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Jupiter's Clunie: 6 signs of market stress I'm watching

Volatility has returned to stock markets but is it just the start of something bigger? Jupiter's James Clunie is eyeing six signals to find out.

by Michelle McGagh on Apr 11, 2018 at 12:23

Volatility has returned to stock markets after a year off but does it mark a profound shift for equities, the beginning of a recession, or just a hiccup?

James Clunie, head of absolute return strategy at fund group Jupiter, believes there are six signs to look out for before investors need to start worrying.

He said that increased volatility was not enough to signal a profound change in markets but noted that ‘something unusual does appear to be happening’.

‘Regime change is difficult to identify with absolute certainty,’ he said. ‘While conditions appear to be evolving we plan to evolve with them rather than acting pre-emptively.’

Click through the slides for the six signals Clunie is watching.

Red alert: collapse of ‘fringe’ bubbles

This year has seen short volatility exchange-traded funds (ETFs) go under and the Faang (Facebook, Apple, Amazon, Netflix, and Google owner Alphabet) stocks are now facing pressure.

However, Clunie points to Bitcoin as ‘the fantastic object of this market cycle’ and the first bubble to burst – the cryptocurrency surged 1,800% last year before plunging over 50% from its peak.

‘While Bitcoin is not directly correlated to equity markets, its plight could be a bellwether for a wider change in sentiment,’ he said.’

‘Bitcoin’s collapse a month before the late-January sell-off in stock markets might be emblematic of a wider change in perceptions of risk.’

Amber alert: fragility in ‘glamour’ stocks

Overcrowding in popular stocks is typically seen before the end of a bull market, said Clunie. He singled out Faang stocks as not only the ‘poster stocks of the current cycle’ but a potential bubble.

The popularity of Faangs was exacerbated by money flooding into ETFs, with an estimated $50 billion invested in S&P500 index ETFs in 2017. The index weighting of these companies grew from 9% to 11% over the year and tech-specific ETFs pushed a third of their assets into FAANGs.

‘The Faang stocks certainly have a bubble-like quality and looked invincible last year,’ said Clunie. ‘While sentiment towards these stocks has started to turn in recent days, it is too soon to know whether this will be sustained. Nevertheless, it does appear that some investors in these shares are becoming more risk aware.’

Red alert: liquidity issues

Clunie takes into account ‘global liquidity patterns’ when trying to predict what stock markets will do next. He said data from CrossBorder Capital showed developed market liquidity flows, especially in the US, were weak.

‘This is due to a combination of factors like increased risk appetite and tighter central bank policies,’ he said.

‘According to CrossBorder, the large capital reversal from US assets might be a warning of “heightened bear market risk from the second quarter”.’

Red alert: Hong Kong dollar weakness

It may not be on every investors’ radar but the Hong Kong dollar is one of Clunie’s indicators for a shift in the market.

The currency is typically held ‘in a tight trading band against the US dollar’ by the Hong Kong Monetary Authority. He said it had been weakening against the US dollar and was now at the upper end of the permitted limit signalling that trouble could be ahead.

‘Historically, moves to the extremes in this band have coincided with turbulence in equity markets,’ said Clunie.

‘The Hong Kong dollar tested the upper end of this band during the credit crisis, the darkest days of the crisis in Greece, and the pullback in markets in early 2016.’

Green alert: ETF stress

ETFs can give an insight into which way the market is going, and according to Clunie, his key indicators are not exhibiting any signs of problems in this area at the moment.

He monitors ETFs focused on initial public offerings, high-yield bonds, and ‘squeeze’ stocks (baskets of US stocks being shorted) to provide insights on ‘market sentiment and signs of exuberance’.

‘Typically stocks tend to underperform for years after they are listed, so I would expect an IPO ETF to do the same,’ he said.

‘The… squeeze ETF, which holds a basket of highly shorted US stocks, should in theory drift lower due to informational advantages short-sellers have. Junk bond ETFs can provide a good sign of credit stress, providing a gauge for corporate health and market risk appetite.’ At the moment, Clunie said none of these ETFs were ‘signalling stress’.

Amber alert: turbulence indices

Turbulence indices are different from those focused on volatility in that rather than measuring just the scale of the market’s move, they also take into account changes in correlation between assets.

Clunie said turbulence was ‘often a forerunner of volatility, and volatility is often a forerunner of lots of interesting movements in markets’.

‘Evidence suggests that periods of excessive turbulence often coincide with excessive risk aversion, illiquidity, and devaluation of risky assets’.

Although he noted that State Street’s turbulence indices were not currently at high levels ‘the data can be quite choppy’.

‘Roughly half of our indicators are showing signs of stress, which suggests that something unusual is happening in markets,’ said Clunie.

‘These are not tools for forecasting change and we tend to look at them in combination rather than individually. They are signals of potential stress in markets that we are using to help us try to divine our way through.’

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