18/11/2011: Navigating drunken sailor markets

The gales of politics and economics have markets sailing in circles, pitching and rolling on nervous seas. Anchors and safe havens seem wishful, steering a long-term course is harrowing. The volatility of it all might actually deliver some return. Just don’t try to predict what tomorrow may bring.

I arrived in the office just past seven in the morning on Monday, 14 November. Silvio Berlusconi had resigned as Italian Prime Minister, replaced by Mario Monti, a move seen by many as the one needed to calm markets.

To prepare for an interview about the Italian political change and its implications for the euro, I head to the coffee machine and punch it twice for a double espresso, then switch on the TV for the latest news from Asian markets to start the week. On CNBC, the news anchor asks a clever trader from an Australian investment boutique, “Well John, what is your feeling for today? Will the market be in a risk-on or risk-off mood?” The double espresso is to no avail; this line of inquiry depresses me.

Is this what things boil down to now? Worldwide, thousands of dedicated analysts, economists, strategists and theorists, technicians and rocket scientists, scrutinize every asset class, dissect economic statistics, examine historical patterns, weigh every word and central banker antic, plumb the Byzantium of Greek politics and the Florentine of present-day Italy. For what? Is all we need to know now “risk-on or risk-off?” Even a dart-throwing chimpanzee seems a worthier benchmark.

What to do in such a market? Wait until European politicians finally make up their minds? For sure, if “risk-on, risk-off” sounds like coin flipping, then trying to time the market is no better strategy. Neither is thinking that a magic, unshakable asset exists somewhere. In my view, capital protection, over a longer time horizon, can already be achieved with a well-diversified portfolio. While equities might induce tachycardia on occasion, at least those paying high dividends consistently grant some income for the doctor bills. Many “safe” government bonds don’t even do this anymore.

Bolder investors seeking opportunities in this challenging environment should focus on market volatility. It is currently very high and hence expensive to buy. History has shown that it tends to revert to its mean. Looking ahead six months from now, we think the euro crisis will have been resolved, either through forceful ECB intervention to end speculation against sovereign European debt (best case scenario), or by a break-up of the Eurozone (worst case scenario). In both cases, the uncertainty will be gone and market participants should again return to fundamentals. This means that market volatility and its price will have dropped. So why not sell some volatility today?

A final piece of advice to those who are flummoxed by market mood changes: don’t try to explain those swings – and therefore stop watching CNBC, or whatever other TV channel. They only focus on high-frequency jitters. While we can explain why the sailor drank and why markets are currently in a “risk-on, risk-off” mood, we will never be able to forecast whether the drunken sailor’s next step will be to the left or the right.