The rise in volatility
First it was the foreign exchange markets, then commodities, followed by fixed income markets. Now it’s the equity markets. Wherever we look, volatility has been creeping higher, not surprisingly. At the end of the US Federal Reserve’s first round of quantitative easing, and at the end of QE2, the markets wobbled. So, with QE3 now winding to a close (and with the ECB still behind the curve), a period of uncertainty and frazzled nerves should probably have been expected.
Nonetheless, viewing the recent market moves solely through the lens of central bank action (or inaction) may be overly reductive. After all, one can look at markets through five different prisms.
- Growth: Apart from the US, which seems to be humming along, most of the recent economic data has disappointed. This is especially true in Europe and Japan, while China, following Beijing’s mini-stimulus this spring, is again undershooting expectations. Worse still, there are few reasons to expect Chinese, Italian, French or German growth to rebound meaningfully between now and the end of the year. Then there are the emerging markets that face significant headwinds, including Russia, South Africa, Brazil and Venezuela. All this contributes to a lacklustre global growth outlook.
- Momentum: We touched on the deterioration of European equities’ momentum earlier this summer. Since then things have got worse, with the Eurostoxx index down in nine of the 13 trading sessions following the European Central Bank’s announcement of ABS purchases. Even more worrying, negative momentum, which until a few weeks ago seemed confined to Europe, now seems to be spreading. The Russell 2000 is down for the year. So is Australia’s ASX, Malaysia’s KLCI, etc…
- Liquidity: Our own analysts argue that signs of a tighter liquidity environment are growing by the day, with credit spreads widening, the US dollar rising, the ECB’s TLTROs failing, random corporates going bankrupt (phones 4U), and breadth deteriorating rapidly in most equity markets.
- Behavioural finance: The thrust of our work on behavioural finance is the notion that roughly two thirds of the time, a given market will act ‘normally’. The pattern of individual stocks within the index will be broadly chaotic and driven by many different factors: oil stocks will move with oil prices, banks will be affected by changes in the yield curve, etc. Then, one third of the time, markets will move into ‘abnormal’ state, when all stocks become correlated, with their performance driven by one factor, usually yesterday’s share price. In such an environment, adding value through stockpicking becomes almost impossible (but trend-followers thrive). An increasing number of markets are now showing ‘abnormal’ behaviour on our behavioural finance matrices.
- Valuations: This is the big debate. With interest rates at zero, one can argue that equities everywhere remain massively undervalued, even though valuations in a number of markets (not least the US) are starting to look rich on a historical basis. Moreover, one can also argue that while an overall market (China, say, or Europe) may look undervalued, the undervaluation is the result of deep distress in a number of sectors (SOEs in China, banks/utilities/telecoms/oil in Europe…).
Putting it all together, it is hard to escape the conclusion that the environment for stocks is turning ugly: global growth is disappointing, liquidity and momentum deteriorating, and markets are starting to act abnormally. When you consider that September and October are often challenging for equity investors’ nerves, perhaps we should not be surprised by the recent wave of profit-taking.