A new year will begin tomorrow, and it is time to have a review of the past year as well as guessing what we can expect for 2020. Let’s start by looking at equities:
The S&P500 returned 28.53% YTD, better than the Dow Jones 21.97% but below the Nasdaq which proved to be the best in this category with a 34.90% return. In my opinion this trend has been favoured by an optimal environment for equities as well as a new round of liquidity injection in the market by central banks, thus indexes with higher beta (i.e. Nasdaq) outperformed.
With regards to the credit market, I think it is time to pay attention closely to such market niche as it is believed to be smarter than equities. The two main trackers I use are ETFs: HYG and JNK.
They both delivered double digit returns, but in 2019 debt piled up hugely and we are still in a dangerous position as we can denote by the following chart:
Essentially, we moved from a system with huge debt (i.e. 2008) with even more debt (i.e. 2019). The main topic is not the amount of debt per se, rather for what purpose debt has been used since we know that when debt/credit is used for financial transactions, like buybacks, the market will go higher, but a bubble will be originated. If we connect dots, we can have a belief that the market is up mainly thanks to two reasons: buybacks and CBs liquidity. But remember, we trade the market and what we see not what we believe.
Indeed, what we have seen during 2019 is a significant increase in credit spread in CCC market (one of the riskiest) from May until December, but now there has been a sharp decrease in the past weeks from 11.55% to 9.94%, in my opinion caused by the repo operations of the FED.
Along with CCC, let’s analyse the BBB market, the largest one:
In such market we did not see any market stress, thus we can conclude that credit has been roughly stable through 2019 and for 2020, at the moment, there is not sign of stress.
Around the world we can see here the overall returns:
We conclude that was a risk-on year with Italy, France, Australia and Japan developing solid performances, moreover, emerging market equities provided interesting returns, especially Brazil and Russia.
Liquidity is the main driver of markets, when liquidity is on you want to be all-in while liquidity dries up it is better to sit and wait for bargains. Liquidity can be defined in many ways, but in my opinion, liquidity is provided mostly by central banks and commercial banks. In the past years, the former played a major role through Quantitative Easing, and now how we can see the balance sheet of the Federal Reserve is expanding at a rapid pace providing liquidity in the market since August 2019 when the repo rates spiked:
Along with this, credit by US commercial banks has gone up considerably compared to a year ago, but the trend inversion of the past few weeks suggests me that something is changing in the banking system, banks seem to be less risk-lover and if they cut credit a portion of liquidity will be removed from the market, leaving to the FED the task of addressing it. If this materialize in the following weeks, I’m keen to forecast a new round of QE around the globe, if this happens be sure to buy any dip in the market. I am still bullish on equities given the M2 money stock in the market but later we will address why at the moment we should by protections and bring our portfolio beta below the market one.
Another indicator I use to track liquidity is the Chicago Fed Adjusted National Financial Condition Index, the rule of this index is pretty simple, above zero, liquidity is tightening while below zero it’s a beautiful environment. To track the trend, I use the one year moving average, now we have the following situation:
Liquidity is decreasing since a while, therefore on a short-term basis a would suggest caution with equities and if possible, hedge or reduce the risk in the portfolio.
The second block of my investment framework are leading indicators because they can tell us where the economy is headed, thus we can profit from it. We are going to see a bunch of them to provide an idea on where we stand currently in the cycle and how we should position our portfolio exposure.
As first, my favourite leading indicators is the Semiconductor iShares ETF because semiconductors rule the world as they are used in every single part of the economy. If we take a snapshot of the past year we can see two things, the first one is that we had a positive trend for the past four months, very bullish for risky assets, while now it seems that we are a little bit stretched as we can denote from the chart will Bollinger Bands. This leads me to the second point, it is likely that we are going to see some weaknesses in the price in the upcoming weeks, therefore caution is a key feature to keep in mind.
But for the upcoming months the economy it is likely to pick up. We can assume that by looking at the China Credit Impulse as it leads the World Markit Manufacturing PMI by 12 months.
In addition to that, we have the same clue if we take a look at the Baltic Dry Index and the JP Morgan World Manufacturing PMI, it suggests that we had a bottom in early 2019 and we can see a positive trend for the first months of 2020.
Sentiment is a key driver for positioning our portfolio and we have to think about it in a contrarian way. We can have a snapshot of sentiment by looking at multiple measures, but I will stick to my favourite. The first one is the put/call ratio twenty day moving average.
Looking at some statistics from February 2018 we can say that on the 27th of December we were at the 73th percentile, excessive bullishness in the market is what I get from it.This is confirmed by the CNN Fear&Greed index:
Lastly, the AAII Bull/Bear Ratio provides sign of a rising bullish sentiment in the market, still not above the 80th percentile, I use five year rolling data, but we are very close to it, thus we are seeing not red but orange.
But one indicator is flashing red, it is the percentage of NYSE Stocks above 200-day moving average.
If we sum all these clues, I believe is better to reduce risk exposure through put options and bring the equity beta to the same level of the market or even below.
If we take a snapshot of the historical seasonality of the S&P500 January and February look like not the best time to be long in the market as we can see here: