Tag Archive: risk

Recent rally in “junk stocks” is not unusual

Financial headlines have been captivated recently by explosive behavior in certain “meme stocks” that have been the subject of intense speculation by online retail traders as well as some hedge funds. This has been accompanied by a general trend of outperformance by smaller, money-losing, heavily-shorted, and volatile stocks (sometimes referred to as “junk stocks”, similar to risky high-yield “junk bonds”).

Other signs of “froth” include aggressive use of SPACs (Special Purpose Acquisition Company, or “blank check” company that raises money to acquire private companies), historically high trading volumes and activity in short-term call options, and growing margin debt.

This has raised broader questions about why “junk stocks” seem to be rallying much more than “quality stocks” and whether this is historically unusual.

The short answer is: no, this is not historically unusual under these circumstances. The specifics vary, but similar patterns have been seen in the past when markets are recovering from a sharp decline and policy support is very aggressive.

The first chart below plots the recent (past year) returns of the Dow Jones Thematic Market-Neutral Style indices. These are hypothetical long-short indices (i.e., assuming equal dollars invested in offsetting long and short portfolios) based on widely-used factors, using the 1000 largest US stocks, and constructed sector-neutral.

The key points are:

  • Quality and Anti-Beta (low beta) are highly correlated, since quality stocks (defined by Dow Jones as those with high Return on Equity and low Debt/Equity ratios) also tend to be lower beta. Size (small-caps) is often negatively correlated with Quality and Anti-Beta (since small-caps are generally lower quality and higher beta). Risk is the key theme connecting these factors.
  • November 6th (where shaded area begins) is when Pfizer announced its first COVID-19 vaccine results.  This marked the point at which the recent themes really began: outperformance by low-quality, high-beta, small-cap stocks. This initially hurt the price momentum factor since those had not been the leadership areas previously.
  • The Value factor had a bounce in November, but since then has shown no net performance. Thus it is not Value that has been rewarded, but risk, in the period since November 6th.
  • It is also not coincidental that early November was when the US election occurred, and the results (fully decided in January) increased the perceived odds of additional aggressive fiscal stimulus. Such stimulus tends to benefit smaller, weaker (riskier) companies that had been hit hardest by COVID-19.
  • Thus riskier companies have had recent tailwinds from both COVID-19 developments and greater fiscal support.

Dow Jones Thematic Style Indices All

The long-term chart below shows the Quality and Anti-Beta factors since the data begin in 2001. We can see the correlation is clear over the longer-term, including the most recent few months.

Dow Jones Thematic Style Indices Quality AntiBeta

The key point here is that in each of the previous periods of post-recessionary aggressive stimulus (2002-03, 2009-13), higher risk (lower quality) stocks were rewarded as investors sought the biggest “bang for the buck” from the stimulus and recovery. Weaker, riskier stocks tend to get the most benefit from policy support, while stable, higher quality companies do not need it and get relatively less benefit. Thus the current conditions are not unusual, and fully consistent with a risk-on environment, in line with our other indicators that remain bullish for equities on a tactical basis.

Still a risk-on environment, but option traders remain nervous

Markets globally continue to show strong risk-seeking behavior, a continuation of the broader trend in place for much of the time since late March 2020. That was the point at which monetary and fiscal policy activity surged to produce enormous stimulus in the US and globally.

Recent US legislation that included a total of about $900 billion in new fiscal support is now starting to be felt, and recent political developments have increased the odds of further fiscal support this year. Alongside this persistent fiscal support to counteract the severe economic impacts of COVID-19, monetary policy remains extremely accommodative. Near-zero policy rates and heavy bond buying programs are expected to be maintained for many months if not years, putting both monetary and fiscal policy firmly in the “highly stimulative” category at the same time.

This backdrop has allowed the strong demand for risky assets to continue, as reflected in many measure of market prices. Our chart below shows four such measures:Global Risk Appetite Measures

Top section: The MSCI All-Country World Index (ACWI) is a broad global equity index, and it has been outperforming the total returns generated by the ICE/BofA Merrill Lynch (ML) 10+ Year Treasury Index (measuring returns to Treasury bonds with maturities of 10 years or more). This stock/bond relative return series has recently moved above its pre-COVID peak as bond returns have been weak and stock returns have been very strong.

Second section: Here we plot our own custom index of global high volatility stocks (top decile of global stocks above USD$200 million market cap, ranked by trailing two-year historical return volatility). This index of risky stocks is a useful measure of investor risk appetite. It has posted powerful gains since the March low in equity prices, and continues to make new highs.

