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