LGT’s Kumada: Anatomy of a Market Turbulence

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Mikio Kumada, Global Strategist at LGT Capital Management, comments on the latest volatility in global equity markets.

Last Friday, equity markets started recovering from their recent “correction”. Naturally, investors can use any rally to sell stocks. That is why many experts correctly warn that we will only find out if the bull market remains intact once the rebound has taken its course. But that is just another way of saying that we can only know the future once the future has arrived. Nevertheless, objectively speaking, the recent market turbulence looks rather harmless in our view.

Every time financial market volatility rises and ugly news headlines dominate, many analysts start turning more cautious again. Some seem to be always moving through a dark, unknown forest by carefully groping their way forward from tree to tree. Recurring uncertainty is only natural in markets, and there is nothing wrong with it per se, particularly since we all know that no one can predict the future. However, stating the obvious is not necessarily helpful when one is looking for a professional opinion.

Very modest increase in volatility in the United States
In this sense, we take another look at the whole forest, i.e. the bigger picture in markets. Since the beginning of the current bull market in March 2009, the S&P 500 has had 13 corrections of more than 5%, without ultimately parting from its uptrend. It had seven pullbacks of more than 7% and three of more than 10%, one of which with losses of almost 20%. On average, the US and global bellwether index has had one larger “correction” every five months. The latest pullback, from June 24 to August 7, brought a loss of just about 4% – but such smaller drops are almost too common to count. The recent increase in volatility has thus been moderate in the US. Admittedly, Europe’s markets were more volatile, but they too remained within historical norms. Without the fear factor triggered by events in Ukraine and the Middle East, it may well be that hardly anyone would have been upset by these moves.

Market breadth: no problematic developments thus far
Next, we look at the socalled market breadth. Generally, a strong equity boom tends to spread to a broadening part of the stock market. If this is not the case, some caution is called for. However, it is sometimes misunderstood that falling market breadth is always bad. Firstly, market breadth always drops in the short term during a market pullback. Secondly, while it can be a bearish sign when market breadth continues to fall amid continued price gains, that too is not written in stone. There have been cases were significant market segments continued to rally even as market breadth declined steadily for many years. During the dotcomboom, for example, overall market breadth kept narrowing from March 1998 through March 2001, but the NASDAQ surged by another 180% through March 2000, while the S&P 500 gained 40% through July 2001.

In other words, the US blue chip index, which represents about two-thirds of the US market capitalization, continued to rise for 28 months even after market breadth began to drop. The divergence between breadth and price observed during that time simply reflected the fact that internet stocks and blue chips were outperforming other segments for a long time (the traditional small caps of the Russell 2000 index, for example, underperformed for several years back then. We have observed the same phenomenon in recent years, as many emerging equity markets did not (fully) participate in the US-led global recovery that began in March 2009.

Convincing warning signs are lacking
Concluding, the following observations are of particular interest. Firstly, the recent turmoil has not led to noteworthy divergences within the US market. The Russell 2000 has underperformed since March, but that need not be a generally negative sign. It could just as well prove either temporary, or simply represent just another turn in favor of other market segments in the context of a continued bull market, like in 1983 and 1994. Secondly, after underperforming for several years, emerging market equities have recovered significantly since June. The post-2009 bull market may thus be finally about to shed its most-notable weakness, i.e. the nonparticipation of the much of the emerging world in the global rally. At any rate, those who resist being overly impressed by geopolitical speculation, and instead focus on market signals and economic data, are likely to come to the following conclusion: rather than facing a sharp correction, or the start of a bear market, we could actually be moving closer to an even broader global bull market that includes many of the emerging markets.

Increase in volatility remains very modest
Looking at the difference between the current implied market volatility in the US and the longterm average volatility level (we take the 200-week moving average as reference). We see that the most recent rise in volatility is hardly noticeable in the larger picture. It also remains clearly below longer-term average levels. In addition, we can observe that even prolonged phases with aboveaverage volatility need not necessarily be accompanied by a bear market. For example, in the volatile period between early 1995 and mid-1999, we had a positive general market environment, which saw the S&P 500 rise by about 200%.

No divergence between breadth and price indicators
We wish to highlight that market breadth is a useful but not all-important indicator. First, we note that in the current phase, we still have no significant divergence between market price and breadth. It is true that US small cap indices have been underperforming since March – but that is approximately 3% of the world market based on the Russell 2000. At the same time, the emerging markets (about 13% of world market capitalization) have been outperforming, which is encouraging, even if this recovery does not yet fully convince us from a medium-term perspective. In any case, NYSE breadth is still moving in line with the S&P 500 price. However, it is worth remembering that even a divergence between these two indicators need not be an immediate precursor of a bear market, as the period from March 1998 to March 2001 clearly shows. Even if we look at shorter time windows we will find some temporary divergences that proved meaningless in terms of predicting a bear market.

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