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What Goes Up...

This week the S&P 500 recorded the longest bull run in history up 322% over 2465 days. The run started just after the 9th March 2009 dip and has had a whopping return to boot in USD for unhedged foreign investors. We are now firmly in the territory of the worst decile for returns in terms of performance over the next ten years for equity markets. However, there is some evidence that the party is not over yet.

Just this week CheckRisk heard a “this time is different” story. Naturally it is important to consider right-hand tail risks as well as left hand, however, please note while we do not believe that the fundamentals have changed at all, there is a sequence of events that is likely to be followed that could make it appear as if everything is just fine. As we reported in our most recent CREWS Quarterly Risk Review:

“The market internals are narrow within the USA, the top 10 tech stocks have been responsible for 100% of the performance of the market. The longer-term signal still favours equities, but clients must be prepared to accept higher volatility, lower expected returns and bigger downside risks.” 

For those not prepared to accept these expected market attributes then it is time to reduce exposure now. We continued,

“The US yield curve continues to flatten. Different parts of the term premium are now close to zero. We expect a pause in flattening for the next quarter due to monetary policy expectations. We anticipate full flattening in 2019. The inversion that follows is a good predictor of macro fragility and recession.”

And thanks to Damian Kestel at CLSA, a little bit of extra information;

“Over the past four occasions, whenever the yield curve has inverted, the market has corrected by an average of 34% (minimum 16% max 52% during the credit crisis). However, there has been a significant lag (about 19 months) between the start of curve inversion, and the peak of the markets, during which the market has delivered strong returns of an average of 26%.”

So the bull case, from a risk perspective, might be that while it is clear that the yield curve is going to invert, and that this is a strong predictor of a market correction, there is still some time to stay at the party.

 

S&P500 to August 22nd 2018

There is also a bull case to be made that many of the current risks like Turkey, Brexit, etc. are being discounted by markets and are all fundamentally manageable. (this ignores network risks and contagion) but it is entirely possible to imagine an Emerging Market rally, for example, on the back of an IMF intervention in Turkey.

So is it possible that the S&P500 will continue the bull run for a while longer and continue through a yield curve inversion for that golden 19 months mentioned above?

CheckRisk has been of the view since 2010 that the primary risk period would be 2017-2020. This is because the effect of the breaking of unconventional monetary policy B.U.M.P. and its related impacts of interest rate risk, trade and currency wars, synchronization risk, geopolitical risks and economic risks tend to lag behind the physical withdrawing of liquidity. We have not been wrong so far.

It is not inconsistent to see the stock markets rise during an elevated period of risk, and it is important to dispel that confusion. Markets, particularly equity markets, rise much more often than they fall, it is just that the falls tend to be of a much shorter duration, and greater intensity and therefore create a lot of damage.

CheckRisk believes that the yield curve will invert in 2019, (we are already at the lowest spread between ten year and two year Treasuries since 2007.) There may be a shorter delay than usual for equity markets to react due to a host of risk issues that will bubble up in 2019 like Brexit, the USA’s trade wars, interest rate shock risk, an oil shock, etc.

Attempting to time corrections is a fools game. One can only start to recognize the risks as they mount and use quantitative approaches, as opposed to sentiment or subjective views, to have strong positional awareness. Our Early Warning Risk System, combined with other risk models do just that, and for the moment, with the notable exception of China, we see a “no story here” picture, it has to be admitted. It is very much steady as she goes, against a backdrop of long-term signals turning less bullish.

From our perspective then the significant event type risks are an oil shock, deepening of China and global trade wars, interest rate shock risk, and Central Bank Policy errors. It is in our opinion the bond and currency markets that are going to inform investors, like a canary in the coal mine, what happens next. Just as Turkey is demonstrating the transition of a currency crisis to a debt crisis as the result of exposure to a strengthening USD and rising interest rates, so bonds, credit, and market risks will do for the next crisis.

Have an enjoyable bank holiday in the UK, and a wonderful weekend for our international clients.

Call the Team at CheckRisk if you would like to learn more about why we believe Risk, Rewarded is the way to invest.


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