Third section: This shows the relative returns of the S&P 500 High Beta index versus the S&P 500 Low Volatility index. The High Beta index reflects the 100 stocks in the S&P 500 with the highest market beta (sensitivity to stock market movements) and is a measure of high-risk stock activity among US large-cap stocks. The Low Volatility index captures the 100 stocks in the S&P 500 with the lowest historical return volatility (both indices are rebalanced quarterly). Their relative return is another measure of risk appetite among investors based on the relative riskiness of stocks within the major US benchmark index. It has been rising sharply again after a pause over the summer and is also making new cycle highs.

Fourth section: Turning to debt markets, this plots the average credit spread on high yield (junk) bonds in the US. The credit spread measures the additional yield investors require over and above the yield on a US Treasury bond of the same maturity to hold the debt of a high-risk borrower (i.e., companies with weaker financial conditions and thus higher default risk). That spread surged in the immediate aftermath of the COVID crisis in March/April of last year, and then has been steadily declining thanks to the Fed’s aggressive support of the corporate bond market. Recently it has continued to make new lows (reflecting greater risk appetite among investors), and is now back to pre-COVID levels despite the ongoing economic turbulence.

So we can confidently say that investors are content to take on greater risk than usual with the expectation that government support for markets and the economy will continue. We also note that the volatility of stock prices recently has dropped back down to very low levels, another condition typically found when risk appetite is high and a bullish trend is well established.

Under these conditions, we would normally expect options traders to react to the low market volatility and favorable backdrop by reducing their expectations of short-term future volatility. This would typically be visible in the CBOE VIX index, which measures the expected level of market volatility over the next month embedded in S&P 500 index options prices.

But right now, we see that the VIX has held at relatively high readings, and allowed a wide gap to open up between implied future volatility and recent realized volatility. We can see in the chart below that normally the VIX and realized volatility move together and are closer than they are now.VIX vs Realized Vol

It appears that options traders do not expect the current stability in equity markets to continue, and are pricing in a significant rebound in volatility (which is typically associated with falling stock prices). Our analysis indicates that this tends to be a favorable contrarian sentiment indicator: when options traders are especially nervous about rising volatility (relative to actual volatility), it suggests that some investors remain unconvinced and underinvested, which can support further near-term gains.

So while some measures of market sentiment are clearly pointing to high optimism among investors (a worrisome sign from a contrarian sentiment standpoint), the VIX is currently providing a supportive sentiment reading in our view. With the market’s trend still strong and the policy backdrop supportive, risk assets could continue to rise at least a little while longer.

Risk on? Not really since early June

In financial markets, it seems like “everything” is going up recently. Stocks, bonds, precious metals, even Bitcoin. Perhaps that should not be surprising given the huge amount of liquidity being produced by global central banks in addition to the fiscal stimulus earlier this year. That tends to have the effect of pushing asset prices up generally.

But when we look at relative returns of some key assets, it looks more like the “risk on” trend has not really gone anywhere since early June. That is, owning the riskier option within various asset classes has not generated excess returns to compensate for that extra risk since the recent peak in risk about June 8th.

As shown in the chart below, buyers of risk in many areas have not been rewarded for about two months now (shaded area since June 8th). Brief comments on each section of the chart are below it.

This could be a natural consolidation after a surge in return to risk after the late-March lows, or a sign that the impact of stimulus, and stimulus itself, is fading.  Many prices/valuations are back near pre-COVID levels even while the economy and earnings are still far weaker than they were in January. Uncertainty about additional fiscal stimulus, now that much of it has expired or been spent, and worries about the continued aggressive spread of COVID-19 in the US are potentially countering the positive hopes for vaccine developments and ongoing central bank support.

We will be watching these returns closely for indications of whether investors are getting properly “paid” for taking on additional risk.

High vs Low Risk Relative Return Measures

  • Top section: Global stocks, measured by the MSCI All-Country World Index (ACWI) have performed no better than long-term US Treasury bonds since early June, and are still far behind bonds on a year-to-date basis.
  • 2nd section: Similarly, within the fixed income market, long-term Baa-rated US corporate bonds have done no better than long-term US Treasuries since early June (despite the ongoing support from the Federal Reserve), and remain well behind Treasuries for the year-to-date.
  • 3rd section: High-beta stocks in the S&P 500 have lagged low-volatility stocks in the index since early June, even as the S&P 500 itself has moved somewhat higher.
  • 4th section: US small-caps have lagged large-caps since early June, and small-caps remain significantly more volatile.
  • Bottom section: Among commodities, industrial metals (copper, aluminum, zinc, etc.) that are used in manufacturing are typically a measure of global growth that rise when the economy is improving (“risk on”). Precious metals are more often preferred as an inflation or currency hedge (“risk off”). So while both industrial and precious metals prices have individually risen significantly recently, industrial metals prices have lagged those of precious metals since June.

