Friday, April 23rd, 2021

There Will Be A Correction

The normal rules of financial markets can be suspended for a while, but not indefinitely. What goes up must eventually come down. There will come a day when the Fed and even the ECB have to taper, and the impact of a fiscal package as large as the current US proposal will start to fade. The problem for the bears that it could take any awfully long time to arrive; the problem for the bulls is that it could be next week – not in the real economy perhaps – but certainly in the willingness of market participants to keep on discounting these events into the future.

Trying to forecast the timing of these turning points is a fool’s errand. Imagining that one can identify a reason and quantify the potential downside as well is quite literally delusional. All we can do is watch the data and react as soon as we see the problem. There are any number of risk indicators that strategists observe at a time like this. In this note we focus on a few of our favourites, all of which tell a story of risk appetite close to its maximum, if not actually at maximum overweight.

The main dollar-denominated equity versus fixed income model peaked at 96% equity on 19th February. It fell to 74% in early March and has bounced back to 84% at the last reading. This peak is slightly below the average peak for last 25 years, but is clearly within the normal range. There have been occasions when the indicator has reached a peak, then fallen back and regained a level close to 100% (e.g. 2013 and 2017) but it has never done it from a level below 80%. However, we cannot say for definite that this won’t be the first time.

The euro-denominated model is at 98% equity and has been at this level, without any wobble, since the middle of February. The euro model normally lags the US model by about two weeks, but the current episode is more than a timing difference. It must be regarded as a divergence, brought about by a weak euro, which makes overseas equities – particularly the US – more attractive to European investors. However, now that euro has begun to strengthen against the dollar, the two indicators should start to converge again. This probably means that the EUR model has to adjust downwards.

Other indicators tell a similar story. US High Yield vs US Treasuries is at 97% High Yield. Gold vs a portfolio of 50% US Equities and 50% US Treasuries is at 0%. Looking at US equity sectors, the difference between our overweight on cyclicals (including Small Caps) and our underweight on defensives (Staples, Healthcare and Utilities) is 95% vs an average peak reading of 98% over 25 years. Japan is above its average peak and has only posted higher readings in March 2017. The UK has just posted its highest ever reading, Only the Eurozone still has further upside on this measure.

If there were a correction in risk assets next week, we would look at all these indicators and say it was obvious in hindsight. Looking forward in real time, there is nothing to indicate that it has to happen immediately. However, there are two areas where we think that investors ought to de-risk their portfolios now: US Small Caps and Eurozone periphery bonds.

US Small Caps’ most recent peak was at 75% overweight on 19th March. They have a history of putting in a false peak about 2-3 months before the final peak, which is typically 5% higher. However, the decline after the final peak is often very steep and the subsequent trough never happens before we fall into underweight territory. Illiquidity is your friend on the way up, but a terrible enemy on the way down.

The difference between our overweight on Italian bonds and our underweight on German bonds peaked at its highest ever reading of 164% on March 12th. It has since fallen to 89%, as German bunds have rallied and Italian has fallen slightly. Like US Small Caps, it is a bad idea to hang around in this position once the peak has been passed; the trough never happens before the indicator is deep in negative territory.

So far, the implication of this piece is that a correction is something to be avoided, if possible. Almost every client we speak to regards this as a buying opportunity, on the basis that the fiscal and monetary support now in place will continue until well into 2022, at least. We agree with the basic idea, but we want to make two points.

First, there is no point in hanging on to stale bull positions, simply because you don’t want to have any more cash in your portfolio. If you intend to buy the dip, make sure that you have enough cash at your disposal to make a difference.

Second, the correction is unlikely to happen without a proximate cause. There has to be a headline which shakes the cosy consensus and removes investors’ faith in a benign medium-term outlook. If you are determined to buy the dip, please make sure that you have war-gamed the following scenarios amongst others: Russian troops crossing into the Ukraine, China announcing a naval blockade of Taiwan, Japan cancelling the Olympic Games because of a surge Covid cases or a health emergency affecting President Biden. If you are happy with your current portfolio as the jumping-off for addressing these situations, you don’t need to do anything.

If not…

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