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MV Weekly Market Flash: The Insurance Cut and the Melt-Up

June 21, 2019

By Masood Vojdani & Katrina Lamb, CFA

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Here’s a quote from a mainstream media fixture. How recent is it? “Financial markets have soared during the last month on expectations of a cut in rates. The Federal Reserve’s top officials…may have grown increasingly reluctant in the last several weeks to risk causing turmoil on Wall Street by leaving rates unchanged, analysts said.”

That little blurb from a New York Times article certainly sounds like it could have been written sometime within the past, oh, forty-eight hours. In fact, that article came out on July 7, 1995, two days after the Alan Greenspan Fed cut interest rates for the first time since 1992 (the article’s subtitle “Stocks and Bonds Soar” of course would be no less appropriate for anything written during the week ending June 21, 2019). The 1995 event was a particular flavor of monetary policy action called an “insurance cut,” and it has some instructive value for what might be going through the minds of the Powell Fed today.

Anatomy of an Insurance Cut

In the chart below we illustrate the context in which the 1995 rate (and two subsequent cuts ending in February 1996) took place. What we think of today as the “Roaring ‘90s” had not yet gotten into gear (in fact it was just about to start with the initial public offering of Netscape, the Internet browser, just one month after the Fed’s rate cut). In July 1995 the Fed had just capped off a series of seven rate hikes that had begun in 1994 and that had taken the stock market by surprise. Core inflation had crept back up above three percent, and a handful of economic indicators warned of a potential slowdown.

Despite the upturn in inflation, many observers at the time – on Wall Street, in corporate executive suites and in the Clinton White House alike – complained that the Fed’s rate hike program in 1994-95 had gone too far, too fast. Politics were certainly part of this mix, summer 1995 being a bit over a year away from the next presidential election (stop us if you’ve heard this one before). While the headline numbers didn’t suggest that a recession was imminent, there were indications that business investment had slowed with a build-up in inventories. The index of leading indicators, often used as a predictive signal for a downturn, had come in negative for four consecutive months. In announcing the rate cut, the Greenspan Fed emphasized that this move was more about getting out in front of any potential downturn, and less about the looming imminence of such a reversal.

Again, any of this sound familiar?

It’s a Different World

Equity investors, of course, would dearly love to imagine that a Fed insurance cut policy will always lead to the kind of outcome seen in the latter years of that chart above; namely, the stock market melt-up that roared through the late ‘90s and into the first couple months of the new millennium. Such an outcome is certainly possible. But before putting on one’s “party like it’s 1999” hat, it would be advisable to consider the differences between then and now.

The most glaring difference, in looking at the above charts, is the vast amount of blank space between the Fed funds rate and inflation. Yes, there was positive purchasing power for fixed income investors back in those days. Moreover, the US economy was able to grow, and grow quite nicely, with nominal interest rates in the mid/upper-single digits. This was real, organic economic growth. Yes – it’s easy to conflate the economic growth cycle of the late 1990s with the Internet bubble. But that bubble didn’t really take off until the very last part of the cycle – and in actual economic terms, Internet-related commerce was not a major contributor to total gross domestic product. This was a solid growth cycle.

The Greenspan insurance cuts, then, were undertaken with a fairly high degree of confidence in the economy’s underlying resilience. Today’s message is starkly different. What the market and the Fed apparently both conclude is that the present economic growth cycle cannot withstand the pressure of interest rates much or at all higher than the 2.5 percent upper bound where the Fed funds rate currently resides (and forget about positive purchasing power for anyone invested in high-grade fixed income securities). It’s a signal that, if the economy does turn negative, then central banks are going to have to get even more creative than they did back in the wake of the 2008 recession, because a rate cut policy from today’s already anemic levels won’t carry much firepower.

For the moment, the mentality among investors is optimistic that a best-of-all-possible-worlds result will come out of this. Dreams of a late-90s style melt-up are no doubt dancing in the heads of investors as they shovel $14.4 billion into global equity funds this week – the biggest inflow in 15 months. But no two bull markets are alike, and that goes for insurance-style rate cuts as well.

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MV Weekly Market Flash: Risk-Off, With a Side Helping of Large Cap Equities

June 14, 2019

By Masood Vojdani & Katrina Lamb, CFA

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Let’s go back in time exactly one year – to June 14, 2018. Someone from the future visits you and tells you that in the first four months of 2019 – from the beginning of January to the end of April – the S&P 500 will rise by 17.5 percent. The future-visitor then beams out, leaving you with just that one piece of information and a portfolio strategy to plan. What would you assume about the world at large? That gain in US large cap equities is one of the strongest on record, so you would probably be inclined to imagine “risk-on” as the dominant sentiment in global markets. A healthy allocation to core equities and higher-risk satellite classes like small cap and non-US emerging markets would be a plausible strategy, while perhaps reducing core fixed income weights to the lower end of your approved range.

