Stock markets normally do not just collapse without an impending economic recession or financial crisis. We have just exited the seasonally weak “Sell in May” period intact. Current bullish market breadth and momentum lends confidence that the cyclical bull-run will continue. However, most investors remain pessimistic, scared and unsure of what is going to happen as they read of the many uncertainties dogging the headlines, chief of which is the ugly mud-slinging that preludes the US Presidential Elections in November. We think that the concerns could be over-rated as the US democratic system has various checks and balances to not allow the President an entirely free hand in policies. Whilst markets typically do not perform as well when the incumbent party loses, any forecasting is probably best left to the soothsayers and haruspices. Stock market valuations is a watch point for us but the overall weight of the evidence still tells us to stay invested. We still look to our Risk Matrix© to trigger us should markets start to detriorate, and help guide our portfolio stop-loss and risk mitigation procedures.
“Should I stay or should I go now?
If I go there will be trouble
And if I stay it will be double
So come on and let me know
Should I stay or should I go?”
The Clash, an English rock band, released this song in 1981 and it became a UK #1 hit a decade later. Whilst the song seemingly dwells on a love-hate relationship, the lyrics seem to perfectly describe the emotions that investors go through. There are so many real-life examples of people who bought at market highs only to sell when the market had bottomed. Legendary investor Warren Buffett summed it up perfectly when he said: “the stock market is a device for transferring money from the impatient to the patient.” With so much negative news and apparently insurmountable headwinds to the stock markets, selling appears to be the right thing to do, but let’s examine whether we should stay and reap the returns reserved for the patient.
Not Really a “Sell In May”
We have just come out of the traditionally weak period for markets relatively unscathed. Current data and market indicators continue to show bullish signals. Just looking at the price of stocks does not tell you anything. To really find out the health of the market, we have to measure underlying metrics like breadth and momentum, which provide us with an assessment on whether we are primed for more upside or a collapse.
(Footnote: Market breadth attempts to gauge the direction of the overall market by analyzing the number of stocks advancing relative to the number declining. Momentum refers to the speed at which a stock price is changing.)
Fig 1 shows a type of breadth measurement for the global stock market. For now, both the shorter term and longer term measurement of overall global stocks show that the market is still healthy, despite the trendless sideways movement we have experienced over the past 3 months.
Fig 1: Present breadth levels not at potential danger levels as compared to recent history
Fig 2 shows a separate measure of market breadth – which is essentially a measurement of the number of stocks breaking out to 52 week highs versus the stocks breaking down to 52 week lows. This indicator measures the US market, which is a huge component and leading indicator in a global equity index. Currently, this breadth is also showing positive signs, despite all the worries affecting the stock market.
Fig 2: Breadth measurement of the us US market shows that it is still healthy, compared to recent history.
We like the momentum indicator shown in Fig 3. The model measures momentum across all cap stocks and across all industries in the US. Again, taking the US total stock market data as a proxy to the broad equity market, the momentum model currently shows that momentum has not yet broken down (despite the perceived weakness in the stock market). Research shows that stock market returns tend to be best when the model is high and rising, and poor when the model is low and falling.
Fig 3: Stock market momentum is still bullish despite the recent trendless direction
As such, with the market breadth still positive, and stock market momentum not breaking down, and with our Risk Matrix showing green, we can expect the current cyclical bull market to continue.
Investors are Dead Scared
News headlines and their scare-mongering ability have had a field day. With the scars of the recent market correction in Jan/Feb still fresh in the memory, pundits have been quick to turn bearish at the slightest inkling of any negative news. The charts below which measure investor pessimism are near extremes – even with the market currently not in a correction phase. As the smart money knows, we should always try to avoid the herd, and the herd is currently expecting the market to collapse. Therefore, we should be positioned contrary to market sentiment, especially when our market indicators are showing bullish signals.
Fig 4: Investor sentiment has been hovering at pessimistic levels despite the market not suffering a correction of meaningful magnitude
Fig 5 below shows the tremendous growth of volatility assets (financial instruments that make money when volatility spikes). Retail investors have been piling into this asset class in 2016, expecting the market to collapse. It is a classic sign of fear, and the price of volatility (which is a form of portfolio insurance) is now near record highs. It does not seem prudent to buy something priced so expensive. In addition, the smart money has taken an opposite view to retail investors, and is net “short” volatility (i.e. not expecting volatility to spike). Again, we prefer to side with the smart money view and if so many investors are so bearish, then a market collapse appears remote at this point in time.
Fig 5: Massive rise in the amount of money in volatility assets as fearful investors pile into portfolio insurance expecting a market collapse
The chart below shows fund flows of equity mutual funds - which is a sign of bullish or bearish retail investor behaviour. For the better part of a year, retail investors have been pulling all their money out of equities which is another classic sign of fear. So what is propping up equity markets, you may ask? It is mainly from institutional smart money, which allocate via low-cost vehicles like ETFs and select low-cost funds. Let’s not forget how bull markets end – typically when euphoria from bullish and greedy investors boils over. The current behaviour of investors is definitely not a sign of elation.
