Written back in spring, this paper foretold of a summer of range-bound asset markets, hopping between indiscriminate falls and recoveries, which largely came to pass. However, the Brexit referendum decision and the election of Trump in the States were not predicted, with the possibility of a bear equity market seemingly now on hold. Sentiment currently feels bipolar, torn between the heady expectation of tax reform and infrastructure stimulus and the gloom associated with trade protectionism, higher bond yields and rising interest rates. 2016 was far from a dull year – don’t expect anything different from 2017. - Eoin Murray, Head of Investment
The bulls are back in control – but behind the market rally, are worrying trends emerging? In his latest investment note, Eoin Murray, Head of the Investment Office at Hermes Investment Management, analyses the dynamics behind the current market surge and asks whether we are experiencing a 'bunny' market.
Should an inquisitive inter-stellar traveller happen to land on Earth this week, it might take a cursory glance at the markets and conclude that the planet’s economics appear to be in rude health.
After all, since the brutal early year sell-off, oil has rebounded strongly, developed and emerging markets have rallied, and equity volatility is way below its long-term average. For now at least, the bears have been chased away. Yet the question remains: how much of this market rally is grounded in reality?
Gruelling road to recovery
Let’s firstly look at the macro picture and check the health of the US economy – still by far the world’s largest and most influential. One interesting measure that takes the pulse of the US economy is Chicago Fed National Activity Index (CFNAI). This is a monthly index that gauges broad categories of data that includes employment, production, income and consumption. For 55% of the months since the global financial crisis this measure has shown economic activity to be behind the long-term historic trend. This has not been a full-throttle roar back into recovery but a long, hard slog, which many would argue is nearing its end.
Developed market earnings have also disappointed; taking the example of US corporate earnings, in Q4 2015 we saw an 11.5% year-on-year decline (BP’s $20.8bn penalty payment in the Mexican Gulf accounted for a significant hit to profitability, but even excluding BP’s numbers, the figures are down 7.6% year-on-year), while the latest forecast for the US Q1 earnings is approximately 8.7% down year-on-year. By any measure, this is a pretty grim picture.
So as the US and other developed markets endure torpid growth, and corporate earnings continue to disappoint, what is turning up the heat on the market?
Beware of the forced buyers
Beneath the ripples of the market's surface, lies some deep and potentially violent undercurrents. One concerning undertow is the growing presence of forced traders, many of them quantitative or systematic strategies, whose actions are often driven by the level of volatility. They include smart beta, risk parity and momentum players, who can drive risk assets back to high levels. To emphasise how broad this move has been, at one interval at the end of April, there was not a single stock in the S&P that was not ahead of its 52-week average – an extremely rare event.
A further worrying sign is lurking within the options markets where traders are hedging their bets. During mid-February, traders were tilted towards puts – essentially buying protection. That positioning had completely shifted towards long calls before option expiry towards the end of April. This positive sentiment shift is causing volatility in the market to dampen.
Hence we see the VIX at a third below its long-term average, a level which seems bewildering given the level of fear gripping the market a couple of months ago. This newly found positive attitude has turned all of the volatility-targeting strategies, such as risk parity funds etc., into forced buyers, sending stocks rocketing back.
Will the market continue to hop?
This behaviour and its knock-on effect underlines just how sentiment-driven the market has become and how powerful the underlying forces are. Given this scenario, we believe it may oscillate between a period of brief rallies and dips for some time yet.
Economists and market pundits often like to categorize markets as either bull or bear. But I think we are in neither. What we are seeing is a classic bunny market: where asset classes hop around a great deal but ultimately don’t really go anywhere.
Bunny markets often occur before the death of a long bull market or before the onset of a bear market. For investors a bunny market means periods of indiscriminate falls and rises. While the bunny market leaps can be jarring, they also present opportunities to find value in individual assets in a sentiment-driven market. Perhaps the deeper, more troubling, question is what type of bear market we may yet face.