INSIGHTS

On April 14, 2025

AAM Viewpoints — History Repeating or Historically New?

Having just encountered some monumental market moves in every asset and debt class, on top of a myriad of market and political events, it is natural for investors to seek some context for these events. We often compare it to times we have experienced and typically that is done on more recent events. While this pursuit is noble, the problem arises that our own behavioral limitations and overriding emotion relative to logic get in the way. One only needs to look back at the last five years to see these battles in real time. Experience has shown that as investors, we can be in three various states: euphoric, catastrophizing or lucid.

The lucid state is always the more optimum state when balancing financial decisions with one’s own risk and long-term plans. However, reality shows that we tend to fall into the euphoric and negative states very easily, which makes the lucid state a fleeting one at best. When we are stuck in a feedback loop of information, whether it is positive or negative, we often exacerbate the future based on our current sentiment. This amplified state gives us historical concentration levels in a select group of companies where momentum feeds upon itself and we disregard potential warning signs, as witnessed throughout last year. The continued increased returns in these companies only appeases our sense of history and we tend to maneuver into “it’s different this time.”

The same works on the negative feedback loop, which we find ourselves in now. It is my experience that when even a direction of change that may be known or outright stated to us, does not get well priced in as the pace of these changes push investors into discomfort and now move to a who is the smartest bear in the room. The smartest bear will arise when a certain form of capitulation in markets and previously held beliefs promote a derivative theory on current events and explains the “just wait until investors get wind of ______ (fill in the blank).” Most investors, as they have their normal lives and distractions that occur inside their household, often do not have the time or bandwidth to spend the amount of time it takes to become knowledgeable on the more esoteric components of the markets. This has become more difficult over the last two decades when our average attention span has been cut by a third.

The behavioral component of investing is, and always has been, a prime component to the dysfunctional aspect of an efficient market and has led to amazing times of investment and understatement of risks. These biases and mental heuristics each investor uses along the chains of investing are equally vulnerable and without knowing or being aware of our own biases and defaults, exacerbates these moments into more emotionally tied decisions.

To explain a bit why this is more pronounced now, but perhaps not addressed across many platforms, we truly did witness some historical movements in the past week. While the equity markets were hit with a massive shift in sentiment due to external events like tariffs, it might shock people that the S&P 500 had one of its better weeks not seen in the last 15 months. Now we know this is externally driven events versus structural or cyclical aspects based on the move from headlines…both accurate and inaccurate.

In light of the recent drawdown from market highs, we often forget that we have drawdowns every year. Though the drawdown last year was very benign compared to history, the belief is that that is the new normal. Surprise, the markets always have a reversion to the mean, and it comes when most do not expect it. If it was expected, we wouldn’t see such volatile price moves. This is why the efficient market theory is great in concept but less so in practice, as the question of what is priced in and how long is it priced in is a fluid and changing answer.

There is a bias called the “zero-risk fallacy” that lulls investors into believing that risk can be managed or even removed by certain instruments and overall philosophy. Whenever this is most prominent, it has always felt to us that this is when you are most prone for the blind spot this creates. Consider the CBOE Volatility index (VIX), which measures equity volatility in a broad sense and rose to levels seen since the onset of the COVID pandemic when it spiked to 82. It hit 55 last Thursday and as is the case with most spikes, it recedes fairly quickly. We wrote a couple months ago about the expectation of increased volatility and the measurement of said volatility does not always give the best representation based on technical functions and the disparity of realized volatility in comparison.

The announcement of a temporary exemption to certain tariffs over the weekend may begin the process of mitigating the announcements coming from the White House as investors begin to discount the lasting impacts of such pronouncements. It is akin to the markets discounting of the initial economic releases in the last few years as the revisions were far more dramatic and increased doubts about the validity of the data. The markets started to utilize trend lines of revised data to get a clearer picture of the economic trajectory.

Since the pandemic, the VIX has averaged 21.37 and the current closing as of Friday, April 11 was 37, while the longer-term average since inception in 1990 is 19. We made note that in the second half of 2024, the markets were experiencing several significant spikes with quick receding moments. History has shown that that typically points to more times of elevated risk versus less so. We continue with our assessment that volatility will be elevated versus not and that our timeframes with investments need to be recalibrated, as well as expecting more muted returns, but perhaps bursts of outperformance as the following chart details from Ritholtz Wealth Management.

