Market movements were mixed over the week, as trading volumes remained thin and intra-day movements showed a lack of direction, which begs us to ask the question, who is buying into this market?
It is well publicised that the first quarter of the year featured a strong rally in equity markets, however data suggests that markets rallied without the help of typical market participants, including mutual funds and exchange traded funds which have seen sizable outflows since the start of the year. To put this into context, over the first quarter, US equities experienced a strong rally, with the S&P 500 up 14% over the quarter. At the same time, US equity funds posted outflows of $39.1 billion, according to Bank of America data. The pace and magnitude of the stock market’s rise and equity outflows are significant. So why is this?
• Corporate Buybacks- Fact set data suggests that the divergence between outflows and equity market gains may be explained by corporate activity in markets, as S&P 500 firms have pursued $227billion in buy backs over the first quarter of the year. This is up from $143 billion in Q1 2018.
While buybacks certainly contributed to the unexplained rally, they cannot account for the full extent of the rally, which has seen the market capitalisation of the S&P 500 rise by $2.96 trillion year to date.
• Stock-Index Derivatives- Option buying and selling can push up stock prices as brokers tend to hedge their bets by buying the underlying stocks in which they’ve sold the call options or futures, or bought puts. Options contracts allow the owner the right but not the obligation to buy or sell at a pre-specified price and date. According to Bank of America data, open interest in stock-index derivatives has risen to $446 billion from -$1.2 trillion at December’s lows. These refer to futures and options contracts that haven’t been settled.
It is likely that this was a significant factor in pushing up stock prices over the quarter, as high levels of uncertainty led to more investors turning to derivative exposure to hedge or add to portfolio returns.
As the market has been rallying in recent months, some clients have asked the question: If the market continues to rally, why are we not investing?
There are a number of reasons why we remain content in our defensive positioning, as the economic data showing a weaker global economic environment is not being reflected in equity valuations. While we continue to trust the economic data over momentum trading, and continue to put capital preservation before chasing gains, there are two other key reasons why we are not investing in this market:
• Equity outflows are one key reason to be sceptical of the longevity of the market rally, as corporate buybacks and stock index derivative effects are unlikely to provide a sustainable boost equity markets into the second quarter of the year. Additionally, market movements continue to show a flight to safety effect, with investors moving away from equities and towards money market and bond market exposure as the risks in the global economy escalate.
• The rally has occurred on extremely light volumes, indicating a lack of market participants to push the market higher.
The trends of equity outflows and low volumes leave the market at an inflection point as it heads into the Q1 earnings season, with expectations for lower corporate earnings indicating that there will be a lack of catalysts to push the market higher. This is why corporate earnings will be vital in determining whether investors remain on the side-lines or whether economic weakness has been overdone. For this reason, we expect greater clarity in the next month as earnings season gets underway, however for now, we remain confident in our defensive positioning as global risks persist while equity outflows and thin trading volumes continue to be observed in markets.
For anyone who wants further data to substantiate the position please review the attached Global Economic News Document.
Model Portfolios & Indices
Following the defensive repositioning of portfolios in December, our OBI portfolios have a low equity allocation, with exposure predominantly coming from the FTSE 100 and S&P 500 shorts as well as the Odey Long/Short European fund. For this reason, the equity exposure within portfolios is inversely correlated to markets ahead of the expected decline this half.
Overall, global indices obtained mixed results over the week as a result of a lack of direction in markets, while Asian stocks continued to gain on more positive Chinese sentiment data. Following a challenging week, the OBI portfolios remained relatively flat as a result of their defensive, well diversified positioning. Although it is not good in the short term YTD we have to remember we are in capital preservation mode for a reason and the strong YTD gains are not built on any solid foundation and we expect them to reverse as fast as they have been realised either in full, in part or even greater depending on what happens in the coming month.
Overall, while we know missing out on the gains in comparison to the benchmark is painful, but we continue to see significant risks ahead in equity markets, with investor sentiment tilting towards the downside and risk off sentiment spreading as risks intensify. The economic data continues to support our expectation for a drop back in markets in H1, (in the coming few months) therefore we regard benchmark movements as irrelevant in the short term in the bigger picture and remain defensively positioned going forward.
It takes time for the data to feed through structurally, therefore as we wait for the data to feed through into markets, we are expecting volatile market conditions to continue, however it is key to bear in mind that the scenario will take time to play out. We must view intra week market fluctuations in the context of longer-term market trends and stay content in the knowledge that portfolios are protected from the excessive risks in markets.
The reason why we say the next month or slightly longer as being extremely relevant is that over the coming few weeks the earnings season in the US will start properly and once we start getting data on Corporate Earnings in Q1 and forecasts for Q2 and beyond we will know what is happening under the bonnet of the US economy. We will also see the first print of US GDP on the 26th April and again that will be another powerful indicator as to where we sit with the markets and whether we are seeing an earnings recession, full recession or a slowdown that has already bottomed out or has further to go.
Either way we are in precarious times and they are very difficult to manage, and the risks are still skewed significantly to the downside and we are still watching data to ensure we stop being defensive when we are confident that the economic situation and data has stabilised. Markets do not only move in one direction and are today expensive on any measure and will therefore fall once reality sets in.
The data above will not directly correlate to the indices as there is always a delay in pricing because the US markets close significantly later than the European markets and the Asian markets. The data set above reflects the last close and much of the days movements will not yet be reflected in the portfolios due to pricing delays. You cannot therefore directly correlate indices to the portfolios. The value of investments may fluctuate in price or value and you may get back less than the amount originally invested.
Past performance is not a guarantee of future performance. Performance figures quoted include the fund manager charges but exclude other fees such as adviser, custodian, switch and/or discretionary investment management fees. Unless otherwise instructed and accrued, income is reinvested into the portfolio.
This Day in History
On this day in 1998, the Northern Ireland peace talks ended with a historic agreement called the Good Friday Agreement.
Have a great week,
Gina & Jason