The Intech Equity Market Stress Monitor saw modest improvements last quarter, but extreme conditions signal more volatility to come.
- Most major market indices are still showing signs of instability, according to the July 2018 Intech® report.
- European equity markets exhibit the strongest stress signals, although global developed markets as a whole are relatively stable.
- Volatility will probably persist, but the likelihood of a major market correction is moderately less likely than it was at the start of the year.
What a difference a year makes. In 2017, the S&P 500 Index® saw just eight trading days in which returns fluctuated by 1%. During the second quarter of this year, the index experienced more than a dozen such swings, with the month of April alone serving up more daily volatility than all of last year.
Instability continues to be the overriding theme for equity markets around the world. Based on the Intech Equity Market Stress Monitor, investors should figure for more of the same as we move through the second half of the year and into the next.
Intech has been studying the relationship between risk and market stability for decades by tracking five primary metrics - capital concentration, correlation of returns, dispersion of returns, index efficiency and skewness of returns. When these indicators have a percentile rank of 40% to 60%, it suggests that markets are stable. When they teeter to the extreme, whether higher than 80% or lower than 20%, it signals stress.
As was the case in the first quarter, most major global indices are sitting on the extreme ends of their historical norms. That said, volatility can serve as a pressure relief valve for markets, and the second quarter did offer some improvements.
Going into the second quarter, the S&P 500 was flashing red on four out of five risk metrics. As of the end of June, just three of those indicators sat far outside their historical norms.
Most notably, the second quarter saw a shift in skewness of returns. Previously near historical highs for bullishness, this signal moved closer to its normal range for all but one major index, the MSCI Europe. In other words, investors are reacting more appropriately to bearish news, rather than being blindly optimistic.
Exhibit 1: Skewness of Returns
Capital concentration, which measures how capital is distributed among stocks in an index, is still extreme for some markets. In the second quarter, more capital was allocated to smaller-cap stocks in the MSCI EAFE and MSCI Europe, while investors favored mega-cap stocks in the MSCI Emerging Markets.
Overall market concentration in the S&P 500 is not yet at extreme values, but some concentration was evident within the energy, technology and consumer discretionary sectors. In the second quarter alone, 82% of energy stocks outperformed, versus 3.4% for the index overall.
Exhibit 2: Capital Concentration
Correlation of returns - the extent to which index constituents move together - suggests that idiosyncratic risk remains high in most markets. Europe was a notable exception for the second quarter. Although its equity markets remain under stress, it did see some normalization in this metric, moving from the extreme left and closer to center.
Figure 3: Correlation of Returns
Dispersion of returns for all five indices remains unusually low, with stock returns relative to their respective benchmarks still converging. So while active managers have a better shot spotting winners and losers, thanks to low correlations, they need to take incrementally more risk to achieve excess returns. This has been particularly true for growth stocks.
Exhibit 4: Dispersion of Returns
Index efficiency saw a slight improvement in the second quarter. Nevertheless, it is at the extreme end for most major indices - an indication that managers need to take more beta risk to beat the market. This proprietary indicator looks at how much beta (market exposure) is required to construct an efficient portfolio (outperforming the index with less risk) by owning a selection of index constituents.
Exhibit 5: Index Efficiency
Signs of Stress Outside the U.S.
While the second quarter brought some balance back to U.S. markets, European equity markets remained under stress, with four out of five major signals at the extreme ends of their historic norms.
Global developed markets as a whole, however, are sitting on relatively stable ground. The MSCI World Index had just two risk measures - dispersion and index efficiency - on the far ends of the scale.
Emerging markets were mixed. On the one hand, correlation of returns, dispersion of returns and index efficiency inched toward the middle, while capital concentration and skewness of returns moved to the extreme.
In summary, the world's major equity markets aren't out of the danger zone. The Intech Equity Market Stress Monitor suggests more price swings to come for the foreseeable future. That said, with the return of volatility, some measures of stability have improved. For investors, that means that the likelihood of an extreme market event has subsided since the beginning of the year.
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