Monthly Letter January 2018

Return of Volatility

When we wrote our first draft of this monthly letter we intended to cover the very strong start to 2018. As we write this letter we’ve been through a correction and subsequently what appears to be a normalisation of the equity markets. After 3 weeks of trading in 2018 the EuroSTOXX50 was up 4.8% and the S&P 500 was up close to 7.5%. That pace is of course not sustainable and we were yet again inundated with reports of an imminent correction or bear market.

Our own thinking has been very much along those lines as well. We have previously stated that we do not try to time market corrections: it is futile and definitely not our edge. We react when the market gets dislocated and we give ourselves flexibility through disciplined risk management and put protection which gives us curvature on the downside (a bit technical, but please feel free to contact us should you want more details on how we structure the option protection). Whether it was just long overdue or there are fundamental reasons for the correction is in the eye of the beholder. Valuations are on the rich side, but nowhere near the levels seen in the IT-bubble.

Around the turn of the century we saw valuations of P/E c30 on the S&P 500 compared to c17 currently. So valuations can certainly go higher even if we admit that it is a bit unfair to use such an extreme point as the IT-bubble for comparison. Before the Lehman crash, S&P was trading around the 18 mark. Not materially different from where we are today. One of our main concerns is the cost of capital. The current bull-market has been based on easy money which has forced allocation of capital to risky assets. Central banks led that charge and the real worry now is if they all of a sudden are behind the curve.

The repercussions could be very painful if inflation starts to rise quicker than what is currently expected. Central banks are then being forced to raise rates a little quicker than their original intention. The world is more interest rate sensitive now than pre -Lehman crash (leverage is higher which is contrary to all deleveraging ambitions) so a small interest rate hike will have a bigger effect on personal consumption. This is not our base case scenario, but we think that the odds of this happening in the next 12 months has increased from maybe 5% to say 15-20%. This should definitely have an effect on valuation.

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