Is the Climate Changing for Risk Assets?
With the third quarter behind us and US equity markets nearly back to record highs, August is likely to become a distant memory for investors. Markets were overdue for a correction, but the August lows were retested and have so far held firm. It's an election year, which is historically good for stocks, and we are about to enter a period (November – January) that has historically been positive for the market from a seasonal perspective. The storm is over, time for risk assets to shine again. Right?
Not so fast – it may be more nuanced than that. While US stocks have bounced hard off the August lows, risk assets have not uniformly bounced back. As we enter the later stages of this bull market cycle, the climate may be shifting for risk assets.
What supports this assertion? High Shiller P/E ratios? No. The looming Fed interest rate hike? No. The stronger US dollar? Not in isolation. Yes, these are factors that often play a role and drive our thinking on long term equity returns, but it's good old fashioned technicals and fundamentals that indicate a new climate could be arriving.
I want to be clear that I'm not calling for a bear market or recession in the immediate future, but simply observing a change from an environment of raw risk seeking behavior to a climate of risk aversion. Now, it's important to understand that risk aversion doesn't necessarily imply avoidance of all risk, but where buyers of risk assets tend to be much more selective. Not all signs point towards trouble, but the list is growing.
Signs of Risk Aversion
- Widening Credit Spreads – Credit tends to lead the equity market and the hunt for yield captures the essence of risk-seeking behavior. Credit spreads have been an excellent leading indicator for the equity markets and at times have provided early warnings of risk-off periods. Unlike the equity markets, which have bounced back materially, we have yet to see credit spreads substantially rally (narrow) back. Credit and equity prices tend to move in similar directions. As indicated by the chart below, equity investors may want to take heed.
What Does This Mean for Investors?
- Rising Volatility – While the VIX (or fear) index has come back down, volatility on a 3-month rolling basis is still elevated. The actions of central banks have suppressed volatility far below historical averages since the financial crisis. Are we in the early innings of a regime shift to that of higher volatility? If so, this is generally a negative for pure risk seeking behavior.
- Small Cap Equity Leadership Breaking Down – We have seen small caps begin to roll over versus large cap stocks, a sign that growth could be a concern and that investors are becoming more risk averse. Small caps typically lead large caps in broadly rising markets.
- Profit Margins Under Pressure – After years of strength, operating margins are beginning to show signs of weakness, and not just in the energy sector. Contributing factors are a reduction in pricing power, combined with steady wage growth and US dollar strength. This could pose a challenge for earnings and additional multiple expansion.
- Relative Weakness in Cyclicals – More cyclically oriented sectors have demonstrated relative earnings weakness when compared to their more defensive counterparts. This is indicative of slowing momentum in economic growth.
- Rising Dispersion – Dispersion between individual stocks and equity sectors is rising from depressed levels. We tend to see this behavior in periods of risk aversion or late cycle expansions.
- Pick Your Spots – If August taught investors anything, it's that trying to clear the deck after the storm has erupted is next to impossible. Given some risk assets are nearly back to record highs, investors should maintain slightly cautious positioning, but also look to capture relative value within risk assets. Emerging markets equities may struggle to find their footing if we are entering a period of greater risk aversion.
- Take Advantage of Rising Dispersion – Stock and sector dispersion is on the rise. Fundamentals tend to matter more in this stage of a bull market. Investors should be invested with savvy managers and strategies that can take advantage. Smart passive, long/short equity strategies, and managers in the natural resource space appear well positioned.
- Harvest Losses – In a year with generally flat returns on risk assets, harvesting losses for tax purposes can be one of the more impactful investment actions.
- Consider Less Liquid Opportunities – Risk aversion tends to be strongest in public markets where securities are frequently marked or valued. Investors can potentially avoid some of this herd behavior by getting into less liquid strategies - like private equity – where managers can be opportunistic and put cash to work over a longer time period.
Time will tell if recent market dynamics indicate a new front is rolling in or if the third quarter was just an overdue change in the weather. Regardless, we think it wise for investors to be positioned slightly more cautious given we expect long-term returns on risk assets to be below historical averages moving forward.
The above article represents the opinions of the author as of 10.29.15 and is subject to change at any time due to market or economic conditions or other factors.