From the Desk of Jean L.P. Brunel, CFA
Chief Investment Officer, January, 2012

• View as a PDF file

Following on a theme from our previous notes, we may be encountering a perfect storm in many investment markets, following a chain of events that are not necessarily connected.

At issue here are 1) the nature and extent of the financial crisis, 2) the determination of selected central banks and government to provide liquidity to head off what they perceive to be a looming catastrophe, 3) the superficiality often fostered by 24/7 news cycle, and 4) the growing dominance of so-called hedge fund managers. Collectively, one could argue that these elements are behind a phenomenon which hasmany pundits, managers and individual investors puzzled: markets seem to suffer from a combination of elevated – though not necessarily record – volatility and abnormally high correlations. The net effect of these latter two elements in markets is making successful stock or instrument selection appears even less achievable than in normal circumstances.

A closer look at trading suggests a relatively simple interpretation to that “surprising” phenomenon of high correlation and higher than normal volatility. What if investors simply had become traders? Note that what follows is not meant as a diagnosis which evaluates and then excludes all other alternatives, but rather as an illustration of a possible scenario, which might serve to explain patterns which several observers find otherwise troubling. Let us explore this thought here and draw a few implications as to how one might deal with them.

Without going back in depth over volumes of literature, I suspect that it will be self-evident to readers that the fundamental difference between a trader and an investor most often is the time over which the investment is to be held. In fact, in certain jurisdictions which still differentiate between trader- and investor-status for tax purposes, one of the “safe harbor” rules to preserve an investor-status is to maintain some minimum holding period for each investment. An important element of the time horizon dimension, though, is that someone we call an investor will not necessarily be long-term oriented; by contrast, most traders have a relatively short time horizon. Ostensibly, one needs to be careful with these dichotomies as one is really dealing with a continuum rather than digital points; thus, I suspect that someone could credibly argue that certain traders have a longer time horizon than certain investors! Yet, I am suggesting this dichotomy in a bid to make a larger point, and would thus invite our readers to accept an admittedly simplistic definition that traders deal in short-term trades, while investors have time horizons which stretch over quarters or years.

The fact that investors as a group have multiple philosophies and multiple time horizons tends to promote diversity within markets as individual decision makers will focus on different fundamental or technical elements, or will view them over different time frames. Traders, by contrast, often tend to react to less diversified stimuli, which will, ceteris paribus, promote more coordinated price moves. Thus, a changed balance between investment- and trading-driven investment decisions could, combined with material excess liquidity and questionable short- to intermediate-term fundamentals, cause markets to behave in a different way, characterized by higher correlations. Further, a higher overall uncertainty combined with virtually negligible risk-free returns could also easily lead to an environment where the herd moves in or out, simultaneously, and thus where volatility ticks up, potentially materially.