Despite a recent respite, our indicators tell us that market volatility is likely to stay elevated for a while longer, with important implications for asset allocation and stock selection. Significant damage is being done to the US economy and the global trading system.

After several years of relatively calm equity markets despite volatility in bond markets, the calm has been shattered by the catastrophic policy mistakes put in place in the most chaotic fashion possible by the Trump administration. The nuclear-level tariffs imposed and then changed almost daily have gotten the most attention in economic circles, but the destruction of US government capabilities across most major elements of government is as bad or worse from a long-run standpoint. This includes severe damage to US immigration policy, health care, education, the military/veterans, retirement support, diplomacy, and basic trust globally. These effects and the unpredictability of them may not show up immediately in economic data or corporate earnings, but reduce the longer-term US economic growth potential.

Focus on the objective data, especially macro/risk indicators

While these events are indeed worrisome and are to a large degree unprecedented in scale and scope, we try to keep the focus on our objective indicators. Even there, however, our historical studies clearly tell us that stock selection models based on fundamentals, valuations, and price trends like our MAER stock selection tool may be less effective in chaotic, highly volatile market conditions. Intuitively, this is because investors simply are less focused on individual company fundamentals and more on portfolio-level “risk on” or “risk off” decisions. And the persistence of earnings and price trends that many models, like ours, rely on tends to weaken as major policy changes can rapidly reverse these trends and those analyzing company fundamentals struggle to keep up with the macro volatility.

This does not mean that watching fundamentals is of no use, as it remains crucial to be aware of how earnings, valuation, and stock price trends are evolving. We just have to be aware that the market may not respond the same way in the short term as it might in more “normal” market environments. In trading parlance, we expect drawdowns to be higher and Sharpe ratios to be lower for most trading strategies, regardless of exactly what inputs they use.

So if “risk on/risk off” and macro trends are more important now, what do our indicators tell us about them?

The Global Equity Risk Model is decisively bearish = high volatility likely to continue

The first thing we always do is check the readings of our Global Equity Risk Model. This is a multi-indicator composite model we have used since 2019, and used a similar model for  years prior to that. It uses eight inputs to produce a percentile score that helps gauge market risk and potential return over a 1-3 month forecasting horizon. Below are historical hypothetical results for the MSCI All-Country World Index (ACWI) based on the model’s reading. Readings below 40% are the highest risk and lowest return zone for equities.

The latest model readings are shown below, and the message is clear: we are deep into the range where market volatility is highest and average returns are lowest. This applies to the traditional stocks versus fixed income decision (stocks tend to underperform bonds), and to “beta” allocation within equity portfolios. That is, we would expect high-beta (riskier) stocks to underperform low-beta stocks as investors seek shelter in a storm, and this is indeed what we have been seeing recently.

Source: Mill Street Research, Factset, Bloomberg

The model’s indicators are almost universally negative now: seven of the eight components are decisively unfavorable (below 40%), with only one clinging to a positive (above 60%) reading. That is the contrarian VIX Divergence sentiment indicator, which had showed extreme pessimism among traders recently when the VIX skyrocketed up to near 50, but most recently it has been falling again as the VIX has fallen below the level of recent realized market volatility. The same pattern is seen in the European VSTOXX index that is also part of the indicator.

The other indicators tell us that:

• Equity volatility has surged to the high end of its range in recent years, and volatility tends to be persistent in the 1-3 month time horizon.
• Investor risk appetite has plunged, based on the rapid reversal of our index of returns to the most volatile stocks globally.
• Intermediate-term equity index price momentum (based on the MSCI ACWI index) has become extremely negative.
• Bond investors are also showing a rapid reversal of risk appetite, as credit spreads on corporate bonds globally have widened rapidly.
• Expectations of Fed policy remains relatively unfavorable in the context of recent years, as the central bank has been on the sidelines in recent months and is only expected to cut rates moderately over the rest of 2025 (i.e., the Fed will not “save us” from the macro policy damage).
• Real (inflation-adjusted) government bond yields remain elevated globally despite the potential for much weaker economic growth, another headwind.
• Economically-sensitive industrial metals prices have been lagging those of precious metals for some time and continue to do so, signaling a weak global growth backdrop, especially with regard to China (the biggest source of industrial metals demand).

So while equity markets have had a bounce recently on hopes (and nothing more than hopes) for some policy reversal that will mitigate the economic damage, our intermediate-term indicators argue against chasing such rallies and point to continued high volatility for a while longer.

What about valuations – are stocks cheap now that they have corrected? No.

In addition to our Equity Risk Model, which intentionally has no valuation inputs due to its time frame, we also check the longer-term valuation backdrop using our Implied Growth Model. This model does not issue buy or sell signals, but seeks to objectively answer the question: what level of long-run earnings growth is priced into stocks? We can then decide if that level is too high, too low, or about right.

The model uses stock prices, normalized (10-year average, inflation-adjusted) earnings, corporate bond yields, inflation, and a time-varying equity risk premium estimate based on the trend in the US Leading Economic Indicators to estimate the level of long-run real earnings growth built into the S&P 500. After showing low (and sometimes negative) readings in the 2-3 years after COVID hit (indicating investors were pessimistic about earnings growth expectations, a favorable backdrop for stocks to outperform bonds), the reading has been rising alongside higher real bond yields and higher stock prices. In recent months it has been at the high end of its 10-15 year range around 3.5-3.7%.

Notably, the recent correction in the S&P 500 has not moved the reading down, as one might expect. This is because corporate bond yields have also risen, due to both higher Treasury bond yields and wider credit spreads. Normally Treasury yields would be expected to decline as investors seek safe havens and growth expectations fall, but the threat of higher inflation due to tariffs, a sidelined Fed, and a move out of US assets by non-US investors has prevented the typical behavior.

The result is that stocks still look quite expensive relative to bonds, in that implied growth expectations have not declined even though potential future growth in US corporate earnings has almost certainly weakened. For stocks to look “cheap” on this metric would require some combination of significantly lower stock prices or much lower bond yields.

Historically, stocks have tended to do poorly when we see the combination of a low Global Equity Risk Model reading and a high Implied Growth Model reading. Of course, the current situation is historically very unusual, so perhaps this will be the exception, but the indicators have clearly been telling us to reduce risk. We have therefore drastically reduced our recommended equity allocation, currently underweight equities versus fixed income for the first time since 2022. We have also sharply reduced our regional equity exposure to the US, now favoring ex-US markets for the first time in two years, especially Canada and Japan.

More to come . . .

Some of our key macro market indicators tell us to be cautious on stocks, and US stocks in particular, and to expect high volatility to continue. In another blog post, we will review the earnings indicators to see what impacts the policy and market backdrop are having on analyst earnings forecasts.

For anyone interested in getting weekly updates of the Global Equity Risk Model, macro market commentary, and stock ideas (both buy and avoid ideas), you can subscribe to Mill Street’s Weekly Roundup report for just $50/month.  

If you are an institutional investor of any size and are interested in Mill Street’s full suite of institutional research and consulting (global macro, regional/sector/style allocation, global quantitative stock selection, etc.), reach out via the contact form on the website, or email info@millstreetresearch.com

Sam Burns, CFA

Chief Strategist