We’re not in Kansas anymore. The S&P 500 racked up another fine quarter with an 8.55% return, which brought the first half of the year to 15.25%. It has been easy to fill in the blanks with apparent reasons for the continued appreciation: Strong economic growth, easy financial conditions, the receding threat of Covid-19, etc. Still, it is hard to imagine the abyss the market was staring into just sixteen months ago.
This paradoxical combination of frightening crashes and eye-watering rebounds has come to dominate market behavior over the last several years. This pattern also differs noticeably from the past when markets traced out the business cycle more closely. The challenge for investors is to find a mental model that can help navigate this unfamiliar territory.
We’re Not In Kansas Anymore
As value investors are well aware, valuation does not make an excellent timing tool. Still, it is closely associated with future returns and therefore has proved helpful for long-term positioning. Since the financial crisis, however, not only has value underperformed consistently, but other investment tools have lost effectiveness as well. John Hussman recently described:
“In market cycles across a century of market history, there was always a ‘limit’ to speculation. The points where overvalued, overbought, overbullish syndromes were so extreme that an air pocket, or panic, or crash would regularly follow. However, quantitative easing made those ‘limits’ utterly unreliable.”
So, if past guidelines to theoretical limits have become ineffective, what guidelines should investors turn to? As it turns out, authors Tim Lee, Jamie Lee, and Kevin Coldiron pursued a similar course of inquiry in their book, The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis. For example, they wanted to know.
“Why have stock markets, over the past 25 years, experienced huge rises and crashes? Why did the US stock market, in particular, quadruple over the years following the 2007–2009 global financial crisis even though US economic performance was at best so-so?”
The Rise Of Carry
These are excellent questions indeed. The answer that best fits the evidence is the market has become one giant carry trade. To appreciate that conclusion and understand the implications. First, however, it helps to be clear about what a carry trade is.
“Carry trades make money when ‘nothing happens.’ In other words, they are financial transactions that produce a regular stream of income or accounting profits. Still, they subject the owner to the risk of a sudden loss when a particular event occurs or when underlying asset values change substantially. The ‘carry’ is the income stream or accounting profits the trader earns over the transaction’s life. In this sense, carry trades are closely related to selling insurance, an activity that provides a steady premium income but exposes the seller to occasional large losses.”
As it happens, carry is “a naturally occurring phenomenon” and “is not in itself wholly bad.” As the authors fairly note,
“The return that carry traders earn is, at least in part, compensation for providing liquidity to markets and for assuming risk.”
One of the unique elements of carry trades over the last twenty years or so is the increasingly active role of central banks. By dampening volatility, central banks have reduced the risk to traders and speculators putting on carry trades. That course of monetary policy has “helped carry returns become supernormal returns” and has “supercharged” the phenomenon of carry in the process.
Characteristics Of Carry
When we examine the characteristics of carry trades, it is easy to see their stamp on market behavior. Critical features include:
“Leverage, liquidity provision, short exposure to volatility, and a ‘sawtooth’ return pattern of small, steady profits punctuated by occasional large losses.”
Perhaps the “sawtooth” pattern of returns is most notable – and pernicious – for investors. When markets seem reasonably calm and safe, something comes from nowhere to throw markets into a spin. Likewise, just as soon as it looks like markets will completely seize up, the skies magically clear, and it is smooth sailing again. This kind of progression of bubbles and crashes is what the authors refer to as a “carry regime.”
One of the fascinating characteristics of a carry regime is “a progressive de-anchoring of the structure of market prices from fundamental economic reality.” In other words, stock prices become driven by a financial market structure more than business and economic fundamentals. Such is precisely why valuation has been ineffective and why other conventional market metrics have also performed poorly. Thus, the carry regime is a financial phenomenon, not an economic one.
Another aspect of the current carry regime gets based in US markets. Such is because there is “greater liquidity and breadth of financial instruments in the US markets.” As such, the S&P 500 index “is at the center of the global carry trade.” Therefore, the carry regime outside the US is “more fragile,” and why emerging markets get hit hard when things turn south.
