI domain.
Ignoring the hype
The hype, it must be said, is not necessarily universal.
Blackrock, for one, has recommended its largest ever allocation to hedge funds and alternatives.
For those concerned that a crash is far from implausible, trend-following funds (often referred to as commodity trading advisers, or CTAs) are one option worth considering.
Trend-following funds analyse price movements and systematically build positions in traded markets as momentum gathers pace, generating, in some cases, very significant returns.
‘Crisis alpha’ – a term often attached to trend-followers – refers to the outperformance they can deliver in times of market stress.
Typically in a crisis, a number of market moves occur simultaneously, with drawdowns followed by sharp recoveries.
But it might not always be obvious why a market has moved, and harder still for a human trader or fund manager to profit from it.
In the run-up to the Covid-19 outbreak in early 2020, our Bowmoor Global Alpha Strategy began establishing significant short positions in lean hog futures and WTI crude oil, guided by downtrend indicators.
As events unfolded, global lockdowns triggered a sharp decline in demand for food services and transportation, as people stopped dining out and driving.
This collapse in consumption validated the positioning and underscored the effectiveness of the trend-based approach.
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While the pandemic was a once-in-a-century event, the strong performance of trend-following strategies during times of crisis is relatively typical.
In 2008, for instance, while the S&P 500 fell 37 per cent, the Soc Gen CTA Index returned plus 13.07 per cent.
Partly, this is attributable to these strategies’ ability to take both long and short positions.
That is important when the returns of all traditional asset classes can become closely correlated to each other, particular in stressed markets.
The other reason is that they trade globally diversified portfolios of futures across asset classes, combining equities, fixed income, currencies, and commodities.
The specific markets chosen (ie grain, metals, energy, livestock and soft commodities) help avoid correlation.
By buying long or short futures, depending on the direction of the trend, it is possible to construct a portfolio with very low correlation to traditional asset classes.
That may frustrate some during strong equity market rallies, as we have seen this year. But diversification cuts both ways.
When equities fall, investors need something in their portfolio to cushion the blow.
Over many decades, trend-following funds have proven their ability to deliver when it counts.
Thomas Gent is co-founder at Fairlight Capital Partners