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James Clunie: something 'unusual' seems to be happening

After the recent volatility, Jupiter absolute return fund manager James Clunie analyses a range of market stress indicators to determine whether something strange is afoot.

After a hiatus in 2017, volatility appears to back says Jupiter Absolute Return fund manager James Clunie. 

But are these recent tremors a catalyst for change or yet another false positive?

'It would all be easy to point to the recent spike in volatility as a sign that a profound change is taking place in global equity markets. Yet, to our view, increased volatility is not a reliable indicator of change on its own,' Clunie says. 

'To give us real confidence that conditions are evolving, we need to see evidence of stress across several indicators. Looking at our dashboard of indicators of potential stress in markets, something unusual does appear to be happening.' 

Clunie takes a closer look at six stress indicators in bid to determine whether regime change really could be afoot.  

 

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After a hiatus in 2017, volatility appears to back says Jupiter Absolute Return fund manager James Clunie. 

But are these recent tremors a catalyst for change or yet another false positive?

'It would all be easy to point to the recent spike in volatility as a sign that a profound change is taking place in global equity markets. Yet, to our view, increased volatility is not a reliable indicator of change on its own,' Clunie says. 

'To give us real confidence that conditions are evolving, we need to see evidence of stress across several indicators. Looking at our dashboard of indicators of potential stress in markets, something unusual does appear to be happening.' 

Clunie takes a closer look at six stress indicators in bid to determine whether regime change really could be afoot.  

 

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1: Collapse of fringe bubbles – RED

Bitcoin has been the fantastic object of this market cycle. If you asked what was hot, exciting and new in markets over the past two years, the answer is Bitcoin. The crypto currency surged by some 1,800% last year, before hitting the wall in late December. It has since fallen 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.

Quantitative fund manager John P Hussman suggests the "the collapse of major bubbles is often preceded by the collapse of smaller bubbles representing fringe speculations".

Fred Hickey, editor of The High-Tech Strategist, has made similar claims, saying fantastic objects tend to break first at the end of a cycle. I haven’t seen evidence to support either claim, but 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.

We have since seen the collapse of other fringe bubbles: the short-volatility exchange-traded funds that went under in February, for example. In recent days, the FAANG stocks have come under pressure. I will turn my attention to that much-loved area of the market now...  



[1] https://www.hussmanfunds.com/comment/mc180302/

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2: Fragile market ecology in 'glamour' stocks – AMBER

Overcrowding and price surges in 'glamour' stocks are quite common near the end of a bull market, typically signifying late-cycle exuberance.

The delightfully named 'FAANGs' – Facebook, Amazon, Alphabet, Netflix and Google – are the poster stocks of the current cycle and are potentially in a bubble. In 1999, Microsoft, Cisco, Oracle and Amazon were similarly loved. In the early 1970s, a group of blue-chip stocks labelled 'the nifty fifty' were seemingly invincible; that is, until the 1973-74 stock market crash.

The popularity of exchange-traded funds (ETFs) has intensified the risks associated with the FAANGs. In 2017 alone, an estimated $50 billion was invested in S&P500 Index-related ETFs. The index weighting of these stocks grew from 9% to 11% at the same time.[2] The launch of dedicated technology and media ETFs with roughly a third of their assets invested in FAANGs is even more worrying.

The FAANG stocks certainly have a bubble-like quality and looked invincible last year. 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.

[2] http://accounts.citywire.info/IFrameRedirector?returnUrl=http%3a%2f%2fwww.mauldineconomics.com%2feditorial%2f4-reasons-you-should-run-away-from-spy-ivv-voo-and-other-sp-500-etfs&via=ClickOut



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3: Liquidity indicators – RED

Global liquidity patterns can be a lead indicator of the stock market and data from CrossBorder Capital (above) shows that developed market liquidity flows, especially in the US, are weak.

This is due to a combination of factors like increased risk appetite and tighter central bank policies. According to CrossBorder, the large capital reversal from US assets might be a warning of heightened 'bear market risk from Q2'.

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4: Hong Kong Dollar – RED

The Hong Kong dollar is held in a tight trading band against the US dollar by the Hong Kong Monetary Authority.

The currency has been weakening against the dollar and is now at the upper end of the permitted HK$7.75 to HK$7.85 trading band.

Historically, moves to the extremes in this band have coincided with turbulence in equity markets. As the chart shows, the HKD tested the upper end of this band during the credit crisis, the darkest days of the crisis in Greece, and the pullback in markets early in 2016.

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5: IPO, high yield bond and squeeze ETFs – GREEN

We are monitoring IPO, high yield bond and squeeze ETFs, which provide insights into 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. The Active Alts Contrarian or 'Squeeze' ETF, which holds a basket of highly shorted US stocks, should in theory drift lower due to informational advantages short-sellers have, on average.

Junk bond ETFs can provide a good sign of credit stress, providing a gauge for corporate health and market risk appetite.

None of these ETFs are signalling stress. The IPO and Squeeze ETFs have been quite strong, suggesting enthusiasm. The junk bond ETF has started to roll-over, but not in any meaningful way.

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6: Turbulence indices – AMBER

Turbulence indices reveal if there are any unusual co-movements between assets. Turbulence is 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'[4]

State Street’s Turbulence Indices are currently at high levels [5]. However, the data can be quite choppy – high one day, low the next – so is not always reliable.

In summary, roughly half of our indicators are showing signs of stress, which suggest that something unusual is happening in markets. We must emphasise 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.


[4] Mark Kritzman CFA and Yuanzhen Li, “Skulls, Financial Turbulence and Risk Management”, Financial Analysts Journal Volume 66, Number 5, 2010
[5] Source: http://accounts.citywire.info/IFrameRedirector?returnUrl=http%3a%2f%2fnewsroom.statestreet.com%2fpress-release%2fstate-street-global-markets%2fstate-street-launches-turbulence-indices-assist-institutio&via=ClickOut

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Evolving with the market

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

This approach should help us avoid being caught out by false positives but gives us the flexibility to react quickly as the market signals grow in strength.

Being sensitive to the prevailing regime has enabled us as specialist short-sellers to survive what was an amazing bull run in markets last year. As the regime changes, we would hope to expand on what we do and thrive in a change of market conditions. 

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