No Reward for Risk

Of course, being in possession of just that one snippet of information about the future means that you wouldn’t have known that stocks came within a whisper of ending their decade-long bull market in December 2018, or that the Fed would make a sudden and radical U-turn in January towards a more dovish policy stance. Even so, one of the noteworthy things about the 2019 incarnation of the equity bull is how confined it is to US large caps, while riskier asset classes have sputtered. The chart below illustrates this divergence between bonds and large cap stocks on the one hand and everything else on the other.

From that point in time one year ago both US small caps and non-US emerging markets are down around 10 percent – still in or close to a technical correction. Non-US developed markets haven’t fared much better, in part due to the translation effect of a strong dollar on foreign currency assets. So a broad-based risk-on mindset has never really set in. The star asset class for this period, particularly when looked at on a risk-adjusted basis, is fixed income. The US Aggregate Bond index is up low-mid single digits for this period, performing a little better than large cap value equities and just a bit behind large cap growth stocks but with much less volatility, as clearly seen in the chart.

Divergence Ahead?

Bonds are in favor largely because the market has talked itself into believing that a forthcoming economic downturn will necessitate aggressive action by the Fed and other central banks (the presumed downturn being global in nature and in fact catalyzed more by flagging economies outside the US than here at home, at least for now). But there is a twist here within the friendly confines of the fixed income space. If economic conditions really are set to turn down, then a logical assumption would be that credit risk spreads start to widen. But that has not happened. Investment grade corporates and high yield issues alike are holding up just fine. The iShares iBoxx High Yield Corporate Bond ETF is up around 6.4 percent in total return for the year to date.

So here’s the picture: while the market is definitely not in a “risk-on” mindset, as evidenced by the poor performance of many higher-risk asset classes, neither is it completely “risk-off” as shown by those healthy returns for large cap stocks and the absence of credit risk spread widening. It’s as if there is some arbitrary line, on the one side of which are assets thought to be protected by a dovish Fed, with the other side being for assets vulnerable to the full-on effects of a worsening economy.

In recent commentaries we have argued that this odd arrangement is not sustainable. At some point either we realize that the economy actually is stronger than expected – in which case asset classes should revert to a more traditional risk frontier (higher return for higher risk) – or that a global recession is indeed imminent, in which case the market goes full risk-off, credit spreads widen and large cap equities get their comeuppance.

But there is an alternative view, which appears to be the one embodied by today’s conventional wisdom. This view holds that the magic of central banks will continue to work well enough to keep the worst of a downturn at bay. In this world, holding a handful of traditionally higher-risk assets like large cap US equities and low investment grade / high yield bonds makes sense, but taking on additional risk from other asset classes doesn’t pay (since the source of market return is permissive monetary policy, not organic economic growth). To be perfectly honest we think this is a risky view with the potential for serious mispricing of certain asset types. But it’s 2019, folks, and strange is the new normal.

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MV Weekly Market Flash: Volatility, The Good and The Bad

May 24, 2019

By Masood Vojdani & Katrina Lamb, CFA

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In our annual market outlook back in January (wait, is it already Memorial Day weekend?!) we had two principal things to say about volatility. First, that we expected to see a higher level of volatility as one of the key defining characteristics of risk asset markets in 2019; second, that volatility is not always associated with downward trends in asset prices (meaning that higher volatility could be present in both up markets and down markets). How has that prognostication played out so far this year? As we head into the summer season it seems a good time to revisit our January musings.

Peaks, Valleys and Mesas

Those of you familiar with how we have described volatility in the past will have encountered our topological renditions of the VIX index of market volatility, commonly known as the market’s “fear gauge.” Briefly, we have intermittent peaks when risk levels suddenly spike into the heavens like so many Gothic spires, and we have calm undulating valleys when investor attitudes are serene. And then we have mesas – extended periods where volatility is elevated but not as dramatic as those short spikes. The chart below provides a full rendering of this VIX topography over the market cycle of the past three years. In this chart the VIX is represented by the dotted green trendline, while the solid blue line shows the price trend movement for the S&P 500.

The peaks are pretty straightforward: they tend to happen when equity prices go into a tailspin. The most prominent risk spikes over the past three years, unsurprisingly, coincided with the sudden correction in stock prices in February 2018 and again in fall-winter of the same year. Those earlier, smaller spikes you see in 2016 coincided with the Brexit vote and the run-up to the US presidential election in the same year. Of course, in the aftermath of that election and throughout most of the following year investor sentiment was for the most part calm, and we experienced a long volatility valley that wound up setting successive new lows for the VIX throughout the summer and fall of 2017.

