How to judge the market mood

“Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.”  

This is just one of the many widely-quoted aphorisms from master investor Warren Buffett, whose long-term performance at Berkshire Hathaway remains a beacon for all patient portfolio builders - and with good reason. Trying to pick market tops and bottoms is a mug’s game, which is why Buffett has never attempted it, preferring instead to focus on companies with a competitive advantage which in turn means they can consistently grow their earnings, generate cash and churn out dividends.

Even if he is 85 Buffett continues to operate as patiently as he always has and the vast majority of investors will – very sensibly – stick to their strategic allocations and look to patiently ride out the sort of turbulence witnessed in August. Anyone looking to bravely tinker with any tactical, short-term portion of their portfolios needs to tread carefully, for fear of incurring unnecessary trading costs or walking into a fresh round of market confusion. The FTSE 100 rose or fell by more than 1% a day just 40 times in  2014, the lowest figure since 2005 and such prolonged periods of calm are often followed by chaos as they often lure the unwary into thinking the markets are safe – or as Buffett puts it, “speculation is most dangerous when it looks easiest”. 

Volatility in itself it not a bad thing – it can provide an opportunity to buy good assets more cheaply or sell bad ones for an expensive price – although investors’ portfolios must be sufficiently well buttressed and diversified to see them through the rocky patches. The FTSE 100 has already risen or fallen by more than 1% a day on 44 occasions this year but it managed the feat 143 times in 2011 (when it fell 5.6%) and 210 times in  2008 (when it plunged by 31.3%), so there has to be a chance there are more swings and roundabouts to come. The chart below shows how extended volatility tends to be bad for the near-term performance of the UK equity market, even if some investors may view it as a chance to build exposure at more attractive  prices for the longer term.

Heightened volatility tends to be associated with poor near-term performance for UK equities

Source: Thomson Reuters Datastream, AJ Bell Research

At least there are a few useful indicators which can be used to gauge whether the summertime’s blues are behind us or not. These are all measures with which regular readers will be familiar:

•    The Dow Jones Industrial Transportation index, Philadelphia Semiconductor index (the SOX), Korea’s KOSPI index, commodity prices, the AAA/BAA risk spread all smack of deflationary fears. 

•    The UK market’s dividend yield suggests there is a valuation case to be made for UK equities while the VIX volatility indicator suggests brave contrarians may be entitled to start looking for bargains amongst the market wreckage.

Red lights

Both the Dow Jones Industrial Transportation and Philadelphia Semiconductor (SOX) indices are good guides to the US and global economy respectively – the former as goods must be shipped if they are to be sold, the latter as silicon chips can be found in growing numbers in a massive range of gadgets and consumer and industrial items, from smartphones to tablet computers to cars to fridges. They led the broader US indices lower and have yet to make a concerted effort to regain lost ground.

Dow Jones Transport index remains off track

Source: Thomson Reuters Datastream

The SOX chip index still has indigestion

Source: Thomson Reuters Datastream

Commodity price action reeks of deflation, even if Doctor Copper, a terrific long-term indicator of global economic health, has crept back above the $5,000-per-ton mark, aided by Glencore’s decision to mothball two giant African mines. Although lower raw material and input costs will be welcomed by many firms, the implication of sagging commodity prices is global growth is not all it could be.

Bloomberg Commodity index is still stuck near 13-year lows

Source: Thomson Reuters Datastream

Copper is trying to rally after a tough year

Source: Thomson Reuters Datastream

Another good barometer of global activity is Korea’s KOSPI benchmark index. Seoul’s economy, the thirteenth biggest in the world according to the International Monetary Fund, is built on exports so if the news here is bad, this would suggest the global economy is not firing on all cylinders. Even allowing for the discomfort caused to Korean corporations by Japan’s devaluation of the yen and China’s moves to both rebalance its economy and tinker with its currency, the picture here is not good.

Korea's KOSPI index is still struggling for momentum

Source: Thomson Reuters Datastream

A final measure of market risk appetite to note is the AAA/BAA risk premium spread, which compares the bond yield available from corporate loans of the very highest quality (AAA) with the lowest investment-grade ranking (BAA). This figure has averaged 0.98% since the mid-1980s but has risen from 0.9% to 1.22% in the past three months. 

