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Four market drivers signalling negative returns in 2020

Fundamentals are currently misleading.
The market appetite for risk is pointing to a bad year for equities. Image: Shutterstock

Investors have been fretting about the slowing of growth, the inverted yield curve and the ineffectiveness of monetary policy throughout 2019.

All of the economic and business cycle indicators have been flashing red, yet equity and bond markets were extremely strong in 2019, especially the US.

It is, however, worth focusing not on economic or fundamental data, but instead on the market drivers of the risk cycle, which we believe is a much more effective determinant of near-term expected returns.

We believe there are four important market-risk appetite indicators that are indicating that the demand for taking risk is negative. This generally results in short-term negative equity returns over the next six to 12 months.

There are four factors in particular that investors should consider:

1. Expect higher-volatility: strong equity returns have become a ‘free lunch’

Quite often equity returns are strong even when economic data is poor. This is because equity market returns are driven largely by sentiment of the future, rather than focusing on current stale economic data.

For the same reasons, equity returns are often strong during extended periods of ‘expensive’ valuations. For example, since the end of 2016, the S&P 500 price-to-earnings (PE) ratio has been significantly above its cyclically-adjusted 10-year average. In other words, the US market has been expensive for nearly four years. Since the end of 2016, the S&P 500 has risen another 57%, indicating that valuations are clearly far from sufficient in deciding when to be in equities. During 2019, the S&P 500 hit new highs 26 times delivering a 33% total return.

However, where we need to be very cautious is when these strong equity returns come at the same risk or volatility as bond returns. Currently, S&P 500 volatility is only two times US Treasury volatility (see Figure 1), which is a record low. This ‘free lunch’ is normally short-lived. Even the Coronavirus effect this year has not had a major volatility impact, unlike the Sars epidemic did. We caution investors to expect higher relative equity volatility in 2020 and weak to negative equity returns, regardless of economics and fundamentals.

Figure 1: Higher relative equity volatility will result in negative equity returns

Source: RMB, Bloomberg

2. No breadth left in equity market: very few stocks are driving returns

Near-record numbers of stocks in the S&P 500 have advanced versus those that have declined over the past year. Yet in terms of contribution to performance, only very few stocks are driving the market. In Figure 2 we illustrate that the cycle of winners to losers is at similar levels to previous equity market pullbacks.

Here are some market breadth statistics that should get more attention:

  • Only about one of five stocks globally has beaten the S&P 500 return over the last two years.

  • The US information technology sector alone delivered nearly a third of the S&P 500 index returns in 2019.

  • Since the end of 2017, the MSCI US Index has delivered a 20% total return and the MSCI World ex-US Index only about a 2% total return. This indicates that global markets outside of the US have had nearly zero performance.

  • Apple and Microsoft together are now bigger than the combined sectors of energy, utilities, real estate and basic materials in the S&P 500 Index.

Figure 2: Beware when many stocks are rising but only a few are driving the market

Source: RMB, Bloomberg

3. Liquidity has dried up: expect any bad news to have a bigger negative impact now

Liquidity is essential if markets are to adapt to new information smoothly and rationally. When liquidity dries up, markets are fragile, resulting in even mildly bad news having a significantly outsized negative impact. Figure 3 demonstrates that momentum in liquidity in US equities has temporarily hit a low, making the equity market very vulnerable to any unexpected shocks.

Figure 3: Average value traded divided by average market cap for S&P 500

Source: RMB, Bloomberg

4. ‘Peak’ momentum: positive price appreciation running out of steam now

We find that, very often, before market corrections and weak equity returns, the momentum equity factor tends to deliver strong outperformance relative to value. Value has been a consistent underperformer for over a decade, and even more so of late.

Value and momentum also show strong counter-cyclical returns. Value tends to do better just after a market correction, whereas momentum generally peaks just before a correction. Figure 4 illustrates that we are rapidly nearing the ‘peak’ momentum performance relative to value returns again. Equity returns are flat to negative subsequent to these periods.

Figure 4: Although still early, momentum is beating value by too much too quickly (again)

Source: RMB, Bloomberg

Roland Rousseau is responsible for equity structuring and portfolio strategy at RMB Global Markets.

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Great article. Thanks.

Price action on the S&P also more than 10% above the 200MA on the daily graph.

Not sustainable.

I’m impressed with such a high quality article – MoneyWeb stepping up its game.

