Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.
As is typical in the majority of market corrections, participants are only able to focus on a handful of themes at any one time which then unfortunately can foster a herdlike mentality and produce pronounced market volatility. This January has been no exception as our first chart of the week shows. The speed and strength of the selloff as measured by the Russell 3000 has only been seen in three previous market selloffs over the last eight years, all with clear and identifiable catalysts. As emotion takes over, disbelief lulls market participants into looking like a communal group of deer caught in headlights, waiting for it to end.
Exhibit 1: The change in the percentage of stocks in the Russell 3000 index with a 14-day Relative Strength Index (RSI) below 30 (a measure this low is generally reckoned to indicate stocks that are oversold) between January 2008 and 23 January 2016.Source: Bloomberg, Factset as of 22/01/2016
Exhibit 2: The change in the percentage of stocks in the Russell 3000 index with a price below the lower Bollinger Band (a measure indicating whether stocks are oversold or overbought; to adherents of the theory, this graph may suggest a significant number of stocks are oversold) between January 2008 to 23 January 2016.Source: Bloomberg, Factset as of 22/01/2016 The primary culprit of the latest correction around was the volatility in crude oil stemming from oversupply concerns as the price marched ever closer to USD 30 a barrel. The momentum and conviction of short sellers intensified, pushing oil to a low of USD 27. As cross asset correlations reached near record highs, everyone began scrambling to declare themselves a self-taught energy market analyst. Figuratively speaking, markets peak when the last buyer has bought and bottom with the last seller selling. Our third exhibit shows the strength and intensity of oil shorts which, by 21 January, also provided the first indication that a local bottom could be closer as the net short positions, as defined by oil ETFs, began to decline.
Exhibit 3: Exchange-Traded Fund (ETF) net short positions in oil soared by 300% in the first weeks of January
Source: Bloomberg, Factset as of 22/01/16
The week ending 22 January saw headline-grabbing falls in global equity markets. This were however only a continuation of their trajectory lower as exhibit 4 shows. The MSCI All-Country World Index is down 19% from its 52-week high in May 2015, which some would suggest is at or near a bear market correction. Explanations for the decline range from slowing global demand, oversupply in commodities, and the end of easy monetary policy from the US Federal Reserve.
Whatever the case may be, market corrections are a process, not point. As market practitioners, we constantly assign intrinsic values to our investments. When that value of an asset is higher than its price, one should buy. Conversely, if the asset price is higher than its intrinsic value, then one should sell. The market volatility and price action over the last couple of weeks, and arguably the last year and a half, have been in the process of identifying the new intrinsic value of asset classes given the economic, monetary and structural changes present in the market.
Exhibit 4: By 21 January, stocks worldwide had fallen by more than 19% from the highs reached in May 2015
Source: Bloomberg, Factset as of 22/01/16
Back in November, I wrote here about the troubling weakness in US retail sales and the declining forward earnings estimates percolating through many corporate sectors. In that report, I highlighted the importance of forward earnings estimates for the first quarter of 2016 and beyond. On 22 January, Factset released an updated forward earnings estimate for the first quarter relative to where those estimates were only three weeks ago. Exhibit 5 shows that only the telecom and healthcare sectors are forecast to have higher earnings than those expected previously. In the coming weeks, we will be looking closely at the guidance that management teams provide as an indication of what value to assign future growth.
Exhibit 5: Changes in S&P 500 estimated earnings growth, by sector, for first quarter 2016 (blue column shows estimates as of 22/01/16, the green column shows the same data as of 31/12/15)
Source: Bloomberg, Factset as of 21/01/16
Lastly, the European Central Bank (ECB) announced on 21 January that it was keeping its refinancing rates unchanged, which was expected by the market. However, what might have come as a slight surprise was during the press conference, when Mario Draghi indicated that the ECB stands ready to act, should economic data not reach the stated objectives. The likelihood of a further cut to the deposit rate would be more palpable than any upscaling of the asset purchase program. After all, even some of the hawks seemed comfortable with doing more than 10 basis points at December's meeting. Draghi was adamant that December was not a mistake. His argument was that the world has changed: the outlook was materially different. His parting shot was when it comes to achieving their mandate: ‘We do not give up’.