Posts tagged Current Market Trends
Summer weather has returned in full. For those of us who call the Mid-Atlantic region home, that means lots of humidity and the intermittent torrential downpour showing up just in time for the evening commute. It’s summertime in the markets as well. Average daily trading volume on the New York Stock Exchange for the month of June to date is about 17% lower than the average volume for the month of April. By the looks of things, not many people sold in May but they did go away, taking their algorithms and server platforms with them.
Light trading volumes are characteristic of many summers, though by no means all. Average NYSE trading volume in June 2011 was about 40% higher than the month-to-date figure for this year. Investors in 2011 were focused on the possible collapse of the Eurozone, and as the summer unfolded the debt ceiling debacle and S&P downgrade of U.S. Treasuries also conspired to keep money professionals from getting away to their favorite vacation destinations. In 2012 June was another busy month, but in early July that year ECB Chairman Mario Draghi uttered his famous “anything it takes” pronouncement to shore up support for still-beleaguered Europe. Average daily trading volume subsided from around 870 million shares in June to 740 million in July, and a listless 615 million in August (which is close to the 2014 June month-to-date figure of 605 million). Resort owners cheered Draghi.
While markets this summer are off to a calm start, there is no shortage of news stories with the potential to cause some near-term mayhem. The recurring 2014 theme of geopolitical flashpoints is back front and center today with Iraq seemingly on the verge of disintegration. The extremist Islamic State of Iraq and Syria is in the process of seizing control of large swaths of the country and converging on Baghdad, while in the north Kurdish forces have taken over the oil-rich city of Kirkuk. Oil prices predictably have shot up. Equities are down, though losses in most major markets are fairly contained. “X-factor” events like this have the potential to move index price returns well above or below 1% from the previous day’s close. That watermark is not being breached today; in fact, the S&P 500 has not experienced a daily gain or loss of 1% or more since mid-April.
Even a worsening of the Iraq situation, though, or a re-intensifying of other geopolitical problem spots such as Ukraine or the Senkaku Islands, is unlikely to keep traders from their beach houses or fly fishing meccas. At this point it would appear that the only thing with the potential to really shake up the current state of complacency would be a fundamental re-think of the baseline economic story. This story rests on several pillars: moderate growth in the U.S., avoidance of deflation in Europe, positive signs of a rebalancing Chinese economy, and healthy price trends in Japan (where headline inflation is now actually higher than either the U.S. or Europe). All with central banks at the ready where and whenever additional stimulus is needed.
It’s a strange calm, to be sure. Sometimes, looming clouds on a calm summer afternoon ominously portend a night of wild and devastating storms. But sometimes the clouds just sit there, and the calm continues.
2013 was a very good year for U.S. equities. Even more impressive than the 32% total return on the S&P 500 was the very low level of risk that accompanied it. Based on the Sharpe ratio, a widely-used measure of risk-adjusted return, the S&P 500’s 2013 performance was in a class by itself, far outpacing even the heady days of the late-90s technology bubble (see chart below). In the world of investment performance measurement, a Sharpe ratio above 3.0 is just about as close as you can get to having your cake and eating it too. Is low volatility here to stay, or is this just an unusual period of calm before the next storm clouds appear?
Not Much Fear in the “Fear Gauge”
In 2014 to date there have been pockets of risk, notably in certain small cap growth sectors. But the story in the broader market hasn’t changed much: subdued baseline risk with a few intermittent spikes when unexpected X-factors briefly flash onto the radar screen. The following chart illustrates this story. On the leftmost side we show the standard deviation of daily S&P 500 returns over rolling 30-day intervals. The right side presents the daily closing price of the CBOE VIX index, which reflects a weighted average of puts and calls on the S&P 500 over a range of strike prices. Standard deviation provides a useful picture of intrinsic volatility, while the VIX gives us a good read on market perceptions of risk; for this reason it is popularly known as Wall Street’s “fear gauge”.
Stuck in the Corridor
It is perhaps somewhat surprising to see this continuing pattern of low risk in the broad U.S. equity market. After last year’s big gains the market has mostly traded in a narrow and choppy corridor this year. Lack of direction can often mean heightened volatility. But apart from one brief spike during the late January pullback, the VIX has not even come close to breaching its lifetime average closing price of 20.1. Investors have largely taken in stride whatever the world has served up: from a harsh U.S. winter that impacted many corporate earnings results, to geopolitical turmoil in Ukraine, to a Eurozone flirting dangerously with price deflation. Support has been remarkably firm around intermediate moving averages, as the chart below illustrates.
Ready for a Breakout?
On the other side of the 50-day moving average support level, the index has several times bumped up against a psychological “round number resistance” point of 1900. At some point we would expect to see a directional trend form one way or the other; either a resurgent X-factor that brings back volatility and another pullback of 5% or more, or a continued rally driven by the meta-narrative of continuing benign economic data, double-digit 2H earnings growth and no new surprises from Ukraine, China or elsewhere. We need to be prepared for either outcome; that being said, the volatility signals are for the time being at least nowhere to be seen. “Sell in May” may not be a particularly helpful strategy this year.
