An analogy our team often uses is to consider financial markets as the surface of the ocean—influenced by tides (long-term fundamental value), waves (medium-term influences of conventional wisdom, macro themes, geopolitics), and ripples (short-term news headlines). Our investment process is designed to ride the tides, navigate the waves, and largely ignore the ripples.

During the last several weeks (up to mid-April), the market rallied quite significantly to the point where I would call this overbought environment a “wave”. What’s interesting, though, is that as the market is moving to overbought territory, short positions also continue to increase. It appears to us that the private wealth market has bought into the recent rally, while the institutional side has not—at least not to any great extent. And we haven’t bought into it. We continue to maintain a lower-risk posture and a focus on navigating the waves.

It’s a quirky market and has been an exceedingly cruel market during the last few years. Just ask value investors about their experience for the last four years, or ask momentum investors about the last year. This is why the ability to dynamically manage risk to navigate such a challenging environment is a cornerstone of our investment process.

Our dynamic approach is reflected in the opportunity set available to us since late 2011. Over the course of 2012 and 2013, prices—in aggregate—in our investment universe converged on fundamental values. Such an environment provides a tailwind to our investment approach.

In 2014, we had a relatively constant opportunity set—an environment that doesn’t typically provide us a strong headwind or tailwind. There wasn’t a “tide” (prices reverting toward fundamental value) to ride like in 2012 and 2013. Beginning in April 2015, the opportunity set then began to widen significantly. This is typically a challenging environment for us as prices in aggregate moved away from fundamental value.

We believe that populism and the move toward antitrade policies is the biggest risk in terms of the vulnerability of capital markets.

In fact, our investment opportunity set went from a relatively low point to an extremely high point after two very sharp market moves during August 2015 and December 2015 into early January 2016. In this case, prices moved away from fundamental values across the board (markets and currencies)—the tide was moving away from our fundamental investment approach.

If the opportunity set is currently so attractive, why are we continuing to keep a lower-risk profile? There are several reasons for that.
Risks across the globe remain elevated, including:

  • China growth
  • Oil prices
  • Brexit (potential for Britain to leave the eurozone)
  • Asylum seekers
  • Spanish elections
  • Greece debt
  • Schengen zone (passport free travel across the eurozone is under threat as several countries close their borders in response to the migration crisis)
  • Unwinding of accommodative central bank policies
  • Increasing populism in the U.S. and across the globe (resulting in a shift toward antitrade policies)

In fact, we believe that populism and the move toward antitrade policies is the biggest risk in terms of the vulnerability of capital markets.
All of these risks still exist despite the recent rally. There are still huge uncertainties and some of them potentially contain unknown unknowns—risks that are yet to present themselves or cannot be accurately anticipated, like terrorist acts.

And then finally, the market remains largely a single, non-distinguishable risk factor, where global equity markets simply move up and own with oil. In such an environment, we don’t believe that it’s appropriate to take a large amount of risk knowing that subsequent results may be highly tied to a single exposure.

That’s why we continue to have a lower-risk posture. We do anticipate raising our risk posture, but not until these risks are deemed adequately compensated.

Brian Singer is head of dynamic allocation strategies team and portfolio manager at William Blair.