18 March 2016

Whither You Go

Executive Summary

The early 2016 market sell-off that culminated on Feb 11 represented a great dislocation in financial markets. From measuring the duration and magnitude of the drawdown from the peak of the market in May 2015 to the bottom in Feb 2016, it appears that the cyclical bear market has run its course. We are now seeing encouraging signals from the market rally indicators. The stabilisation of the commodity sector and a dovish Fed has also encouraged risk appetite. However, we are cognisant that some upside obstacles remain – namely valuations and current asset allocations. However, with risk signals receding, we remain fully invested until our Risk Matrix signals otherwise.

Detailed Commentary:

We recently highlighted that equity markets had seemingly become more correlated with oil. For risk taking behaviour to resume, we needed some form of stabilisation. Coupled that with peak pessimism on Feb 11 and our hypothesis for an "Echo Bear" scenario, it appears that the correction may be behind us. For now, we are closely watching longer term rally signals to confirm that the upside is sustainable.

Stabilisation for Commodities - Especially Oil

The sell-off during the last few months brought out extreme fear in many aspects of the markets. There was talk about 2008 and the Great Financial Crisis again. Everyone feared the banking sector would collapse. Equity markets in non-oil related countries suddenly moved in tandem with oil prices even though there was absolutely no good reason behind it. What happened represented a big dislocation in markets. Now as we see oil slowly stabilising, risk taking is creeping back and investors who had stayed out of the market or sold out in great fear would have missed the recent recovery.

Fig 1: Extreme Equity Market Correlation to Oil. UK, Spain and Europe are Hardly Oil Producers.

Market Technical and Leading Indicators

What does investor sentiment tell us about the market? We have watched as risk aversion slowly gave way to risk taking again. We have passed the peak pessimism seen in late Jan and early Feb. However, we are not at bullish levels yet as many investors still remain fearful and sceptical. This shows that there could yet be more upside once those on the sidelines rush back into the market. Another sign of easing fear can be seen in the Volatility Index, where it has been slowly receding from its extreme highs just a few weeks ago (Fig 2).

Fig 2: Retreating Volatility Index Shows Risk Appetite Picking Up

Technical indicators that track bullish activity in the markets have turned positive since 8 Mar 2016. This is an encouraging sign that the rally could be sustainable. We were hoping for a similar signal during last Aug's sell-off but it did not come. It now appears that the rally from the Feb bottom can continue (Fig 3).

Fig 3: Bullish Technical Signs are much more positive now than the Post Aug 2015 Correction.

Another sign that points to a sustainable rally is a "broadening" of the advance. What this means is that we want more stocks to participate in this rally, instead of only the large cap names driving the performance of the index. This shows that the rally is healthy and across most sectors. The chart below shows a positive sign, where the equal weighted index relative to the cap weighted one has broken above its 200-day trend (Fig 4).

Fig 4: The Performance Of the Equal Weighted ACWI Index Shows a Broadening Rally Since the Feb Lows.

Another encouraging development has been the performance of the high yield bond sector. We have seen credit spreads start to narrow once again, with rising high yield bond prices – in line with rising risk appetite (Fig 5). Investors had begun selling out of this asset class since the middle of 2015 as many high yield issuers were from the energy and materials sectors.

Fig 5: Another Sign Of Risk Appetite Returning Can Be Seen In the High Yield Bond Market

One more positive sign is the recent relative strength of the resource-related sectors, namely in the energy and commodity space. As oil and commodities start to stabilise, investors will start nibbling into these beaten down sectors. In addition, we also want to see underperformance in the defensive equity sectors like Consumer Staples (Fig 6). We have also seen a revival in the commodity currencies of Australia, Canada and South Africa relative to the US Dollar. The return of investors to these areas once considered "too risky" is a good sign.

Fig 6: Continued Recovery In Energy and Materials Is a Positive Sign

US Rate Hikes

On 16 Mar, Federal Reserve Chair Yellen also gave a dovish press conference acknowledging the risks to global growth, highlighting that financial conditions were tightening in the US, and downplaying the recent pick up in core inflation in the US and thus expressing the need not to hike interest rates too fast. The "dot plot" released by the Fed was also dovish, with only a 50bps hike pencilled in for 2016 (Fig 7). This means that the Fed could likely only raise rates twice this year, and are very aware of the present volatile market conditions. This sparked a rally in risk assets as markets appeared comforted by the policy response.

Fig 7: Dovish Fed Press Conference Which Projected a Slower Pace of Hikes Sparked a Rally in Risk Assets

Headwinds

Our enthusiasm is not without some worries of course. One headwind which could cap some upside are market valuations. Looking at the S&P500 index, valuations continue to remain expensive from an earnings perspective (Fig 8). The little box in the chart shows how earnings plunged to $86.47 in 2015 from an initial estimate of $130. The expectation for 2016 is for earnings to come in at $111.50 that is also optimistic given the slow growth environment we are in now.

Fig 8: Valuations May Provide a Stumbling Block to the Market

Another potential headwind that we see is that current asset allocation for both households and institutions continue to remain quite bullish. Whilst the data is only released quarterly and is quite laggy, the charts show that the allocation to stocks remains above mean levels (Fig 9). There is usually more upside to the market when there are few owners, and less upside once the number of buyers reduces.

Fig 9: Stock Allocations for US Households and Institutions Continue to Remain Quite High

Conclusion

It appears that the cyclical bear market has run its course and risk appetite is slowly returning to the markets. The stabilisation of commodities will provide a stable backdrop for equity markets to recover. Technical indicators show that the rally can be sustainable as we are getting better signals from the recent uptick than the one in Sep 2015. However, we would like to see further confirmation before turning fully bullish. Some headwinds are equity market valuations and asset allocation. However, our Risk Matrix is currently showing a positive green signal and we are thus fully invested until we see the signals turning negative.

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