Indexology^® Blog

As of Nov. 26, 2014, Modi “Sarkar” (Modi’s government) has completed six months of leading the central government.  Since Mr. Modi assumed office, there have been high expectations from the corporate community, not just in India, but across the world.  This is represented by the barometer of the market in India: the S&P BSE SENSEX.  Over the past few months, the S&P BSE SENSEX has repeatedly recorded new all-time highs.  A similar atmosphere was seen in 2009, when it became clear that there would not be a hung parliament and that the UPA would form the government; the S&P BSE SENSEX recorded a steady increase, recovering from the bottom of the financial crisis.

The recent strong performance of the S&P BSE SENSEX has prompted close study of the market performance during the initial period of both of these Indian governments.  For this analysis, we have taken a base date of six months from the date of formation of each government.  As elections are announced, the market tends to be more sentimental, which is why we chose to begin measuring the performance from the election announcement date.  Exhibit 1 shows the key dates of comparison, from the election announcement until six months after the formation of the government.

Source: Asia Index Private Ltd.  Charts and tables are provided for illustrative purposes.

The S&P BSE SENSEX showed higher returns during the initial period of Manmohan’s government (UPA 2009) than during the same period of Modi’s government (NDA 2014) (see Exhibit 2).  What is more interesting to note is that in 2009, from the announcement of the election results until the completion of six months of Manmohan government, S&P BSE SENSEX almost doubled.  During the same period of Modi’s government in 2014, the S&P BSE SENSEX had total returns of approximately 35%.

Exhibit 2: Total Returns 

Source: Asia Index Private Ltd.  Total Returns in INR.  Charts and tables are provided for illustrative purposes.  Past performance is no guarantee of future results.

Another interesting statistic to note here is that for the period from the election announcement through the completion of six months in office for each prime minister, the GICS^® financials has contributed the most to the total returns generated by S&P BSE SENSEX out of any sector (see Exhibit 3).

Exhibit 3: Returns from Election Announcement versus Financial Sector

Source: Asia Index Private Ltd & Bloomberg.  Total Returns in INR. Charts and tables are provided for illustrative purposes.  Past performance is no guarantee of future results.

Furthermore, during the same measurement period for Manmohan’s government in 2009, there were 15 trading sessions in which the S&P BSE SENSEX closed above 3% (by total return).  Meanwhile, during the same period for Modi’s government in 2014, there was no trading sessions that closed above 3%.

Could these levels of performance simply be contributed to the expectations of the ruling government?  We believe the answer is no.  It would be unfair to attribute market performance exclusively to sentiments toward the expected or ruling government.  However, this is certainly one of the many factors.  Other factors that may affect the market may include growth rate, inflation, past market performance, growth of major economies across the world and more.

Last Saturday’s Wall Street Journal carried an excellent list of “16 Rules for Investors to Live By.”  I was particularly impressed by rule #1: “All past market crashes are viewed as opportunities, but all future market crashes are viewed as risks.”  Serendipitously, the 16 rules followed close on the heels of our latest white paper, which deals with many of the same concepts.  In particular, volatility rises when markets crash, and volatility and opportunity are closely related.

It’s comparatively well-understood that changes in volatility are negatively correlated with returns; it’s less well-known that higher levels of volatility are also negatively correlated with returns.  Below we’ve charted the average monthly change in the Dow Jones Industrial Average against its concurrent monthly volatility.   Although there’s no relationship to speak of in the middle quintiles, the lowest quintile of volatility shows the highest average returns, and the highest quintile of volatility shows the lowest average returns.

These data make the connection between volatility and return on a short-term basis.  But is there opportunity in high volatility?  For investors willing and able to look beyond a one-month holding period, perhaps so; if volatility indicates distress for existing investments, it may signal an attractive entry point for new ones.   We tested this hypothesis by calculating returns for holding periods of various lengths, conditioned on whether volatility is above or below the 85th percentile of the distribution.  Given the relationship between high volatility and low returns, it’s not surprising that investments made during periods of lower volatility outperform over short holding periods (up to about 11 months).  After that, however, fortune favors the bold:

The J curve illustrates why investing in periods of high volatility has been compared to “catching a falling knife.”  The risk of short-term loss is significant (and bottoms at about the 8-month point).  Thereafter, the advantage goes increasingly to investors who bought during periods of high volatility.

There’s a reason why the British financier Nathan Mayer Rothschild is reputed to have said “Buy when there’s blood in the streets, even if the blood is your own.”  It may be true that all future market crashes will be viewed as risks when they are happening.  But it’s equally true that they may appear, in retrospect, as opportunities.

The end of 2014 feels a lot like the end of 2013 in regard to fixed income market sentiment.  As the Yogi Berra quote goes: “it’s déjà vu all over again”.

The yield of the S&P/BGCantor Current 10 Year U.S. Treasury Index reached a high of 3.03% on December 31^st as investors debated the impact of the Fed’s eventual reduction in stimulus which now is commonly known as the “Taper Tantrum”.  The current level of yield for the index is nowhere near 3% at its current level of 2.31%, though it has increased by 17 basis points from the year’s low of 2.13% (10/15/2014).

