#Market Strategy — 06.02.2018

Sell-off in Equity Markets: We Remain Neutral Short Term and Bullish in the Medium Term

Roger Keller

This market sell-off was long overdue. We are convinced that we are in the late phase of the bull market but we expect more upside potential.

The S&P 500 index lost 4.1% overnight and is now 7.8% below its recent record high of 2872, at early December levels. Having fallen below the 50-day moving average, it is still 4.3% short of the 200-day moving average. The Topix has shed 8.6% since its recent high of 194. Chinese H shares and Taiwan shares are currently down 4.9% from yesterday’s close; the selloff was a little less dramatic in other emerging stock markets. Logically Europe opened down, by nearly 3%.

The main driver of the repricing in stock markets is a rapid rise in bond yields. The 10-year US Treasury yield stood at 2.30% on 30 November and rose rapidly to 2.84% last Friday on concerns over inflation and the pace and extent of Fed rate hikes.

A long overdue sell-off

This market sell-off was long overdue. Since the creation of the S&P index in 1927, it had never experienced such a long period (more than 400 days) without a price decline of at least 5%. Recently, warning signals had started to multiply. We will mention just three of them:

  • Sentiment indicators had reached positive extremes with bears among institutional investors being the least numerous since 1987. The gap in favour of bulls is at its largest in a long time between bulls and bears among individual investors;

  • Technical indicators such as the MACD (moving average convergence divergence) a few days ago sent daily negative signals and the relative strength indicator index had never been so high;

  • According to a survey by Merrill Lynch Bank of America Fund Manager, investors had not been more overweight in equities relative to government bonds since August 2014, prior to a 10% correction.

We maintain our short-term neutral and medium-term bullish stances

The Vix index of volatility has jumped to 37.2. It stands at attractive levels, at its highest since August 2015 when the Chinese yuan was devalued. This exceeds levels seen during the Greek debt crisis and the Brexit referendum.

We nevertheless stick to our short-term neutral stance for the time being as there is still downside potential towards the 200-day moving average and we will gauge market behaviour in the coming days.

We remain medium-term bulls as global growth is synchronous (which, in turn, is supporting solid earnings growth) and as the recovery in capital expenditure could extend the current economic cycle.

We are convinced that we are in the late phase of the bull market but we expect more upside potential. We foresee record highs ahead in view of the continued rise in earnings, slow pace of monetary policy that is shifting away from accommodation and admittedly high (but not extreme) valuations that are defended by good visibility on the economy. That said, the price to pay to stay invested in the market is higher levels of volatility.