The mesas – that third topological element – figures into the interim period between the market correction spikes of February and October-December 2018, and again in the period since. Here we circle back to those comments about volatility we made in our January annual outlook. Higher volatility has indeed been a characteristic of asset markets this year, even though the overall price trend for most asset classes has been resoundingly positive. You can see that the VIX mesa between January and May 2019 is somewhat more elevated than that of April – September 2018, with more time spent above the long term average of 14.22 for this entire three year period. We think this is consistent with the contextual themes we discussed in our outlook: expectations for slower growth and a tougher set of comps for corporate earnings and margins, along with continued uncertainty about global trade. The mesa probably would have been higher still had not the Fed turned abruptly on its monetary policy towards a more dovish stance, with no more rate hikes in the foreseeable future.

Wider Intraday Spreads

The VIX, of course, is not the only way to look at risk and at times it can be misleading. VIX contracts are traded, bought and sold like any other asset, and as such what the index may be telling you on any given day can have more to do with flighty investor sentiment than with the underlying risk properties of the assets themselves. One such risk property is the intraday spread – the magnitude of difference between a stock’s intraday high and low price, expressed as a percentage of the closing price. In the chart below we show the intraday trend for the S&P 500 between August 2017 and the present.

Here’s how to interpret this chart: it shows the number of trading days each month for which the day’s intraday high-low variance (HLV) was greater than the average HLV for the entire period. For the entire period measured, the average HLV was 0.89 percent, meaning that the price difference between the high and the low was 0.89 percent of the closing price. So for any given day, if the HLV was higher than 0.89 percent that day was counted in that month’s tally. For example, in each of the months of September, October and November 2017, there was only one day in which the high-low variance was higher than the period average. By contrast, in both October and December 2018 the daily HLV was higher than average for nineteen days (in other words, for practically the entire month).

How does this chart help us understand the current risk environment? Well, the average number of higher HLV days for the first five months of this year (through the 5/23 close) is 8.2, including double-digit HLV days in both January and May. Again we want to make the point that volatility can be elevated even when the market is going up – January 2019 saw one of the strongest monthly price gains on record for the S&P 500, but there was higher than average intraday volatility for fourteen out of twenty-one total trading days. Conversely, the twelve HLV days recorded thus far for May coincide with a more risk-off mentality for investors as they pulled back in the wake of new record highs in April.

We believe there continues to be good reason to expect higher volatility in the weeks ahead. Remember – that may be good volatility or bad volatility. Given the way stocks trade in the present day, driven largely by reactive short-term quantitative models, any directional price trends are largely at the mercy of the daily headlines. The collective wisdom of the market may determine that trade war fears are overblown and the Fed has its back. Or, the consensus may be that the Fed’s toolbox is already pretty low on new surprises and global developments are unnerving. Either way, we will be looking at the elevation patterns in those mesas to gauge how much more volatility may lie ahead

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MV Weekly Market Flash: The Bull Is In the Eye of the Beholder

April 12, 2019

By Masood Vojdani & Katrina Lamb, CFA

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New fiscal quarter and same old bull market, or so it would appear. Which probably should not come as much of a surprise, given the veritable absence of anything markets would find new and newsworthy. The Fed pivot has come and gone, the trade war turned out in the end to be a paper tiger, economic growth is slowing everywhere but still positive. Corporate earnings will be weaker than previous quarters but probably not as weak as the dramatically ratcheted-down estimates of Wall Street analysts. The old parlor trick of outperforming a low bar is back in full force! Meanwhile, the Brexit extension to the extension to the extension (which you, dear reader, will recall we predicted back in January) was agreed to during the same week that we got to see a picture of an actual black hole, in space. No coincidence, surely, between those two events.

The Rule of 145 Days

So the good times continue…depending on your perspective. Year to date? Things are great. The S&P 500 is up nearly 16 percent (in price terms) since the start of 2019, which is one of the best starts to a calendar year, ever. Moreover, the intraday tempo of this rally has been relatively calm, with only a small number of instances where the index moved by more than one percent from open to close.

If you step back and take a wider view, though, the picture looks a bit different.
 

That 16 percent calendar year gain looks a bit different in the context of what preceded it: not just the sharp pullback of last autumn but a much longer trading period going back to January 2018. Here’s what has happened since the S&P 500 reached a then-all time high on January 26 of that year. There was a technical correction, followed by an arduous 145-day climb to a new record high (in August), then a bit more upward momentum to the record high of 2930 set on September 20. 135 days have passed since then, and now we are within striking distance of yet another record high (maybe, who knows, when the day count hits 145 again).