Relative volatility risk in US small-caps remains high

Among the various asset allocation decisions for which we provide guidance to clients is whether to favor small-caps or large-caps (i.e., the “size” factor) within the US equity market. In our view, small-caps do not reliably outperform large-caps consistently over time (as some models and studies might suggest), and instead view the “size premium” (outperformance of small-caps) more as a cyclical phenomenon that tends to show up under certain macroeconomic and market conditions.

While there are many potential conditions that might affect small-cap/large-cap relative performance, much of our work is oriented around the idea that small-caps give the best “bang for the buck” in the periods just before and through the early stages of a new economic or market cycle. That is, recessionary troughs in the economy and equity market set up the conditions for future small-cap outperformance, as smaller companies tend to benefit most from the re-acceleration of economic growth that typically occurs after recessions. This is also when monetary and fiscal stimulus tend to be strongest. In these scenarios, small-caps have typically underperformed before and during the preceding recession/bear market and become out of favor and potentially undervalued. Conversely, the later stages of an economic cycle and the early stages of a recession or bear market tend to be unfavorable for the riskier and more economically sensitive small-caps.

Looking at conditions now, there is certainly evidence that a recessionary trough has occurred or is in process, and both monetary and fiscal stimulus have been very aggressive. This would potentially argue for favoring small-caps over large-caps, and indeed small-cap relative returns have stabilized after a sustained period of significant outperformance by large-caps since mid-2018 (and arguably longer). However, it may be worth an extra dose of caution before making heavy overweight allocations to small-caps on an intermediate-term (6-12 month) basis. This is not only due to the unusual nature of the current cycle, but also more specifically to the extremely elevated relative risk still apparent in the volatility of small-caps versus large-caps.

Using the Russell 2000 Index to measure returns for US small-caps and the Russell 1000 Index for large-caps, the chart below shows the rolling three-month annualized volatility of daily returns for both indices over the last 20 years (small-caps in blue, large-caps in red) in the top section, and the difference between them in the bottom section.

US Small Large Cap Relative Volatility

A few things jump out: first, volatility for all equities surged to extreme levels earlier this year, matched only by the Great Financial Crisis in the last 20 years, and has been declining rapidly thanks to the Federal Reserve’s extraordinary interventions. And second, the difference between small-cap and large-cap volatility has remained near historic extremes even as volatility has declined for both size categories.

As shown in the bottom section of the chart, small-caps are almost always more volatile than large-caps (i.e., the volatility spread is usually above zero), with a historical average of about 4.5%. However, the latest readings on the volatility spread of over 14% are the highest in the last 20 years. That is, while large-cap volatility has dropped to a (still elevated) level of just under 24% (equal to average daily index movements of about 1.5%), the small-cap index volatility has only managed to decline to 38% so far (equal to average daily movements of about 2.4%). This is still far above the normal level of volatility for small-caps historically of about 22%.

The bottom line is quite straightforward: even after sharp rallies in equities and lower market volatility in general, owning small-caps remains much riskier on a price volatility basis than owning large-caps. So if expected returns must be commensurate with expected risk, then a decision to allocate heavily to small-caps requires either 1) an unusually high excess return expectation, or 2) an expectation of drastically lower small-cap volatility soon.

Given the economic backdrop and the reliance on government stimulus as well as the relative fundamentals of small-caps versus large-caps (a possible topic for another post), it may take a little while longer to have confidence that small-cap excess returns will be sufficient to compensate for their unusually high extra risk relative to large-caps.

Global risk appetite measures slipping recently

July 14, 2020

Stock prices globally have remained unusually buoyant in the face of well-known health and financial risks. Thanks largely to aggressive global monetary and fiscal stimulus starting in March and still going on (though arguably fading), risk appetite jumped dramatically following the severe but relatively brief sell-off from late February to late March.

Most recently, however, several metrics of global risk appetite that we track have either plateaued or weakened. This coincides with a reduction in the pace of central bank activity and growing uncertainty about further fiscal stimulus programs, especially in the US. It also coincides with the recent turn higher in the growth of COVID-19 cases in the US and globally.

The complete explanation of the chart below follows and makes this post somewhat longer, but the key point is that multiple metrics show at least a pause if not an incipient downturn in risk appetite that is worth watching, particularly given that it occurs with the Fed and other central banks still actively pursuing asset purchase programs, even if at a less frantic pace recently.

 Global Risk Appetite Measures

The chart above plots four price-based measures of investor risk appetite. Three are based on equity prices, and the bottom section shows US high yield credit spreads from the bond market. In all four, the preference for higher-risk assets has either lost its earlier momentum or is weakening.

The top section plots the relative return of the MSCI All-Country World Index (ACWI), one of the broadest measures of global equity returns. It includes both developed and emerging markets and has approximately 3000 constituents. Like most equity indices, it is capitalization-weighted, so the largest global companies get the most weight in the index. The US currently makes up about 57% of the weight in the index. We plot its total return relative to that of the ICE/BofA Merrill Lynch 10+ Year Treasury total return index. As its name indicates, it tracks the returns of all US Treasury bonds with 10 or more years to maturity, and thus better aligns with the long-term nature of equities as an asset class but is still considered a “risk-free” asset from the standpoint of return of principal. US Treasury bonds are a widely used global benchmark and the largest and most liquid bond market.

