Improving markets: a sign of climate change?

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Climate change experts speculate that because a warmer atmosphere can absorb larger amounts of water vapor, drought periods are lengthening. For the same reason, rains are becoming more intense as they unleash larger amounts of air-trapped water.

Changes in the investment climate have caused similar effects. Large amounts of investable money have evaporated out of the equity world into the perceived safety of bonds and cash that float above equity market tribulations. This created a long drought that central banks tried to relieve with artificial money irrigation.

But, as a confidence front advances through the land, a huge chunk of that bond-trapped money is leaving that rarefied atmosphere and pouring down on equity markets once again.

According to Lipper US Fund Flows, equity mutual funds and exchange-traded funds took in $18.3 billion for the week ended January 9, the fourth largest net inflows since January 1992.

Separately, a Bank of America/Merrill Lynch report shows a $19bn inflow into U.S. equity funds for the first full week of the year, the biggest surge since June 2008 and the fourth highest since 2000.

Additionally, a Morgan Stanley report indicates that hedge funds are borrowing the most to buy equities since 2004. Coincidentally, the New York Stock Exchange shows that the amount of margin debt (what all participants borrow to buy stocks) is at its highest level in four years.

Why the sudden change of heart, after years and years of equity market outflows?

A marked improvement in economic conditions in the US and the world, along with significantly better market dynamics, are responsible for this change. Together, they suggest that the crisis environment of the last four years may be approaching its final stages.

On the “fundamentals” front there is a long list of encouraging news. The latest OECD report of leading indicators shows that the growth outlook of 33 countries, led by the US and the UK, is improving. China and India have reached positive turning points, and growth prospects for core eurozone countries are stabilizing. Meanwhile, Japan has launched a big fiscal and monetary stimulus, adding to the optimistic view for global growth.

The US has taken the first steps towards progress on the fiscal front after legislators came to a (small) agreement to increase revenue, and market observers seem to expect that upcoming battles will lead to further progress on the spending side in the months ahead.

Meanwhile, private sector job growth in the US is at the highest rate in a year, while announced layoffs in 2012 have reached the lowest level since 1997. Car dealers had the best three-year run in 40 years, wholesale trade rose at its fastest pace in 20 months, and US factory activity reached a 7-month high. Even more significantly, all these milestones were reached in the middle of the uncertainty surrounding the “fiscal cliff” negotiations. For more good news and to see the sources for these reports, see our Better News Blog.

Improvements in market "technicals" are more complex, but equally compelling – if not more so – for professional investment managers.

In short, both market volatility and inter-asset correlations have gone down. These are two important measures of market dynamics that are crucial for portfolio management success.

High volatility is at once a symptom, a cause and a consequence of an unsettled market. Rapidly changing conditions and unexpected challenges push the market up and down in disconcerting ways, scaring investors away. It also has a direct impact on retirement and other income portfolios used for cash flow, since higher volatility most often impairs their ability to support withdrawals without creating a shortfall (see our newsletter of 4.26.2012 for a discussion on how volatility affects retirement portfolios).

High correlation among portfolio assets is also an undesirable condition, because it reduces the benefits of diversification. Assets that move in tandem fail to produce smooth returns, forcing portfolio managers to focus on placing bets on market direction. This creates a “risk-on/risk-off” investment setting, further increasing volatility and creating a very tough environment in which to generate positive returns.

But both volatility and inter-asset correlation have come down quite consistently in the last few months. For a portfolio of equities, commodities and other risk assets, both factors have jointly decreased to some of the lowest levels in almost six months.

Thus better fundamentals and better technicals have resulted in an unexpected inflow of money into stocks and other risky assets. This may be significant because in the last few years investors consistently took money out of the market even when things seemed to be getting better. The vast amounts of money waiting to be redeployed into equities can provide fuel to a long rally if conditions remain benign and sentiment continues to improve.

Does this mean that all our worries are finally over? Hardly.

While the investment climate seems to be improving, it is too early to know whether recent conditions reflect a return to more normal times or simply a temporary break in the weather. It is very easy to come up with a lengthy list of things that can still go badly. But there is nothing wrong with basking in balmier weather while it lasts. For the time being, at least, optimism has rewarded those upbeat investors who have chosen to go long.

What now?

We use quantitative measures to build and maintain dynamical multi-asset portfolios for our clients, using a process that aims at identifying tactical opportunities such as the one described above - all along keeping an eye on controlling potential losses. Please send us a request for a copy of a whitepaper describing our investment process, or contact us if you would like to know more about how Path Financial’s investment processes works. We’ll be happy to set up a confidential meeting to discuss new paths to financial success. Read more