Wait-and-See Markets

What this means in actual performance terms is that the S&P 500, as of yesterday’s close, had gained a grand total of 0.5 percent from that January 26, 2018 peak. That’s cumulative, not annualized. Zero point five percent is not the stuff of a robust bull. Arguably, this sixteen month period represents a distinct phase of the great bull market that started in 2009: a phase we would term “wait-and-see.” The previous phase was the exceedingly non-volatile stretch from November 2016 to January 2018 (which phase certainly qualified for the moniker “robust”), and before that was the Mid-Decade Pause (another wait-and-see period) that came on the heels of the Fed’s ending its last quantitative easing program in 2014 and persisted through summer 2016.

That 2014-16 period may be instructive. Below we extend that same S&P 500 chart shown above to encompass a longer time period, where this bull market’s distinct phases are evident.
 

Of course, and contrary to our tongue-in-cheek section heading above, there is no such thing as a “rule of 145 days.” But it does feel like we might be getting close to the end of this particular phase of the bull as the market closes in on a new record high. The question, as always, is what comes next. Recall that in 2016 there was not much in the way of a compelling case to make that would have predicted the bull run of 2017. The bond market for much of this year has been suggesting that slower times are ahead. But the tea leaves, as always, are subject to multiple interpretations.

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MV Weekly Market Flash: Something’s Gotta Give

March 22, 2019

By Masood Vojdani & Katrina Lamb, CFA

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Well, the first quarter of 2019 is about to enter the history books, and it’s been an odd one. On so very many levels, only a couple of which will be the subjects of this commentary. To be specific: stocks and bonds. Here’s a little snapshot to get the discussion started – the performance of the S&P 500 against the 10-year Treasury yield since the start of the year. 

Livin’ La Vida Loca

For an intermediate-term bond investor these are good times (bond prices go up when yields go down). For an equity investor these are very good times – the 2019 bull run by the S&P 500 is that index’s best calendar year start in 20 years. There are plenty of reasons, though, to doubt that the good times will continue indefinitely. Something’s going to give. The bond market suggests the economic slowdown that started in the second half of last year (mostly, to date, outside the US) is going to intensify both abroad and at home. The stock market’s take is that any slowdown will be one of those fabled “soft landings” that are a perennial balm to jittery nerves, and will be more than compensated by a dovish Fed willing to use any means available to avoid a repeat of last fall’s brief debacle in risk asset markets (on this point there is some interesting chatter circulating around financial circles to the effect that the equity market has become “too big to fail,” a piquant topic we will consider in closer detail in upcoming commentaries).

Flatliners

We have been staring at a flattening yield curve for many months already, but we can now dispense with the gerundive form of the adjective: “flattening” it was, “flat” it now is. The chart below shows the spread between the 10-year yield and the 1-year yield; these two maturities are separated by nine years and, now, about five basis points of yield.

Short term fixed rate bonds benefitted from the radical pivot the Fed made back in January when it took further rate hikes off the table (which pivot was formally ratified this past Wednesday when the infamous “dot plot” of FOMC members’ Fed funds rate projections confirmed a base case of no more hikes in 2019). But movement in the 10-year yield was more pronounced; remember that the 10-year was flirting with 3.25 percent last fall, a rate many observers felt would trigger major institutional moves (e.g. by pension funds and insurance companies) out of equities and back into fixed income). Now the 10-year is just above 2.5 percent. Treasuries are the safest of all safe havens, and there appears to be plenty of safe-seeking sentiment out there. The yield curve is ever so close to inverting. If it does, expect the prognostications about recession to go into overdrive (though we will restate what we have said many times on these pages, that evidential data in support of an imminent recession are not apparent to the naked eye).

Max Headroom

What about equities? The simple price gain (excluding dividends) for the S&P 500 is more than 13 percent since the beginning of the year, within relatively easy striking distance of the 9/20/18 record high and more or less done with every major technical barrier left over from the October-December meltdown. “Pain trade” activity has been particularly helpful in extending the relief rally, as money that fled to the sidelines after December tries to play catch-up (sell low, buy high, the eternal plight of the investor unable to escape the pull of fear and greed).

The easy explanation for the stock market’s tailwind, the one that invariably is deployed to sum up any given day’s trading activity, is the aforementioned Fed pivot plus relaxed tensions in the US-China trade war. That may have been a sufficient way to characterize the relief rally back from last year’s losses, but we question how much more upside either of those factors alone can generate.

The Fed itself suggested, during Wednesday’s post-FOMC meeting data dump and press conference, that the economic situation seems more negative than thought in the wake of the December meeting. The central bank still appears to have little understanding of why inflation has remained so persistently low throughout the recovery, but finally seems to be tipping its hat towards the notion that secular stagnation (the phenomenon of lower growth at a more systemic, less cyclical level) may be at hand. This view would seem to be more in line with the view of the bond market than with that of equities.

As we said above – something’s gotta give. Will that “something” be a flat yield curve that tips into inversion? If so, what else gives? That will be something to watch as the second quarter gets underway.

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