The investment management business isn’t always as great as the industry is made out to be. For most professional investors, days are filled with long hours of tedious research, punctuated by periods of fear and avoiding risk.
You might think that during a bull market, fund managers and investment advisors can relax and just let their portfolios appreciate. But the reality is that during these times, it is imperative for these managers to keep up with benchmarks.
A fund manager who decides to “play it safe” and take less risk with his clients assets, runs the very real risk of not keeping up with other professional investors. Any investment manager who values his career knows that failing to keep up with the competition can be grounds for firing (either by one’s firm or by one’s clients).
And so the fear of missing out on profits often drives even the most savvy investment managers to take more risk during strong market periods. And in order to keep up with benchmarks and competing managers, it usually makes sense to overweight growth stocks which will appreciate more quickly during bullish market periods.
A shift in the environment requires a shift in strategy
So what happens when markets transition from a bull market to one in which stocks are falling? Or even to a sideways market that carries more risk for investors?
Well, gradually (or sometimes very suddenly), the collective mindset on Wall Street shifts from the risk of falling behind competitors, to the risk of losing real money in client accounts.
This is an important shift in perspective, which can lead to major changes in investment allocations. Specifically, the high-beta (or more volatile) stocks that investment managers counted on to help them beat or even just keep up with competition, become the very same positions that represent the most risk of loss.
(The term “high-beta” technically refers to stocks that move faster than the market. So if the market is up 5% a month, a high-beta stock may be expected to gain 10%. And conversely, a high beta stock is likely to decline 10% in a month in which the market only falls 5%)
When investors start to move capital out of these high beta growth stocks and into more conservative, stable positions, valuations for growth stocks typically contract. This is essentially a function of less investor appetite for risky stocks (and not necessarily a reflection of poor prospects for the underlying companies.)
August was the beginning of a risk shift for professional investors
The August pullback in stock prices was likely the beginning of a major shift in risk appetite for professional investors.
While the move was largely triggered by a surprise currency devaluation from Chinese policymakers, the shift in direction has implications that stretch well beyond just stocks that are tied to the Chinese economy.
After nearly four years of market advances without any material pullback to speak of, professional investors suddenly had to worry about the risk of losing money. This sobering reality may be particularly acute this time around because investors have had so much time to get used to rising prices (and professionals have had to work harder to keep up with the competition).
Given the break of such a long-term bullish trend, we would be very surprised to see investors simply shrug off the market weakness and continue to buy stocks and push prices higher.
Instead, it is likely that professional investors will use any material rally as an opportunity to shift capital out of growth positions, leaving them with a lighter allocation to high-beta positions.
Overhead resistance also poses a threat
Another challenge investors are likely to run into is the issue of overhead resistance.
To understand how this resistance could affect stock prices, consider the mindset of investors who bought shares of stock between May and July. During this period, the market traded in a relatively tight range, and so many investors have a cost basis for new positions in this area.
Human nature being what it is, these investors are now likely frustrated with their positions since the market has traded lower. Many of these investors are now resolved to sell their new stock positions (and possibly long-standing positions that have appreciated and then pulled back) if only they can recoup their recent losses.
While this strategy may not be logical or based on the fundamentals or valuations of individual positions, behavioral psychology tells us that many traders and investors will have an urge to sell if we move back into the range where stocks were trading before the market sold off.
How to book profits despite the market shift
Unfortunately for many, a shift away from risky stocks will likely cause many of investors’ favorite stocks to trade lower.
But this doesn’t mean that savvy income traders won’t be able to generate profits from the markets. In fact, a more volatile environment actually sets up more opportunity for many of our strategies.
In particular, we should be able to profit from entering credit spread trades where we sell one option contract and buy another contract at a cheaper price. Our income represents the difference in payment between the two contracts.
Another income opportunity involves selling puts which allows us to collect instant income, while agreeing to buy shares of stocks that we want to own at a discount price.
When stock prices are more volatile (as managers move capital out of some positions and into others), the price for option contracts naturally rise. Higher volatility is directly tied to option prices.
Both our credit spread strategy and our put selling strategy benefit from higher option prices – giving us more income from these trades. And at the same time, both of these strategies have statistically less risk than buying shares of stock outright, allowing us to bypass much of the potential losses we could face owning stocks that investment managers are selling.
Over the next few weeks, we will be setting up more income trades that take advantage of the current shift in investor sentiment. In the meantime, we think now is a good time to begin lightening up on aggressive positions as prices for growth stocks could drop significantly in the near future.