Equity Risk Monitors — August 9, 2022

Equity Risk Monitor Highlights | Week Ended August 5, 2022

  • Market Sensitivity and Volatility returns turn positive
  • Market bottom or dead cat bounce?
  • Dispersion increasing as Volatility decreases

Market Sensitivity and Volatility returns turn positive

In most bear market scenarios, Market Sensitivity and Volatility factors not only lead on the way down, but also on the way up.  It may therefore portend the end of the downward slide, or at the very least be a sign of short-term strength that in the US, worldwide, and Europe factor models, the factor returns over the last month, and particularly last week were quite strongly positive:

See graph from the Equity Risk Monitors as of 5 August 2022:

Market bottom or dead cat bounce?

July overall was a month of strong equity market returns globally, with even the Stoxx Emerging Markets 1500 index eking out a positive return.  With that, we saw a commensurate decline in forecast volatility across the board as well, when using the short-horizon variants of our risk models.  The medium-horizon models have not yet picked up on the recent decline in realized volatility, due to their longer “memories” of past returns, nor had they risen anywhere near the recent SH peaks:

In all cases it is interesting to note that the medium horizon models were between 300 and 700 bps lower in their forecasts than the more reactive short horizon models prior to this latest decline in short horizon risk.  We see more dramatic reactions to events in the shorter horizon models around the start of the Ukraine War and the central bank acknowledgement of high inflation and their policy responses to it in the short forecasts, but these forecasts eventually come down as markets digested the news.  The medium horizon models, in contrast show a much more gradual incorporation of higher volatility overall without the peaks and valleys demonstrated by the shorter models.  It will be interesting to monitor this spread over the coming weeks as we head deeper into the summer lull, and address the question “will the short horizon forecasts continue to decline or will they find equilibria at or around the longer forecast levels?”  Perhaps the muted reaction to Friday’s positive surprise in the US jobs report indicates less concern about a full-on recession (at least in the US).

Dispersion increasing as Volatility decreases

Especially in the US, we have seen increasing dispersion every week for the last 4 weeks even as market volatility forecasts decline sharply:

What can this mean? While market returns were positive and muted, it is remarkable that the STOXX USA 900 index return was driven almost entirely by the IT and Consumer Discretionary sectors last week, and the last month:

When we check this against what we discussed earlier, it is not surprising to find that both IT and Consumer Discretionary have the largest Market Sensitivity exposures of any sectors as well:

As these two sectors, which have led the economy over the last decade or so, come back into favor, it is not surprising to see volatility decline and dispersion increase as investors have a better sense of the winners and losers.  One begins to get the sense that things are calming down demonstrably, even though, as usual, this thesis could be put to the test in the near future.