To add:

1) CAPE (cyclically adjusted price ratio) at expensive levels last seen in Dotcom crash and 2008 crash

2) All regions are expensive on a 15 year view (emerging markets & Europe >1std deviation expensive, USA nearing 2 std deviations)

3) Global public debt at historic record high

4) global interest rates (yield on government debt) at record lows – many governments have negative yields (imagine the bank paying you interest, when take a loan for your house!)

5) Global GDP consistent downgrades for last 5 years

6) Europe, USA and Japan have no fiscal policy left (QE effectiveness is used up [record debt])

7) Corporate debt in US is at record highs (cheap financing from low interest rates – Gov can’t raise rates because corporate will go under. If inflation arrives then raising interest rates is the tool used to addressed inflation ..this tool isn’t available.

8) China has big reserves (and their nation has good personal savings (which protect the consumer against global crashes) – but 25% gov reserves were spent in just 18 months to prop up the economy (2014 -2016). Current reserves will be cushion ..but won’t completely protect them from a global recession.

Ah… All clever accurate talk, but who has the guts to offer suggsstions where one should invest!
Old adage… Spread your risk… Diversify. Any comments?

@911: great question. Honestly: there’s nowhere to hide. You need 2 things: cashflow & cash savings.

for most people in SA:

1) pay down your debt

2) move your investments down the risk ladder: move from a balanced fund (which are normally quite aggressive) to a defensive balanced fund.

3) hold at least some Rand cash in a money market account (gives you +6% ..much better than bank savings account) – you can get this from passive (Satrix money market) or most active managers (one of the few funds where they consistently outperform after fees). Make sure to use an investment company, (not an insurance company or a bank!) ..why? Investment companies give you 2day withdrawal (i.e. liquidity): when you need cash, you need it quickly.

For the more experienced investors:
1) hold at least some cash in foreign currency (easyequities give cheap access to foreign currency etfs or investec give actual foreign currency accounts)

2) SA bonds give you 9% while inflation is only 4-5%. you can access bond funds from most active managers (e.g. coro strat income fund) & passive (satrix nominal bond ..I wouldn’t use inflation-linked bond)

3) Create cash-flow businesses/income streams if you can. (if you need to go into debt then DON’T start now – reducing debt should be priority)

4) gold: this is speculative so >10% is irresponsible. you can access gold etfs cheaply from easy equities

5) alternative assets: mut be liquid. no point getting “diversified returns” from private equity when you can’t sell it for 10 years. for most people a rental property would be a good alternative asset. (if you need to increase your bond/mortgage debt then DON’T buy now – reducing debt should be priority)

Finally: remember your job corporate or entrepreneur business) is probably your most important asset:

1) build relationships (inside & outside)
take time to understand your client more (if you work in a corporate then your boss is your main client)

2) keep upskilling

3) keep your cv fresh

Remember many millionaires are made during recessions – if you have cashflow & cash savings.

Great article, thank you. I agree 100%. This market is largely driven by sentiment and it is ridiculous and dangerous. US will lead the correction and possibly next bear market. Consequently, it will bring down all markets, irrespective if EM and other developed markets provide better value. Looking forward to a huge downside. Offshore markets the place to be, really?

Awesome article! Thank you.

Insightful, well researched article! If there was ever a time not to join / not to be in investment funds that did rather well over the recent past (herd behaviour) – NOW IS THAT TIME. The market correction / slippery down-slope might not be immediate or very sudden like with previous major market corrections. You would want to re-adjust your retirement fund investment allocations, R.A’s, unit trusts, etf’s, offshore investments, etc to be majority focused on income generation funds (locally and internationally) – probably 35% or more; pref share dividend funds – probably 20% or more; money market funds – probably also 20% or more; and start building up your exposure to value funds – probably 15% initially and increasing the exposure as the down-slope materialises and contract further over time. Rather save than sorry for the next two to three years. Be warned – your broker or adviser will most probably try to convince you otherwise. Remember, ultimately you are the only person responsible and accountable for your own savings. Take control if you so wish. This is not meant as advice but as a seasoned, considered opinion.

SAfrican….. Spit on.. Thanks man. Total agreement. Crazy unpredictable times we live in.

Waiting on @Sensei to provide a witty analysis of these (partly) cognitive biased analyses.

He said it so it must be true. I guess RMB has advised all its clients to liquidate their portfolios and come back when the time is right. I suppose that is what makes the market..

End of comments.





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