2019 has been a tremendous year for equities globally following the significant correction we saw in the last quarter of 2018; the MSCI World index is up nearly 20% since January, experiencing one of the strongest yearly gains in the past cycle after the 27-percent rise in 2009 and 22% gain in 2013. Figure 1 shows the monthly performance of the index since 2000; we can notice that a third of the performance came from January after the drastic December sell-off. Investors who have been calling for a “bear rally” earlier this year must have been surprised by the strength of the equity momentum, which have hurt a lot of short sellers in the market. We can also notice that months with excess gains (resp. losses) are usually followed by months of excessive losses (resp. gains). For instance, the 7.7-percent drawdown we observed in December 2018 was followed by a 7.7% rise in January. A 5.2-percent gain in January was followed by a 4.3% drop in February. Based on this table, equities tend to mean-revert following months of excessive gains or losses.
Many indicators were pricing further deterioration in equities this; for instance, the global Economic Policy Uncertainty index has consistently been reaching new highs, significantly diverging from price volatility (figure 2, left frame). In addition, the inversion of the yield in the US (and the UK) in the end of August also increased participants’ skepticism on the equity rally as the probability of a 2020 recession surged to high levels in the middle of 2019. Figure 2 (right frame) shows that a flattening yield curve tends to lead to the VIX by 30 months and the 2Y10Y yield curve is currently pricing in a much higher price volatility.
Another important indicator we like to watch is the dynamics of the JPYKRW exchange rate. As Russell Clark from Horseman noted, in bull markets, Japanese investors are often attracted to South Korean assets as they offer higher rates, which tends to gradually strengthen the KRW. However, when risk-off rises, the yen appreciates drastically as Japanese investors bring capital home. We can notice that the Japanese yen has remained strong in the past year and is also pricing in higher volatility in the equity market. One last important factor is the trend of the global policy rate. In the past two cycles, aggressive rate cuts from global central banks were usually associated with a sharp sell-off in global equities (figure 3, right frame).
Source: Eikon Reuters, RR Calculations
Outlook on US stocks (SPY)
Despite all these factors that have been pricing a sharp rise in price volatility (therefore implying more selloffs in equities), US stocks have continued to reach new all-time highs with SPY breaking through the psychological 300 resistance, significantly diverging from the US 10Y yield. Figure 4 (left frame) shows that the rise in equities we observed from January 2016 to October 2018 from 200 to 290 was accompanied by rising US LT yields; the 10Y bottomed at 1.37% in July 2016 and then rose to 3.25% in October 2018. However, while SPY has rallied from $250 to $311 since the beginning of the year, the 10Y continued to decrease in the first half of 2019 and has been oscillating around 1.75% in the past few months.
Even though some Wall Street names have turned bearish on equities lately (we saw Bridgewater betting on a market drop, paid $1.5bn in options speculating that stock market will fall by March 2020), we do not think it is the right time to short US stocks (SPY) outright. A better play for equities would be to bet on the outperformance of the rest of the world RoW (ex-US) equities (VEU) relative to the US equities (SPY). In a recent article, we explained some of the reasons why the US dollar should start to depreciate in 2020 after an eight-year rally. Figure 4 (right frame) shows that the RoW (ex-US) equities (VEU) should outperform US stocks (SPY) when the US dollar weakens. As investors’ positioning on stocks is still “low”, we remain neutral to slightly bullish on US equities (SPY) in the short run.
Disclosure: I am/we are long EURGBP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.