When looking ahead to 2015, again the Fed will play a big role in the direction of the fixed income markets.  Investors are looking ahead to an expected rate increase.  The question is how soon and how aggressively will the Fed act and to what impact will such action have on both short and long term investments.

In the near term the need for yield will continue and if healthy economic growth continues, the balance sheets of these speculative rated companies should remain intact.  The S&P/LSTA U.S. Leveraged Loan 100 Index which currently yields 4.85% had an October positive returns of 0.61% and 0.36% for November which helped this index return 1.9% year-to-date.

Bank Loans are likely to be hurt less by higher market rates than their high yield fixed rate counterparts.  The average floor on a loan is 1% so Libor would have to move up significantly from its current level of 0.24%, but once the floor is breeched, the instrument become more floating in nature moving up with rates.

Recently I visited a few pension plans and it amazes me how the policy views on risk differ to meet seemingly similar return goals. The National Association of State Retirement Administrators (NASRA) reported earlier this year that of 126 major state and municipal systems, 32 had set an assumed rate of return between 7.5% and 8%, 37 had set a rate between 7% and 7.5% and 45 had an 8% rate.  However, the risks the plans are taking to make their return goals differ significantly and may be the result of an evolution of risk-awareness.

According to one of the pension executive directors, “1/2% [assumed rate of return] won’t change anything about how we invest… we take as little risk as possible to get to our 8% goal and would never invest in risky assets [like commodities, the way another pension would].”  This particular pension manages risk mostly from a liquidity perspective with three main buckets being “liquid”, “illiquid” and “moderately liquid” – where about 60% of the assets are allocated. The “liquid” is mostly cash, the “illiquid” contains private assets and real estate, and the “moderately liquid” contains mostly equities and credit.

“Another pension” with the same return goal of a real rate of return (the rate by which the long-term total return exceeds the inflation rate) of at least 5.5% per year claimed, “their peers will follow in their footsteps but someone needs to go first.”  Follow in their footsteps to do what? Manage risk. Their target allocation is based on risk parity, just like Texas Teachers announced today, and the asset allocation target looks much less like the traditional stocks, bonds, real estate and alternatives like in the “conservative plan” described above. Texas Teachers’ has five different buckets, which is one less than “another pension” but is comparable.

Some of the noticable capital allocation differences are in the inflation linked bonds, commodities and global equities. In the self-described “conservative” plan, there is a policy of about 45% equities, 5% TIPS and no commodities. In the “risk-based plan” that describes themselves as flexible to take advantage of changing market conditions, equities get a target of about 10%, 30% TIPS and 8% commodities that mirrors Texas Teachers’ much more closely.

According to Cerulli Associates, since the early 1970’s, Modern Portfolio Theory has influenced asset allocation. Institutions looked to increase diversification and reduce risk by allocating to a broad number of diverse asset classes typically defined by underlying security type and marketability. However, the severe market stress and extreme volatility experienced in the global financial crisis of 2007-2009, caused many correlations between asset classes to rise that not only increased risk but lowered returns.

Today, institutional investors are under pressure to increase returns, while keeping risk unchanged, forcing many institutions to rethink their approach to portfolio construction. Many institutions and investment consultants are giving a face-lift to their traditional asset allocation classification approach for a “role bucketing” or risk-based approach, identifying the risks of an investment rather than which asset class it falls in. With the objective of generating more consistent returns across different economic environments, a growing number of institutions are changing their framework for asset allocation using a risk-based lens, reclassifying assets by factors that explain their risk and return characteristics.

Eighty-five percent of consultants surveyed by Cerulli consider asset allocation and diversification of investment portfolios according to underlying risk factors, as opposed to using the traditional style boxes. Of those 85%, 75% of gatekeepers indicated that they currently use a risk-based approach for constructing portfolios, and have made changes to clients’ investment policy statements and asset allocation accordingly.

This is a big change from the 60% stock / 30% bond / 10% alternative average allocation of ten years ago.

Chinese bonds continue to attract attention from global investors as they offer relatively higher yields, what’s more, Chinese bonds also have historically demonstrated low correlations with global markets.

Exhibit 1 shows the correlation of the S&P China Sovereign Bond Index with major sovereign bond indices in global markets. While the index has a low correlation of 0.09 with the developed sovereign bonds, it exhibits a negative correlation of 0.12 with the Eurozone developed sovereign bonds.

Thus, Chinese bonds do not only provide the portfolio diversification through the exposure to local rate, credit and currency, they would also be a good hedge to the global fixed income portfolio. And of course, not to mention, China has a higher credit rating than most countries.

The S&P China Sovereign Bond Index currently tracks CNY 9.3 trillion of sovereign bonds. As of Dec 4, 2014, the index has delivered a YTD return of 9.48%.  The index’s yield-to-worst is at 3.54% with the modified duration of 5.55.

Exhibit 1: Correlation Chart

Please click here for more information on the S&P China Sovereign Bond Index.