Our brains are wired to seek explanations for things - to weave a sensible narrative around events in the hope of making them seem less random or threatening. We see this play out every time a reporter stares at us assuredly from behind the anchor desk and tells us that “the stock market did X today because of "Y”. “Y” could be the release of Fed meeting minutes, or Russian troops amassing on the border of Ukraine, or a Chinese bond auction failure. It doesn’t really matter what the day’s headline is; the news anchor is crafting a story out of the millions of random buy and sell orders flashing in trading system centers around the world. The stories may help us process information, but there are limits to how much light they can really shed on the goings-on of the capital markets.
Cyclicals and Defensives
One of the recurring favorites of Wall Street storydom is how various industry sectors and investment styles perform at different stages of the business cycle. The rule of thumb is that defensive sectors tend to do well when the economy turns down; conversely, cyclicals have a history of outperformance during times of economic strength. Slowdowns favor value-oriented stocks, where dividends contribute significantly to total return. Growth stocks are the leaders during the good times. Or so the story goes.
Time for a Value Story?
Consider the last twelve months; we show here below the performance of US large cap value and growth equities.
The chart shows a seemingly nice, tidy style trend. Growth stocks decisively took command in summer 2013 and led the market’s rally through January 2014. That trend started to run out of steam in February and went into sharp reversal last month, with value back in the ascendant. How closely does this trend track the business cycle from last summer through the present?
Quite a lot, perhaps, at least on the surface. During the fourth quarter of 2013, a series of macroeconomic data built a case for stronger than expected growth. The Fed’s December Board of Governors meeting ended with a decision to begin tapering the QE program, another sign of confidence in economic recovery. Markets rallied strongly through the end of the year. But the New Year presented headwinds. Jobs data painted a mixed picture: lower unemployment, but less-than-stellar payroll gains. A harsh winter took a toll on much of the country. Russia amassed troops on the Ukrainian border. This would seem to paint a compelling value/defensive narrative.
More Than Meets the Eye
If you look closely enough at the underlying data in any given market trend, though, you are likely to see more complexity than the top-line narrative would suggest. Consider that the top-performing sector during that growth run in the second half of 2013 was healthcare, traditionally considered to be one of the more defensive sectors. Or that the cyclical materials and consumer discretionary sectors were strongest during the February pullback.
Moreover, with the harsh winter behind us, the US economic picture for the rest of the year continues to look relatively upbeat. Economists have lowered their expectations for first quarter earnings, but expectations for the full calendar year are in the high single digits – hardly indicative of a burgeoning slowdown.
Certain growth sectors do indeed seem to be reversing – much of the decline in major US indexes this week has come from the tech and biotech sectors. But that may be more about investors rebalancing their portfolios – buying the losers and selling the winners – than it is about any meta “return to value” narrative. If there is a sector story, maybe it is simply this: mean reversion happens. Every now and then it’s time for something to mean-revert up, and something else to mean-revert down. It’s not a very colorful story, to be sure. But letting the data speak for themselves may be a better way to invest than trying to guess what the next big-picture story will be.
Michael Lewis, the ex-Salomon Brothers trader turned investigative author, has always had a particular sweet spot for the world of finance. His knack for shining a bright light into the obscure, murky corners of Wall Street was on display again this week with the publication of Flash Boys. In the crosshairs of Lewis’s investigative storytelling this time was the little known, but very influential, world of high frequency trading (HFT).
The Evolution of Modern Markets
Critics of HFT point to its existence as a proxy for all that has gone wrong in securities markets – from being the oil which greases the wheels of productive investment to a giant casino where the house enjoys even better odds than in Las Vegas. There is more than a kernel of truth to this view. On the other hand, HFT is a logical outcome of the two forces that, more than any others, have shaped the fabric of modern markets: the steady pace of deregulation and the explosion of technology. These two forces collided in the early 1970s. The financial world was beginning to comprehend the power of Moore’s law (the inverse relationship between cost and capacity in data storage). Meanwhile the Bretton Woods framework for stable exchange rates was collapsing, the regulation-lite Euromarkets were taking off, and the era of fixed commissions was ending on the New York Stock Exchange.
The Value of a Microsecond
A frenzy of innovation ensued in all manner of financial products. As markets globalized, traders increasingly saw speed as one of their most important sources of competitive advantage. Getting an order from a trading floor to an exchange and back faster than your competitors got you a slightly better price at execution. For any given trade the advantage could amount to mere pennies or even less. But those pennies turn into millions of dollars when tens of thousands of trades are at play every day. As the technology improved, it became no longer a game of seconds, but of milliseconds (a thousandth of a second) and microseconds (a millionth of a second).
No More Men in Funny Colored Jackets
What happens when you place a trade? The image most people have is of an order being routed to the floor of a stock exchange, where burly men in brightly colored jackets and badges holler and wave their arms in strange ways to make the trade. That is an outdated image. Human floor traders have largely been replaced by black boxes in climate-controlled data centers strategically located near the world’s major financial centers. High frequency trading accounts for more than 65% of the daily trade orders whizzing in and out of these black boxes along glass fiber optic lines at light speed. Now, the revelations in Lewis’s latest book may spur action to rein in some of the most egregious byproducts of HFT. But it is not hard to imagine that somewhere, well outside of the public eye, some group of extremely smart, tech-savvy individuals is busy developing and testing the next big thing.