By Kevin Hurd and Steve Togher for Cross Shore Capital Management
Volatility returned to equity markets in the fourth quarter following two relatively benign quarters and, unfortunately for most market participants, it was predominantly to the downside. Despite the highest annual GDP growth rate in 10 years and 80% of S&P 500 companies beating earnings expectations, Q4 saw two massive technical sell-offs driven by fears over the potential impacts of Fed policy and a trade war between the US and China.
There was nowhere to hide as the S&P 500, MSCI World, and Russell 2000 were down 13.5%, 13.4%, and 20.2%, respectively, during the quarter. The sell-offs left many cyclical companies priced near book value which typically occurs following a recession and is a good indicator of how much fear was in the market during the quarter.
It’s also a stark reminder of how equity markets can diverge from fundamentals in the short-term during periods of geopolitical and economic uncertainty. Long/short equity hedge funds fared better than the broader equity indices during Q4 but still lost money on average, down 8.3% (HFRI Equity Hedge (Total) Index).
Many of the managers we speak with described the quarter as the most challenging investment period since 2008 with the difference being that equity markets reacted rationally to the economic backdrop in 2008, whereas equity markets behaved irrationally in Q4.
Source: Yahoo! Finance
October was a very difficult month for equity markets globally. The MSCI World lost 7.3%, the S&P 500 lost 6.8%, and the Russell 2000 lost 10.9%. The month also turned out to be very difficult for long/short equity hedge funds, down 4.6% on average. Many investors wondered why long/short equity managers did not do a better job protecting capital on the downside.
Anticipating a strong earnings season, many managers entered the month towards the higher end of their gross and net exposure ranges. Even though the majority of companies beat analysts’ earnings expectations, and many raised guidance, investors gave them virtually no credit and most of these companies finished down for the month.
While short positions did help, many funds did not have enough short exposure to significantly offset the cascade of October’s sell-off. Managers that did well during Q4 on a relative and absolute basis were those that entered the quarter with a more pessimistic view of the U.S. economy and hence had considerably lower exposure levels.
During the period of late October/early November we made two observations with regards to the managers we invest with. First, across the board, managers continued to maintain strong conviction in their largest positions and believed fundamentals were unchanged, if not improved, following the October sell-off. Second, we saw a divergence in pain tolerance among managers.
Managers with lower pain tolerances, despite continued high conviction in their largest positions, took down their gross exposures to avoid future pain in the event the sell-off continued. Managers with higher pain tolerances maintained existing exposures and, in many cases, took advantage of the sell-off to add to these positions, while at the same time initiating new positions in companies that had reached more attractive entry points.
November was a choppy month but ultimately finished in the black with the S&P 500, MSCI World, and Russell 2000 returning 2.0%, 1.1%, and 1.6%, respectively. Long/short equity hedge funds finished the month flat on average.
December featured another massive technical sell-off, driven by many of the same fears as the October sell-off. The S&P 500, MSCI World, and Russell 2000 lost 9.0%, 7.6%. and 11.9%, respectively. While the average long/short equity hedge fund was down 3.7%, returns among individual managers varied widely. Managers who grossed down following the October sell-off fared much better than managers who did not with many in the latter camp suffering significant losses.
The dislocations created by this volatility during the fourth-quarter could result in significant opportunities for skilled managers coming in 2019. In January, many managers are reporting very strong results, particularly those that maintained exposures in the face of the Q4 sell-offs and added to high conviction positions.
The majority of managers we speak with continue to believe the US economy is strong, growth will continue in 2019 at more moderate rates, and the risk of recession is very low in the near-term. They also believe that inflation trends will slow with moderate economic growth and lower oil prices which should cause the Fed to reduce tightening measures.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of NASDAQ, Inc.