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May 26, 2016

A Summer Swoon for Equities

by Amareos.

In recent blogs we have outlined why we consider the price trends that have prevailed year-to-date for crude oil and the USD (higher for the former, lower for the latter) to be vulnerable[1]. In both instances our assessments were based on analysis of the trends in the sentiment indicators for each asset separately. That said, as many investors have noted and remarked upon, there has been a consistent negative correlation between crude oil and the USD over the past year or so, which, if our analysis is correct, seems set to continue. It also naturally leads one to question the outlook for global equity markets because periods of USD strength and crude oil price weakness tend to be associated with “risk-off” episodes and equity market corrections. So what are the global equity market sentiment indicators telling us at present? Are they suggesting a significant correction is likely?

Since the start of the month, equity market sentiment has declined in all but four[2] of the twenty indices we track globally – indicative of a fairly broad-based decline in confidence in stocks (see chart below).

Exhibit 1: Global Equity Market Sentiment (Change since May 1)

1 better

Source: www.amareos.com

Given the positive correlation we have observed between movements in equity market sentiment and future price performance the pullback in sentiment is a warning sign about the near-term direction for global equity markets[3]. So too is the gradual drift higher in stress across the major equity market indices (see chart below) since the start of the year. 

Exhibit 2: Equity Market Stress- Major Indices

2

Source: www.amareos.com

It is also worth noting that we have just entered a period that tends to be a seasonal weak spot for equity market performance. For example, based on market data going back to 1928 in the six month period from May to October the S&P500 index rises on average 1.9%, a significant underperformance relative to the 5.1% average gain recorded in six month period between November through April[4]. Obviously there is considerable volatility in the year-by-year returns for these two six-month periods. Nevertheless, this is a seasonal pattern that has proved surprisingly resilient despite the obvious motivation for investors to arbitrage it away and is the source of the old market adage “Sell in May and go away”.

That said, while we acknowledge that based on recent sentiment trends the outlook for global equity markets is less constructive than previously[5], the same indicators also suggest we are not standing on the precipice as some commentators would have us believe.

As the global equity market sentiment heatmap below confirms when sentiment is considered in levels as opposed to changes, most are either in slightly positive territory (green) or slightly negative (turquoise) i.e. not a million miles away from the historic average. This may not seem to be especially noteworthy, but perhaps it is when one considers that as of last month the current US equity market bull market is the second longest recorded in the post war period[6] – one only surpassed by the 1987-2000 bull market.

Exhibit 3: Global Equity Market Sentiment Heatmap

3

Source: www.amareos.com

It is the longevity of the current bull market, combined with the recent loss of positive price momentum, that is prompting some financial market commentators to speculate that a significant correction in the equity market is just around the corner, especially given the obvious economic risks including but not limited to Brexit, Donald Trump’s potential to, er trump (sorry – awful pun but we couldn’t resist) the other candidates in the US Presidential race or a June Fed rate hike.

However, just like the business cycle there is no pre-set or pre-defined duration for a bull market. Rather, economic expansions and bull markets come to an end because increasing numbers of individuals doubt the achievability of future returns[7] that typically rise in tandem with the increased optimism fostered during the upswing[8].

Valuation seems a natural and obvious method to attempt to gauge whether expectations about future investment returns have risen to unsustainably high levels. Unfortunately, as investors also know valuation is a poor market-timing tool and calling a significant equity market correction too early because equity markets are overvalued can be as disadvantageous to ones financial health as getting out too late.

An alternative, yet complementary[9], approach is to assess crowd sentiment because – as mentioned above – bull market peaks are typically characterized by high levels of sentiment and optimism; it is the fuel that drives expected returns to unsustainably elevated levels. After all, recall the unparalleled mood of optimism that immediately preceded the bursting of the dotcom bubble in 2000 that brought to an end the longest US equity bull market in post war history.

The global heatmap above suggests we are nowhere near this situation at present with scant evidence that investors have become overly optimistic about future equity market returns despite the duration of the bull market. If anything, it suggests the equity market rally continues to be very unloved.

So to reiterate, while we would not rule out a near-term bout of equity weakness, one that would be consistent with the aforementioned trend reversals in the USD and crude oil we anticipate, the conditions necessary for this to be the next “big short” do not appear to be in place. Likely as not if any correction in global equity markets were to materialize in the next few months, it will go down in the history books as a summer swoon and nothing more[10].

[1] See: https://amareos.com/blog/2016/05/05/on-the-cusp-of-a-usd-rally/ andhttps://amareos.com/blog/2016/04/28/oils-volte-face/

[2] German equities (Dax) are a notable exception for reasons we outlined in last week’s blog discussing Euro zone reflation.

[3] See: https://amareos.com/blog/2016/04/14/emotions-and-markets/

[4] See: https://www.fidelity.com/viewpoints/active-trader/sell-in-may

[5] See: https://amareos.com/blog/2016/01/20/just-one-thing-you-need-to-know/ andhttps://amareos.com/blog/2016/03/17/green-for-go-for-now/

[6] See: http://www.ft.com/cms/s/0/4b25b264-08a1-11e6-a623-b84d06a39ec2.html#axzz490L5DwoB

[7] Growth in terms of the broader economic investment returns in terms of financial assets. Note this includes occasions when economic slowdowns or outright recessions are triggered by central banks tightening monetary policy to reduce inflation so as to achieve their mandated targets.

[8] In his fabulous book “The Alchemy of Finance: Reading the Mind of the Market”, George Soros details his reflexivity hypothesis which posits that there is a feedback loop between peoples perception and reality and that as a result of misconceptions financial markets do not tend towards equilibrium as economists are wont to claim but instead experience booms and subsequent busts.

[9] Feel free to get in touch if you are interested in knowing more about how to incorporate financial market sentiments into existing investment processes.

[10] Also it is worth considering how central banks – indeed policymakers in general – would respond to a significant correction in global equity markets. Having injected unprecedented amounts of stimulus into the global economy we have a tough time envisaging them sitting on the sidelines and not responding with even more aggressive policy measures, especially as the taboo associated with helicopter money appears to be weakening.

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