Fig 6: Equity fund flows have been negative for nearly 1 year as fearful investors pull the plug on their investments
Such negative investor sentiment and positioning is contrary to how market tops are formed. We do not expect the market to suffer anything more than a minor sell-off as it continues on its bull market trend.
US Presidential Elections
As investment advisers, we are apolitical but feel compelled to allay investors’ concerns about the impact of the US Presidential Elections on the markets. The general sentiment and recent media headlines have alluded that a Trump presidency would be disastrous for markets as opposed to a Clinton presidency. But the truth is that nobody knows for sure. The example of how markets reacted to the recent Brexit ‘yes’ vote is a case in point. Who knows, maybe Trump in the White House could be beneficial for the American economy as he cuts taxes and drives up consumption. But this is not the point we want to make. All we know is that it would be difficult for a radical President to make outright changes as there are checks and balances to govern policy making in the American government.
For example, in order for any law to come into effect, it has to pass through the US Congress, made up of the House of Representatives, and then pass through the Senate. Even if a law comes into effect, the President can still veto it or the judicial branch can declare the law unconstitutional. Although the executive branch (and President) could unilaterally declare Executive Orders, the judicial branch can declare it unconstitutional as well. In effect, no one person is able to wield considerable power without first needing to pass through some form of a check, and as such any reaction to an “unfit” President would likely be temporary. Therefore, any impact to markets is likely to be temporary regardless of who is elected as the President. We thus continue to defer to our Risk Matrix and longer-term indicators of market stress to really tell us whether or not a big collapse is coming.
Fig 7: The US Government is split into three branches which ensures no one branch would be able to have too much power
We would like to point out that markets always dislike uncertainty and would come under some pressure should the incumbent party lose. This is likely due to expectations of policy changes as the opposition may dismantle existing policies put in place from the previous administration. So how are markets likely to react in either election scenario? Fig 8 below shows the average of all previous market reactions to different election outcomes.
Fig 8: The chart shows the average of market reactions based on election years from 1900. Usually when there has been a switch of party, the market ends up trendless with small losses.
Financial Crisis Part 2
We were also surprised with the recent market reaction to Deutsche Bank’s tussle with the US Department of Justice over a US$14bn fine related to mis-selling during the 2008 GFC. This resulted in a lot of pundits calling for another “death spiral” for global banks, reports on financial sector collapse and further calls for recession and an equity market collapse. Investors who believed in this flawed analysis have absolutely missed the forest for the trees. Fact: the banking sector is nowhere near the risk levels which preceded the 2008 crisis. They have far more good capital, deposits and are, most importantly, backstopped by the central banks. The chart below shows that many banks have cleaned up their act since 2008 and are very much less likely to suffer a default today.
Fig 9 shows that the amount of unsecured deposits used to fund bank assets have dramatically decreased post-crisis
In addition, the chart below shows that throughout the recent Deutsche Bank debacle, European financials have continued to perform well both on an absolute and relative basis, showing that investors in this sector are not pricing in any collapse of the European banks. This also proves that simply reacting to headlines would have proved to be a very bad investment strategy.
Fig 10: The market is not pricing in a collapse of the banking sector and despite the headlines, it is not happening in Europe
Financial sector performance is an important leading indicator which prices in expectations of improving economic growth. As long as global financials continue to perform, it provides support to the cyclical bull case.
So What Is Wrong?
Given our optimism, is there anything we are worried about?
We would definitely like to see improvements in valuations of global equities. Most absolute measures of valuation show that stock markets are more or less fairly valued. As such, we should not be expecting to achieve returns from multiple expansion and instead need to rely on corporate earnings for prices to improve. When we look at relative valuations however, it appears that there is really no fighting the central banks if they want to create asset inflation. Stocks relative to bonds look cheap in comparison, and when you factor in inflation-adjusted earnings, valuations appear more normal.
Fig 11: Global stocks appear fairly valued on an absolute basis...
Fig 12: ...but are below median when you factor in inflation
Fig 13: This is a clear sign of how not to fight against the central banks when they want to boost assets. More than half of the S&P500 stocks give higher yields than treasuries. Which one would you rather buy now?
Whilst valuation does not make us excited about the markets, stocks still present the best risk/return opportunity for investors. But we are keeping a close watch on it, as well as our Risk Matrix which would provide a stop-loss in the event that the market decides to turn down.
Investors remain pessimistic and unsure about the direction of the markets, especially if they have been following recent headlines in the financial media. We would strongly recommend our clients to stay invested. We summarise our reasons from the write-up above:
- Stock markets do not collapse unless a recession or financial crisis is looming. Currently, there is an absence of both.
- As we emerge from the dangerous “Sell in May” period, we currently see bullish breadth and momentum market signals, which is very positive for equities.
- While equity valuations are not cheap, stocks relative to bonds still appear cheap in comparison and appear normal when you factor in inflation-adjusted earnings.
- Our Risk Matrix© signal is still green, meaning we should remain invested. With our current risk mitigation processes in place, unless signals change, we feel very comfortable staying in the market.