Despite all the uncertainty surrounding key macro inputs, as well as a volatile geopolitical environment, the STOXX US Index is up more than 18% year to date in line with other major US large-cap indices. And quite notably, market volatility, as measured by the various time horizons in our risk models and VIX, has been steadily declining (Exhibit 1).
Exhibit 1: US predicted risk and return – STOXX US Index
Exhibit 2: US predicted risk and return – VIX Index
Speculation is rife
We believe that the low volatility regime has helped market gains this year. However, the problem with a prolonged period of low volatility is that it encourages risky behavior, sometimes beyond what is prudent. Not all trades in a low volatility environment are speculative, but low volatility offers more incentives to speculate. Small predicted losses have lured investors into a false sense of security, and complacency has taken over as the major investment strategy. Most investors are running long only, concentrated portfolios, and there is very little evidence of any hedging having been put in place, suggesting the market is not expecting a sharp decline (see number 4 below).
Buyers beware
The irony is this is the typical environment we are used to seeing right before a sharp market correction. Crashes of any size all have two factors in common: First is the element of surprise – nothing in the predicted risk picture forecasted this. Second is a trigger event, like an unexpected miss on an important macro metric like inflation, unemployment, or consumer spending, or an unexpected change in monetary or fiscal policy decision, a large geopolitical risk event, or an extreme weather event (we’ve had a few of those lately). All of these remain strong possibilities.
Here we outline 10 such market concerns:
1. Market gains have been concentrated (with only 30% – 40% of stocks beating the index in most weeks since the beginning of this year) and from June since the beginning of August, on low trading volume.
2. The “risk spread”: A comparison of the risk forecast of our fundamental model, with that of our statistical model, to identify if we are missing a source of risk. By focusing only on known fundamental factors, we see our first red flags, both in the short and medium-term. For both risk horizons, the statistical risk models are predicting a higher risk than the fundamental ones, although the gap has narrowed recently. We believe this indicates that the statistical models may be ‘seeing’ a risk not captured by our fundamental models. Could it be ‘concentration risk’?
3. The Crowding factor: In our US Trading Horizon risk model, which measures the popularity of a stock with hedge funds, this factor had returns that were in the 98th percentile of our history (going back to 2006) in August. A strong positive return for this factor means that a strategy based on following the crowd has paid off. It also underscores the narrow breadth, highlighting that most investors are following the same names, crowding the trades in those stocks. If/when they unwind those trades, the decline could be sharp.
4. The Short Interest factor: Another factor in our trading horizon model, which measures investors’ interest in shorting a particular stock. A positive factor return here means that shorting is being rewarded by the market. For August, the Short Interest factor return was so negative, it was a 4th percentile event in our history. This means that shorting was heavily punished by the market. Implicitly, this means most investors are long and very little hedging has been done. If/when they cover those trades, the decline could be sharp.
5. Valuations are high, especially relative to interest rates. If/when a catalyst leads to a market sell-off of those trades, the decline could be steep, as valuations overshoot their fair level.
6. Yield curves in the US, Europe and UK remain highly inverted, suggesting investors are concerned about the economy over the next couple years. Given commentary from the Fed, it is unlikely to revert in the US by short rates falling, at least for the next 6 months or so (according to CME Fed Watch, the probability of the Fed raising rates in January is about 30%, and the expectation of rates falling by then is less than 20%). If investors decide a recession is on the horizon (no real evidence exists yet), they could decide to trade stocks for safer bonds.
7. Inflation remains stubbornly higher than the Fed’s target. We’ve noted in the past that some inflation can be good, because it signals economic strength. It is just when it passes a certain threshold that it becomes a concern because:
- Central banks are likely to tighten
- Consumers may pull back hurting revenues
- Costs go up, and profit margins fall
Until the Fed says they are done fighting inflation and we see evidence that they were able to engineer a soft (or no) landing we will continue to be concerned about its impact.
8. Investor sentiment has been less than supportive this year, and turned negative at the end of June following a short recovery post banking crisis in mid-March. It is more difficult for the market to rise on low or negative sentiment.
9. Low risk does not always mean smooth sailing ahead. Exhibit 3 highlights the 13 substantial market drawdowns since 1998. Risk was below the long-term average at the outset of the drawdown for 10 of these events. It does appear that when the initial risk is higher, the market decline is bigger, which makes sense. However, lower starting risk has also meant a larger increase in risk during the drawdown. It is also interesting to note that in the 2000, 2011 and 2012 drawdowns short-horizon risk had fallen substantially prior to the market peak, indicating the recent drop does not at all mean we are out of the woods.
10. And finally, although October gets a lot of attention as the market’s “bad month”, September is the only month to see a negative return on average over the past 40 years.
Exhibit 3. US market risk during major drawdowns since 1998
Source: Axioma
Bold bet or mean prank?
We believe the prolonged low (or at least below average) volatility period since late April has resulted in a higher-than prudent willingness to speculate in the market, which manifests itself through concentrated portfolios and a lack of downside risk protection. As both the macro and geopolitical environment remain unpredictable, the probability of a risk event trigger remains larger than normal, so both the element of surprise and the probability of a trigger event are in place. Were a trigger event to occur, both the level of concentration in investors’ portfolios would necessitate a rush for the exit, since no hedges are in place. With high valuations leaving more room to fall and accentuating the market correction. Of course, the trigger is most likely something unforeseen at this point.
Get more information about our Axioma Equity Factor Risk Models.
