The Big Three: Meet The Themes That Will Continue to Haunt Markets
Here are three issues that have dominated financial markets and appear likely to continue to shape investor returns and thus be worth monitoring: the risk on/risk off trend, commodity prices and the slowing global economy, and the downturn in corporate earnings growth.
Over the last three quarters, three outsize themes have dominated financial market performance and investor returns. Odds are that they’ll continue to do so in the coming months, with the ongoing drama surrounding Europe’s sovereign debt crisis (and the impact of that on the region’s financial system) providing an additional source of anxiety and unease. We have distilled these core issues into three Datastream charts for Alpha Now readers; all three also were featured in today’s survey of “The Most Important Charts in the World” at Business Insider.
Perhaps the one thing that every market participant would agree on is that global financial markets have been volatile – and that some assets have been far more volatile than others. In the chart above, the vertical axis shows returns over the last month, while the horizontal axis plots volatility over the last year. In a “normal” month, the trend line in the middle should slope slightly higher, reflecting the tendency for assets that demonstrate the most volatility (and thus the greatest level of risk) to offer investors the greater return. That’s the heart of the “risk/return” tradeoff, after all. Taking a look at this slope will give you an insight as to where we stand on the “risk on/risk off” trade that has been so much a part of recent investor psychology, with sentiment changing on a dime. If the line that best fits the scatter chart slopes very steeply upward, it tells us that risk is being rewarded; a downward slope says the opposite is true and that investors appear to shun risky assets in favor of safe havens. The bottom “line”? Markets have been volatile and choppy, as investors switch in and out of higher-risk assets, and that appears unlikely to change. But looking at the scatter pattern might help investors identify outliers – such as soft commodities – that could be might be of interest.
It’s critical for investors to have a sense of where they stand in the global economic cycle at any given point in time – and worldwide, national governments and other organizations bombard us with enough data on the subject to make answering that question almost impossible to decipher amidst all the noise. Another way to pose that question is to go beyond the economic data and look at what is happening to the performance of metals and mining stocks relative to the rest of the equity market. That provides a snapshot of what is happening to asset prices, which contain a lot of information. A big additional edge: data based on asset prices reflects real people making real decisions with real money, not surveys of what they think or believe, or what they might do. Right now, as you can see, that line is falling, suggesting that these stocks are falling relative to their peers because demand for their economically sensitive products is dipping to a greater extent – and that suggests that a cyclical slowdown is underway. Blending this indicator with other barometers of economic strength (and weakness), such as metals prices, demand for semiconductors and even crude oil prices, could help paint an even more vivid picture of what is really taking place with the economy.
For stock market investors, it all boils down to corporate earnings. Are they going to rise? By how much, in both absolute terms and relative to the last few quarterly periods? Gauging where corporate earnings – in aggregate – are in the cycle that they, too, tend to follow is important to any investor pondering their portfolio and wondering if it’s time for a change in their asset allocation. Robert Shiller, an economics professor at Yale, has devised a fresh way of looking at P/E ratios that take the business cycle into account, one that is often known as cyclical adjusted P/E, or CAPE. (It is calculated by dividing the current stock price of a company or other market metric by a 10-year average of inflation-adjusted earnings.) On an absolute basis, corporate earnings today are still above trend – but the chart above shows that they appear on the verge of rolling over and heading back down toward that trend line. The question on everyone’s mind, needless to say, is whether that dip presages something altogether more ominous – a complete collapse in corporate profitability as the impact of the eurozone crisis spreads.
Given that Chinese growth appears to be slowing more than that country’s authorities had anticipated, while economic indicators continue to deliver bearish news to the U.S. market, the stage seems set for another volatile period – one in which monitoring these three themes may help investors cope with the choppiness.
Learn more about how Datastream can help you better analyze macro data and quickly identify data trends and relationships.
Request a free trial today.