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In this article, we will review three metrics that I believe are relevant to understanding a tight market or a weak economy. When, together, these indicators give the same signal, protecting your portfolio with hedging is recommended.
Inversion of the yield curve
Keep in mind that the yield curve of a healthy economy generally looks like this:
An inverted yield curve happens when short rates become higher than long rates; or at least the spread between the two weakens. The literature on the subject is vast. It confirms the relationship between the slope of the yield curve and the future evolution of economic activity. The work of Harvey (1988) and Estrella and Hardouvelis (1991) shows that there is indeed a correlation between US economic growth and the spread between the US 10-year rate and the 3-month rate. They also suggest that the evolution of the yield curve makes it possible to predict recessions. As Christophe Blot and Eric Heyer point out in the paper (2018), "a reduction in the slope of the yield curve is associated with a higher probability of future recession." Beyond a correlation, there are reasons that can explain a causal effect of the yield curve on activity (Monteta, 2005).
Among the assumptions that lead to these results, economists consider that long rates reflect market expectations of future short rates. In other words, if the markets anticipate a recession and think that the central bank will pursue a more accommodating policy, they expect a future drop in short rates, which reduces long rates today (a relationship that is not so obvious). The results put forward by economists are therefore based on the conjunction of two expectations: an expectation of a decline in activity and the expectation that the central bank will play a proactive role and lower short-term rates.
For their part, Blot and Heyer have examined the relevance of this relationship for France and the euro zone, and I strongly recommend that you read their work on the subject. They validate the relationship between the slope of the yield curve and US growth but conclude that the information contained in the yield curve for France and the Eurozone is much too weak to predict recessions or growth.
In practical terms, the curve to follow is the spread between the 10-year constant maturity US Treasury bond rate and the 3-month constant maturity US Treasury bond rate. On the same graph, in grey, are marked the periods recognized as being major crises.
When the curve goes into negative territory, it means that the slope of the yield curve has flattened. You will notice the regularity of the signal in anticipation of a correction. It can be very interesting to study this curve in parallel with the evolution of the GDP of the analyzed economic region.
How the U.S. market welcomes the rate of earnings surprises
On February 18, 2022, John Butters published an article entitled: "Market rewarding positive EPS surprises less than average for S&P500 companies for Q4" on the FACTSET website (Insights tab). At the time of writing, 84% of S&P500 companies had reported Q4 earnings. Of those 84%, 77% reported EPS above average expectations, slightly above the 5-year average of 76%. The average surprise rate was +8.5% for the quarter, slightly below the +8.6% based on the previous 5 years.
This average of +8.6% leads us to believe that analysts are conservative in their estimates but also that the market, used to impressive surprise rates, is already pricing in this surprise rate. At least, this is what we can understand when we look at the market's reaction to the release of the figures to the public, in other words, the average of the variations over the 4 days surrounding the publication.
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For Q4, the share price of companies that released a positive surprise rose, on average, by only 0.2%. This figure is low compared to the historical average, and especially very low compared to the previous 3 quarters.
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In my opinion, the reception of the Q4 results highlights the fact that bearish catalysts are far more serious than bullish ones. The market is extremely tense, reflecting the conflict in Ukraine, and is severely punishing below-expectation results. We have seen that this is also true in Europe. Together, the yield curve and the market's reception of earnings are two very strong indicators to get a sense of the economic health of a region and to take stock of the pressures in the market.
Who better than the index publisher to tell us about it?
The CBOE VIX Volatility IndeX is often cited by traders and financial media as the ultimate benchmark of volatility. It is also known as the fear index. It should be noted that the VIX is an index, in other words, a measurement tool. Therefore, it is not possible to speculate on it directly.
It indicates the level of uncertainty in the US markets. To be more precise, the VIX measures the expected volatility over 30 days and is based on the trades made on the options listed on the CBOE with the S&P500 index as the underlying (SPX options).
It is expressed as a percentage of the annualized standard deviation of changes in the S&P500. The inputs to its calculation are the prices that traders are willing to pay to acquire SPX options. The price of these options reflects the potential changes in the S&P500 index. The word "potential" is important because it emphasizes the fact that the index provides information about expected market movements.
Between 1990 and 2020 the closing prices of the VIX have moved in a range between 9.14 and 82.69 (covid crisis). A high VIX reflects traders' concerns about the future evolution of the US markets. It is interesting to note that the VIX Index and the S&P500 are inversely correlated. When the S&P500 rises, the VIX tends to fall because traders are confident and vice versa.
The VIX index is most often used as an indicator of future market levels. A trader can also speculate on the evolution of the VIX through derivatives (futures and options) listed on the CBOE.
It is very important to note that most institutional investors who own stocks directly use options to protect their portfolio. The activity of these investors (pension funds, insurance companies, mutual funds...) The buying activity of these investors (pension funds, insurance companies, mutual funds, etc.) is therefore primarily related to the purchase of puts! The increase in the VIX then occurs when investors buy a lot of puts, thinking that the markets are uncertain and that the danger of a fall is approaching. The fact that panic is contagious explains why volatility tends to stay the same from one session to the next. However, it has been shown repeatedly that an increase in the VIX index does not necessarily lead to a decline in the markets. Markets are more volatile, investors hedge, the VIX remains stable and an auto-catalytic phenomenon occurs, but this does not mean that the markets will collapse. Hence the need to couple the analysis of the VIX with the other indicators mentioned earlier in this article.
An opening
If we study the first two indicators (the market's reception of surprise rates in Q4 2019 and the inversion of the yield curve), we notice that everything led us to believe that a major crisis would surprise the markets at the beginning of 2020. However, this financial crisis has been delayed and a health crisis has occurred. It was only then (March 2, 2020 to be exact) that the VIX began to explode. But the causes of the market collapse are not comparable to historical crises. Still, an investor who followed this approach with a note of common sense might have anticipated that this health crisis, occurring in a faltering economy, would have a significant impact on the markets. In the end, this crisis was short-lived in the markets. The V-shaped recovery took place and there was no real (perhaps necessary) reset of the economy. In fact, real estate has even benefited from this crisis and housing prices relative to consumer purchasing power remain extraordinarily high. All this is rather worrying, especially since the Russia/Ukraine conflict will certainly delay the necessary tightening of monetary policies by the FED and the ECB.
The indicators presented in this article are, in my opinion, much more interesting than the study of market valuation levels. It doesn't make much sense to compare the valuation levels (PEG for example) of 2022 with those of the 1980s, when the risk-free return was above 10%. It is therefore quite normal that a 20% return in 2022 costs much more than a 20% return in 1980.