Carry Is About Power
Finally, carry is about power in a meaningful sense.
When markets go down, only those with strong balance sheets or close government connections survive. During the financial crisis, all major banks (except Lehman Brothers) got backstopped by the Fed. When volatility spiked in February 2018 in the Volmageddon event, retail investors in the XIV ETF got wiped out.
“Long term, this leads to three critical outcomes. First, it makes prospering in financial markets less about competence and more about insider status. Insiders with weak balance sheets can survive crashes thanks to central bank action. Second, it reinforces wealth inequality by truncating losses for already wealthy investors who benefit from action to suppress volatility. Lastly, the distinction between economic recessions and financial market downturns becomes increasingly blurry. Recessions no longer cause severe asset price declines or bear markets; they are a function of the asset price declines.”
To sum up, then, carry trades are naturally occurring phenomena but have become supercharged due to central bank interventions that artificially moderate volatility. Insofar as central banks stay the course on interventions, a carry regime develops, which is comprised of a running series of carry bubbles and carry crashes. Because the drivers are financial, conventional economic and market-based metrics and decision tools lose effectiveness.
One of the adaptations some investors have made is to “Buy the dip.” While this strategy is painfully simplistic, it has also been amazingly effective. While such robotic behavior may not seem worthy of earning excess returns, in a carry regime buying the dip provides liquidity and therefore does earn excess returns.
There are two problems with managing through carry regimes, though. One is carry crashes can occur suddenly and without warning. The authors describe,
“In the world of extreme carry, high financial asset prices do not guarantee that the economy is ‘good for now.’ The carry crash can occur suddenly—at the point when leverage has reached too great an extreme to be sustainable.”
Longer Than Logic Would Suggest
Another problem is carry regimes can last longer than one might guess, although they can’t last forever. Part of the reason is “The carry regime in itself is fundamentally deflationary over the long run, primarily because it exists in an economic environment of very high, and burdensome, debt levels.” Relatedly, a carry regime directs the course of the economy by “creating a pattern of economic growth driven by consumption and capital allocation driven by speculation, as opposed to a more healthy economy driven by the investment of the economy’s savings in future growth potential.” In other words, it is parasitic.
Over the long run, the carry regime de-anchors stocks from fundamentals, facilitate debt accumulation, weakens growth, and increases economic risk. It will end. But what will cause it to end, and what will follow in its stead?
When push comes to shove, and central bankers get forced to decide between tanking the economy by withdrawing monetary support or throwing the machinery into full inflationary gear, the authors assume the latter will happen. In their words:
“Governments together would implement extreme measures that would be outside the bounds of current law but gets deemed imperative to ‘save the world.’”
In summary, the carry regime provides remarkable explanatory power to market behavior over the last twenty years or so. For example, it helps explain the sawtooth progression of bubbles followed by crashes, and it helps explain why the value style has underperformed.
As long as the carry regime persists, the easiest path to success is buying the dips. It is essential to note in doing so. However, one must have money to survive carry crashes and be on the lookout for the end of the regime.
It is also helpful to highlight the potential this environment has to wrong-foot all kinds of investors. Many investors will be comfortable riding out the carry crashes of the sawtooth pattern to ever-higher market highs. That will end when it all comes collapsing down once the carry regime fails. Others may prefer to buy the dips of the sawtooth. But they need a regular supply of capital to do so. Even then, it will be just as vulnerable to the outcome of the carry regime.
Still, other investors will prefer to sit out the carry regime or to remain underinvested through it. This strategy is notable for avoiding much of the potential for permanent losses of capital. However, it requires a great deal of patience. Further, since the carry regime will most likely end with inflation, appropriately sizing inflation hedges is a challenge.
The carry regime does not provide the kind of markets most of us would prefer to invest in, but we still need to contend with it nonetheless. At least by understanding its characteristics and developing an appropriate mental model. Then you can have a fighting chance to make the most of the market exposure you accept.