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Duck or rabbit? Optical illusions in US equities

17 April 2016

Optical illusions are often described as images that differ from reality. The illusion of gently rising US equity prices ignores increasing levels of realised volatility, argues Old Mutual North American Equity manager Ian Heslop.

By Ian Heslop,

Old Mutual Global Investors

Optical illusions are often described as images that differ from reality. Those familiar with the drawing of a duck’s head, which can also be construed as that of a rabbit, will appreciate that things aren’t always quite what they seem.

The image of a gently rising US equity market, which has delivered positive returns every year since 2009 could be deemed illusory, ignoring, as it does, the wide swings in realised or actual volatility that have accompanied those price returns.

Accommodative monetary policy from the US central bank has attempted to whip up investor appetite and power share price valuations ever higher, in theory producing a seamless upward trajectory of share price returns.

 

In practice, things look very different. Stripping away the constant macroeconomic ‘noise’ over when officials at the US Federal Reserve will likely push the button on the next US interest rate, what our key indicators conclude is that underlying investor sentiment is poor, realised volatility is at extreme levels and investors appear willing to cluster in ‘crowded’ areas of the stock market.

The same mood as prevails now dominated markets in two distinct and highly memorable periods for investors. The first, March 2000, ushered in the fall-out from of the bursting of the dot.com bubble. The second was the spring of 2009, post Lehman Brothers going under.

Investors will also remember that the stock market moved in two very different directions subsequent to those time periods – sharply down in the first example, sharply up in the second. It’s too early to tell in which direction the market is headed this time round.

At the time of writing, value stocks are beginning to outperform growth stocks. The focus on value is typically consistent with two scenarios.


 

Either investors believe that the future macroeconomic environment will improve, or that value stocks have been oversold. The latter sentiment prevailed in 2000 as investors woke up to the fact that, relative to historic levels, value stocks appeared cheaply priced compared to growth stocks.

That proved to be a very different scenario to 2009 when concerted action by central banks to avoid a banking crisis, and subsequent worldwide recession, resulted in both value and growth stocks rallying. Quantitative easing was, in effect, the rising tide that lifted all boats.

For a long time, our strategy has veered away from value stocks in favour of quality growth stocks. While we are still not aggressively ‘pro’ value, there has been a subtle change of emphasis away from quality stocks and towards value-orientated companies.

Performance of indices over 2016

 

Source: FE Analytics

Themes that have worked well in the US over the past 12 months – the rise and rise of the ‘FANGs’ (Facebook, Amazon, Netflix and Google), reminiscent of a Nifty 50 style scenario, are less likely to do well going forward in our view.

Of course, today’s economic environment is very different to that of 2008-2009 when the effects on the US economy of the subprime mortgage crisis, subsequent financial crisis, and rising unemployment left almost all developed economies teetering on the brink of recession.

Today’s softness in the US manufacturing sector, evident in the weakening trend of corporate earnings is being counterbalanced by underlying strength of US consumption and services sectors, accommodative monetary policy, and strong employment numbers.


 

The jury is still out on whether there will be a recession but US dollar softening should allow some breathing space for US corporate earnings.

For now, fund flows into the US equity market, predominantly through the mechanism of exchange traded funds, have acted as a floor for US equities. This is not entirely helpful.

Despite a raft of negative worldwide investor sentiment - the slowdown in global growth, the precipitous fall and subsequent bounce in the oil price and China devaluation fears, the US stock market has ended the first three months of the year in positive territory in dollar terms.

While implied volatility as measured by the VIX volatility index trades at disturbingly low levels in my view, realised or actual volatility is performing very differently. Image divorced from reality. Active fund managers take note.

Ian Heslop is head of global equities at Old Mutual Global Investors. The views expressed above are his own and should not be taken as investment advice.

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