Markets are clearly worried.
After stocks rebounded from a brief stint in correction territory (technically a 10 percent decline from the most recent highs), they are actively retesting the February market lows. They are also on the verge of re-entering correction mode, with the S&P off 9.91 percent as of the close on March 23. The extreme calm of late 2016 and 2017 that investors became accustomed to seems so very distant now, given the current market environment of increasing volatility or growing price fluctuations.
Not only have price swings become more pronounced in 2018, particularly since the February sell-off, but measures of implied volatility (or forward looking expectations of market volatility/risk) are also climbing.
The VIX index measures the 30-day expected volatility of the S&P 500. A higher VIX indicates elevated market uncertainty (risk) while lower VIX readings indicate market complacency toward risk. Keep in mind that the VIX registered an all-time low in 2017, with a reading of 8.56 on an intra-day basis on Nov. 24, 2017. We are far from that today with a reading of 24.87. Since the VIX peak on Feb. 6 (50.20 on an intra-day basis), the VIX has averaged 18.74 while the VIX averaged a mere 11.10 in 2017.
If this is the case, why have price fluctuations increased dramatically and why has expected volatility nearly tripled since the 2017 low? I suggest that a variety of factors have contributed to this: the United States brewing trade wars, the twin deficits of the country (fiscal and current account), Facebook’s data breach, European and Chinese economic slowing data and excessive leverage in China. Additionally, there are difficult earnings comparisons ahead in the U.S. despite the fact that thus far in 2018 earnings estimates have increased by the greatest amount ever recorded. Finally, the Fed’s Jerome Powell as a new figurehead for the most influential central bank in the world is also a contributing factor. Some of these risks are new, yet others are more systemic.
How markets deal with risk, and by extension, how societies deal with risk, is a fascinating subject – one that has its own field of research called behavioral finance. Markets can be thought of as entities composed of collective participants and risks have a habit of brewing before markets react to them. Often, the market recognizes an isolated risk, sizes it up, and if the current market disposition is bullish, it will place the risk on the back burner. Additional risks may arise, and the end result can be the same, with them ultimately shoved aside. This happens until the market’s ability to absorb risk becomes saturated. Once this critical point is reached, all previously acknowledged risks, waiting on the back burner, can rush to the forefront and become the catalyst for a significant market decline. Past risks that were once dismissed become fresh once again, building until there is an avalanche.
One factor that is not helping markets keep risks at bay is the fact that markets are not inexpensive. This is seen on both of the equity side of the equation as well as the debt side which was the subject of our last column, “Are bonds your safety belt? Buckle up.”
For stocks, valuations take many forms. Common examples are price to earnings, price to various calculations of cash flow, enterprise value to cash flow, price to book and more. However, nuances exist between industries. For example, the balance sheet of a levered utility can look dramatically different than a high-growth technology company with considerably less debt. Price to earnings metrics can be significantly under or overstated if forward looking estimates are utilized in lieu of trailing earnings.
For the market as a whole, Warren Buffet has a beautifully simple method of determining how expensive markets are at any given time. Rather than calculating the aggregate price of a stock index relative to total earnings or cash flow of the index, he looks at the total value of the U.S. stock market (all shares multiplied by price) and divides it by the total output of the U.S. economy using Gross Domestic Product. Rather than relying on earnings estimates, or estimates of cash flow, this approach takes the total economic output of the U.S.
If GDP is rising, earnings and cash flows follow. But are stocks too far ahead of the GDP?
As it stands today, taking the total value of the U.S. stock market (measured by the Wilshire 5000 stock index as a proxy) and dividing by the total U.S. Gross Domestic Product, we arrive at 136.3 percent. This number exceeds the 2007 top of 105.4 percent and is eclipsed only by the mania before the dot-com Internet blowup that measured 142.5 percent.
To get a sense of how far stocks could potentially fall, the same ratio measured 70.4 percent following the dot-com bust and 51.3 percent following the financial crisis.
Currently investors are walking a tightrope between the dot-com market cap/GDP peak and the current levels. The future is unfortunately obscure, since we do not know if the peak is already in or whether the market will forge higher.
Ultimately, market risks are piling up and the market’s ability to dismiss them is fading. We are seeing this through increased daily price swings, what we call historic or realized volatility, and increased implied or forward-looking price expectations (VIX). These are grey clouds that are starting to surround our current base camp.
It makes sense to increase protection, given the predicament, at least until the market signals an “all clear.” As we mentioned in our last column, bonds are not a compelling safe haven. Bonds are also expensive by historical metrics. and central banks around the world are focusing on removing monetary stimulus which would push rates higher and drive bond prices lower, increasing already elevated volatility.
Alternatively, given that short-term rates have climbed significantly, 30-day treasury bills or U.S. dollar LIBOR approaching 2 percent seems quite attractive relative to the 10-year treasury yield of 2.81 percent without the inherent duration (interest rate) risk of those longer dated securities.
As a result, cash is king – for now.
Jean Paul Lagarde is portfolio manager and partner at Faubourg Private Wealth. All data sourced from Bloomberg. Securities offered through LPL Financial Member FINRA/SIPC. Investment advice offered through Level Four Advisory Services LLC, a registered investment adviser. Faubourg Private Wealth LLC and Level Four Advisory Services LLC are separate entities from LPL Financial.
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