Drach divides the ascent portion of infusion cycles into three parts.
- A rapid, broad advance that ran from March to September 2009 with some of the worst quality companies rallying strongly.
- A relatively lengthy period of volatile price gyrations in both directions with a net positive bias; this began Sept. 17, 2009. Since then, the market has exhibited gyrations in both directions with a net positive bias.
- Gyrations are replaced by a more clearly defined trend-like advance ending with a speculative fluff.
While Drach noted through 2012 that we are currently in phase two, value begins to assert itself as we progress through the phase. The transition from two to three is a function of internal pricing normalization, i.e. pricing relationships thrown into disarray by the recent huge recession and financial storm return to norms. While the normalization process can complete quickly or drag on, as of March 1, 2013, Drach stated that normalization is possibly close to completing provided that further massive monetary intervention does not delay it.
Should Drach's research again be proven correct, we could soon see more “normalized” moves in many financial and commodity markets, as well as the U.S. stock market. On the other hand, remaining risks range from the macro effects of QE to the intentional and unintentional effects on the balance sheets of financial institutions, all with their potential to affect market trends.
We know that QE is a wild card; there is a significant probability that QE will continue to have diminishing returns, and there are significant unknowns regarding the effects of future Fed policy as we face issues never before seen (such as trying to unwind up to $2 trillion of assets). Currently, as PIMCO has noted, interest rates at zero are forcing people into the equity markets as there are no other choices. The Fed-created 50 to 75 basis point reduction in 10-year rates, translated into an 8% to 10% price subsidy for all financial assets, as equities price off of bonds. As such, PIMCO believes it only will take a small upward adjustment in rates to create dramatic reallocations to most portfolios.
So is it different this time?
Are these observations above an explanation for why the complexion of trends seems to have changed? While noting factors that may point to more normalized markets in the near future, Drach also pointed us at the classic Black Swan condition through his above observations, i.e., events that have probabilities we can't compute and consequences that are significant. Managers must avoid optimization now more than ever, which is always a temptation when markets become relatively stable. We only can make sound predictions in stable environments. With the VIX hovering near all-time lows and the Dow at new highs as I write this, we all are looking over our shoulders for the next shoe to drop.
The more things change – the less weight we can place on the past – and most of the big blow ups are a consequence of naively applying statistical methods (or yesterday's strategies) to a world housing more Black Swans than ever before. We now have a greater number of hedge fund managers than ever, with over 10 times more assets than a decade ago; we all have broader and faster access to information, more computing power, all of which have led to a reduced dispersion of fund returns. The talented innovators always will prosper, but perhaps now, more than ever, the aggregate return profile of the mediocre will be more homogenous and more negatively skewed. In other words, it may be more difficult than ever to find truly skilled managers without embedded tail risk and to separate them from the pack.
Futures traders like to say “the trend is your friend,” but until trends return, perhaps its best to keep your friends “closer” than your enemies. Don't simply read managers' monthly reports - a rigorous program of ongoing due diligence is now more important than ever.