The relative returns of global stocks versus bonds captures the severe drop in stock prices starting in late February of this year, and the subsequent rebound. It bears noting, however, that even with the sharp rebound in stock prices, long-term US Treasury bonds have still outperformed global equities since the pandemic began (i.e., the stock/bond relative return series is lower than it was at the start of this year). The relative return series is also still below its own one-year average, which is itself declining. We also see that global stocks had struggled to outperform long-term Treasuries over a longer period even before COVID-19 became a factor earlier this year, reflecting the general weakness in the global economy developing in 2019. High total returns in bonds are potentially harder to generate now that interest rates are so low (though long-term bond prices can be quite volatile), so if stocks begin to lag bonds again on a sustained basis, it would reflect a clear shift in preference for “return of capital” rather than “return on capital”.

The second section of the chart plots our own index of high-volatility stocks globally. On a quarterly basis, we screen the global stock universe for all stocks with at least USD$200 million market cap (and at least $1 million/day average trading value) and identify those ranking in the top 10% (top decile) based on their trailing two-year price volatility (price risk). We track the daily returns of those top-decile volatility stocks as a proxy for global equity risk appetite. The index thus shows risk appetite in absolute terms, and confirms the stock/bond relative return pattern, though more dramatically. From its initial peak on January 16th 2020, the index plunged -49% to its trough on March 18th. From there it posted an extraordinary rise up to a new recovery high, gaining 123% from the low to its peak on June 8th, putting it higher for the year-to-date at that point. After a short-term sell-off from the peak, the index has been moving sideways recently, off about 10% from the June peak. It remains above its one-year average, and in line with levels seen in late 2019. The positive trend is thus arguably still intact, but has lost momentum.

The third section is somewhat similar but plots the relative returns of the S&P 500 High Beta index versus the S&P 500 Low Volatility index. These indices are constructed based on the 100 stocks within the S&P 500 with the highest market beta (sensitivity to market movements) and the 100 index stocks with the lowest historical volatility (rebalanced quarterly). The relative return series thus shows relative preferences for risk within the US equity market. It has followed a similar pattern to the global volatility index above it, but we can see a notable recent difference. The relative returns of high beta stocks versus low volatility stocks has turned down more distinctly recently, and is now back to about its one-year average. A drop below the average would potentially mark a reversal of investor risk preferences to at least neutral if not outright risk aversion, at least temporarily. We will be watching this series closely.

The final section of the chart plots the average credit spread (the option-adjusted spread, which accounts for call features on corporate bonds) for bonds in the Bloomberg Barclays US High Yield Index. Thus it measures the yield premium on high yield (“junk”) debt (rated BB/Ba or lower by Moody’s or S&P) over US Treasuries of the same maturity. A higher spread (rising line) indicates greater risk aversion and expectations of higher default risk on high yield bonds, while a lower spread indicates lower perceived credit risk. Within the fixed income market, high yield debt is closest to equity in risk, making this another useful proxy for investor risk perceptions.

This series is arguably slightly more difficult to interpret right now than it would have been historically, due to the Fed’s new direct influence on corporate debt, including high yield debt1. Nonetheless, the message is similar. After surging as COVID-19 and the associated lockdowns halted much economic activity and the corresponding ability for companies to service debt, yield spreads have come back down sharply thanks to Fed support. But most recently, the narrowing of credit spreads has stopped and may be starting to reverse. It also still remains above (worse than) its own one-year average (which would be expected given the severity of the economic weakness). The underlying fundamentals for many junk-rated companies have not improved substantially and face continued risk from the virus, but monetary and fiscal support (along with the historically low yields on “safe” debt) have increased investors’ willingness to bear credit risk recently. If that risk tolerance recedes (due to policy changes, or worsening fundamentals), both the high yield debt market and the stock market would potentially come under renewed pressure.

Overall, investor sentiment is arguably quite positive (high equity valuations, low recent demand for put options, high proportions of bullish advisors represented in surveys, etc.), and this has been reflected in returns. But the most recent price action has shown some early warning signs of stalling or reversing that risk appetite, which could lead to renewed volatility in equities.

1 While historically the Fed has been prevented from owning anything other than government-guaranteed debt, the recent legislation (CARES Act) passed in the wake of the economic and market distress allowed the Fed to act in concert with the Treasury to buy corporate and municipal debt, as well as backstopping direct loans to companies. This has directly impacted the credit spreads seen in debt markets, as intended, though at the potential cost of reducing the ability to see investors’ true risk preferences.