Past performance is not indicative of future results.

Perhaps the most significant move was what we witnessed in the credit markets. The 20-year Treasury closed last Friday at a level of weekly change that was right at a four-sigma event relative to the four decades of history. For those empirical loyalists, this should only occur 0.006% of the time. This is truly a massive move considering inflation numbers came in much more benign than expected and would seemingly give the Federal Reserve room to cut rates to ease strains in the markets and economy. However, there are some reasons for this move beyond just the momentum trades that exacerbated it. When one of the three Treasury auctions came in particularly weak, a fear of foreign selling of U.S. Treasuries (primarily by China) started to make the rounds. While there was some evidence of a lack of foreign demand, calculating exactly where some of this came from at the current moment is a bit speculative. On top of that, worries about a leveraged situation on what is called “basis trades” — where certain funds exploit the difference between cash bond rates and future swap spreads — had risen to dangerous levels totaling around $1.5 trillion. It then became easy to say that we are approaching another long-term capital management situation where the Federal Reserve is going to have to step in and solve this. For history, this trade occurred during COVID and was estimated to be a third of the current size. You can be sure that if this is known by many, the Fed is very aware of it and with it not being addressed formally, in their mind they may appear to have a solution, or solutions, for it. While I believe addressing potential challenges earlier is better than overreacting, it seems that we will only know after the fact what they were working behind the scenes. If and when this gets addressed, it seems that the historic spikes in the bond market may become a bit more subdued, but the direction may not be altered.

Perhaps a more eye-opening component is what occurred in the weekly change of the 30 year that hadn’t seen such a rise in one week since 1987 as provided by Jim Bianco Research. This is especially important when one considers the more benign inflation prints that often influence the long end of the yield curve than it does in the earlier maturities.

Past performance is not indicative of future results.

In the tax-free municipal markets, we witnessed something I had not seen in my three decades in the business…we saw an increase in yields to levels that were approaching 100% of Treasury yields. Now, municipals offer the majority of their bonds as federally tax free and if investing in the state in which you reside, state tax exempt. This enhances their tax-equivalent yield to spreads well above high yield corporate debt. One day, we witnessed a 50bps (basis point) move upward, which I have personally not witnessed until now.

As we write this, the question is what to do. First, it is vital to ascertain the cause of this in an agnostic manner and break it down to mitigate the emotional pull that exists. Much like Covid, the current state of fear is arising from an externally driven influence versus structural and cyclical. I think the following chart is very appropriate to ascertain what may occur should this hit a bear market.

Source: Goldman Sachs

As witnessed, the event-driven and cyclical reasons for bear markets have the same downside, however, the length of recovery is roughly a quarter of the time. It is even much less so when looking at structural issues, which would be a reference to the Great Financial Crisis of 2007–2009.

In looking at times of stress, I went and looked at spikes in policy uncertainty particularly over the last 40 years. What I found is when this spiked, as it did in the last two weeks, the 12-month forward returns for the S&P 500 was 18.15%, the MSCI world excluding the US was 19.00%, and the MSCI emerging market index was 26.49%. Now, we know future returns cannot be guaranteed by past results, however, it is significant that the International excluding the US and the Emerging Market returns on the 12 months following were three times their long-term average and the S&P 500 was just 0.8 times greater.

To corroborate the listening for the cannons on when to invest, consider the following table and returns after certain volatility measures are hit.

So, while it is most difficult to not lose one’s head when everyone else may be, what should we be looking at moving forward? This chart is floating around to show just what values certain equity markets are trading.

So, as we continue with our calls for diversification, be deliberate and discerning, and look for dividends or income, certain areas are pointing to better longer-term risk/reward scenarios, in our view. It is also very prudent to recalculate what your timeframe is as this sets the stage for nearly every investment decision and what risks to take in a calculated manner and which ones to avoid. We would never conclude that the noise is all done and there will not be more of these events as life follows “the rule of entropy” — we are constantly moving from a state of order to chaos — and as such, the only certainty is uncertainty. However, historical context has shown far greater resilience in markets and investors than we care to credit while attempting to fly a kite in a hurricane while in the middle of an earthquake.

Challenging times beget challenging times for when it rains it pours, and it never pours softly.

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