- It is important to understand the dynamics of the capital markets, especially through a historical context.
- Monitoring market internals is very important, and can provide clues about various market climates and their risk/return profile.
- Interest-sensitive sectors have given strong signals of impending downturns.
In another post (Beta Exposure), I spoke about conditions that have historically preceded significant market downturns. These were overvalued, overbought, and rising yield conditions. It is very important to continue monitoring other market internals that could raise risk premiums.
There are a number of different market internals that I have been investigating, and all of them have a solid theoretical underpinning. As a supplement to the overvalued and rising rates conditions, I have added the performance of small cap stocks relative to large cap stocks, utilities, and consumer stocks, all of which are interest-rate sensitive. Utilities are considered "bond-like" due to their safety and yields, so when rates begin to rise, they start to look unfavorable from a yield perspective. Small cap stocks are inherently riskier. Some demand high liquidity premia, carry heavy debt loads as a result of expansion, and are generally more speculative. Finally, consumer stocks can be influenced by macroeconomic factors and can be adversely affected by tightening credit conditions.
The criteria I have chosen are as follows:
- CAPE > 18
- Utilities < 5% off 6-month high
- Small cap stocks underperforming large cap stocks by < 5%
- Consumer stocks < 1% off 6-month high
- Rising Fed Funds Rate
If all of these conditions have occurred at least once in the past 3 months, a signal is given.
This signal has clearly captured all of the large historical drawdowns.
In 1995, there was an early false signal. The next batch of signals came from the end of 1998 to 2000. It is important to remember that the 2000 collapse wiped out all the returns, in excess of Treasury bills, all the way back to 1996. Also, the 2008 decline wiped out excess returns all the way back to 1995.
Based on various market internals that I monitor, including the above, there are currently no signals generated, despite the gross overvaluation that will remain a headwind for long-term returns.