AAA yields have barely moved since July but BAA yields have moved sharply higher, to suggest someone, somewhere is less confident about the future ability of corporations to fund their debts. BAA yields are nowhere near where they were during the 2007—09 crisis, when they surged beyond 9%, but credit may be coming harder to obtain, also an sign the economy could be in for tougher times ahead.

Risk premium spread is on the rise

Source: Thomson Reuters Datastream, Moody's

AAA yields have barely moved since July but BAA yields have moved sharply higher, to suggest someone, somewhere is less confident about the future ability of corporations to fund their debts. BAA yields are nowhere near where they were during the 2007—09 crisis, when they surged beyond 9%, but credit may be coming harder to obtain, also an sign the economy could be in for tougher times ahead.

BAA corporate bond yields in  the US have marched higher

Source: Thomson Reuters Datastream, Moody's

Green lights

None of the above look like a classic bull market, at least if history is any guide. Yet contrarians will look to shrug off such concerns, or at least suggest value may be emerging, by referring to two other indicators.

The first is the Chicago Board of Exchange Volatility Index, or VIX. The so-called “fear index” measures market expectations of near-term volatility, as conveyed by S&P 500 stock index option prices.  It has averaged around 19 since its inception in 1990 and currently stands at nearly 28. History suggests any move above 20 and the market could be oversold, at least short-term, while any drop below around 14 suggests it may be overbought.

The VIX spiked to 40.7 on 24 August, a level exceeded three times this decade, inn early 2010 and summer and autumn 2011. On each occasion the S&P 500 tumbled, only for this to present an opportunity for those brave enough to buy on the dips.

Fear index offers some grounds for hope after sharp spike

Source: Thomson Reuters Datastream

Further comfort can be drawn from the dividend yield offered by the FTSE All-Share. According to Thomson Datastream this is now 3.7%, compared to the post-1986 average on the index of 3.5%. Clients and advisers need to make sure dividend forecasts are credible – FTSE 100 firms Glencore, Morrisons and Centrica have all announced payout cuts in the past few months – but income hunters may be intrigued.

That said, the chart below shows the yield can easily reach 4% or even exceed 5% in times of market distress (as share prices fall) so there is no guarantee that the above-average yield will provide an immediate market floor.

FTSE All-Share now offers an above-average dividend yield (assuming forecasts for payments can be trusted)

Source: Thomson Reuters Datastream

Equally, the differential between the yield on the equity market, as defined by the FTSE All-Share, and the 10-year Gilt yield remains very high, at 1.88%. This could provide support to stocks, although it does also raise the issue of what might happen if and when the Bank of England starts to increase interest rates and this gap potentially starts to close if bond yields go up too (as would normally be the case).

UK equity dividend yield is a lot higher than the 10-year Gilt yield

Source: Thomson Reuters Datastream

Highs and lows

One final indicator which is still worth watching is the number of new 52-week highs and lows on the New York Stock Exchange (available on  its excellent website at www.nyse.com) and on the London Stock Exchange (available in the physical, paper edition of the Financial Times each day). 

This column last looked at this subject in late August with what proved (for once) a degree of prescience. The number of new 52-week lows had begun to substantially outnumber the new 52-week highs, even though the S&P 500 overall had held relatively firm and traded within a very narrow range. Such poor internals normally signal trouble and so it proved – in the two days before the market rout on 24 August, lows outnumbers highs by 995 to eight and on the 24th itself the figure was 1,315 to seven. 

Source: Thomson Reuters Datastream

One sign of a healthier market would be a better balance between lows and highs and eventually the highs taking the lead. In August 2011, the last time we saw a 10% correction in US stocks for 19 days out of 20 but by a progressively smaller degree and once calm descended the market gathered itself and began to motor higher again. Let's see what happens this time but a little more conversation and little less action (to traduce the title of an Elvis Presley classic) would be welcomed by market bulls.

Russ Mould

AJ Bell Investment Director