A multi-asset toolkit that serves well in challenging markets

22 Oct 2018

When markets are volatile, timing is everything. Complementing fundamental analysis by also studying markets’ dynamics and technical frameworks can prove effective in spotting – and taking advantage of – investment opportunities.

Last week, global equity markets experienced one of the sharpest sell-offs so far this year. The S&P 500 fell by close to 7% from peak to trough while other major indices in Europe, Japan and emerging markets experienced similar moves. Many analysts and market participants have tried to explain these moves with competing fundamental stories. We agree that fundamentals matter, but they are usually well understood ex-post. We therefore need to complement fundamental analysis with the study of the markets’ dynamics and technical analysis to extract signals that may help time our investment decisions.


Fundamentals: between a mature US recovery and quantitative tightening

Analysts are right to flag some similarities between the October correction and the one in January-February. Both were sharp, equity-centric, largely unexpected and they came after a sustained back-up in US Treasury (UST) yields and an environment of low volatility (exhibit 1).

Exhibit 1: As in February, US equities fell sharply after a sustained back up in US Treasury yields


Source: Bloomberg, BNP Paribas Asset Management, as at 18/10/2018

Fundamentally, the main reason for these sudden moves is the fact that markets are facing the conflicting forces of a strong but mature US recovery and quantitative tightening as the Fed gradually removes stimulus after years of unconventional easing. This process has been further complicated by the fact that the US government embarked on substantial fiscal expansion late last year. Fiscal stimulus has added to the demand pressures that the Fed needs to contain so as to keep inflation close to its target. In other words, markets are recognising the risks that the US economy may be on course towards overheating.

Most markets observers understand these tensions as well as other notable risks to markets such as Italian politics, the ongoing slowdown in China and US-China trade tensions. But what most observers struggle with is in understanding how these fundamental stresses finally translate into such sudden adjustments in risky assets.


Markets dynamics and technical analyses are helpful tools for investors

The multi-asset team at MAQS (Multi Asset Quantitative Solutions) have a suite of ‘Market Dynamics’ indicators that seek to understand these imbalances to exploit market dislocations like the one equity markets have just experienced. These indicators include metrics related to sentiment, volatility, liquidity and positioning, among others. Some of them were sending strong signals that a market correction could occur.

First, measures that seek to gauge investor sentiment on US equities (Investors’ Intelligence) reached a level of bullishness in September that we usually consider a good contrarian indicator (exhibit 2). Other metrics showed a drastic drop from bullish to bearish on 11 October (Daily Sentiment Index). Indeed, the move was so aggressive that it is flashing ‘excessive pessimism’ now. In addition, according to the American Association of Individual Investors (AAII), cash levels in portfolios rose steadily after having dipped to the lowest level since the 2000 peak.

Exhibit 2: Bullish sentiment was high in September suggesting possible excess of optimism


Source: Factset, BNP Paribas Asset Management, as at 18/10/2018

Second, the US equity rally has been led by the IT sector and has decoupled from other cyclical indices like small caps and transportation over the past few months (exhibit 3). But there is also evidence of a thinner rally within the tech sector. Indeed, the returns of the IT-related giants such as Netflix, Google, Facebook, Amazon, Apple and Microsoft have been more dispersed recently, with only the latter two showing signs of resilience in the sell-off.

Exhibit 3: US equity market dispersion has increased in the past few months


Source: Bloomberg, BNP Paribas Asset Management, as at 18/10/2018

Third, as in February, the correction took place at a time when a large number of companies in the S&P 500 were in a ‘blackout’ period which prevents them from buying back their stock ahead of reporting their earnings. Indeed, according Morgan Stanley, the latest correction coincides almost exactly with the peak number of companies in the buybacks ‘blackout window’.

Fourth, despite the fact that implied volatility (notably for US equities) rose in the January-February correction, it fell to historical lows again in September under the pressure of selling strategies (consistent with extreme short VIX[1] non-commercial futures positions reported by the CFTC[2]). Implied volatility for other assets like currencies and rates also remain close to historical lows, despite the threat of liquidity withdrawals by the Fed and other major central banks (exhibit 4). As we flagged in a recent piece ‘Blackout: be on the alert for a rebound in volatility, July 2018’, the phase-out of asset purchases by the central banks and share buybacks by companies are likely to cause equity volatility to rise and stay at higher average levels in the future.

Exhibit 4: Implied volatility remains very low despite the threat of quantitative tightening


Source: Bloomberg, BNP Paribas Asset Management, as at 18/10/2018

Finally, we use these indicators along with our in-house Dynamic Technical Analysis. The latter uses state-of-the-art technical analysis tools to assess the prospects of material market moves.


Asset allocation implications

Taking all of these indicators together with our fundamental analysis, the multi-asset team at MAQS flagged the complacency and vulnerability of the US and other equity markets in September. As a result, we reduced risk to very low levels in our multi-asset portfolios and have adopted a more tactical approach in response to these signals. For example, we entered a short US IT vs. the overall US equity index in early September which has performed well so far.

These indicators also helped us to form a judgement about when to buy the dip. In particular, following the initial spikes in fear indicators on Wednesday 11 October, we saw the first signs of exhaustion and short-term capitulation with a huge spike in traded volumes.

In the last few days, these signals, together with our view that the US economy remains robust and supportive of strong earnings growth, led us to gradually add risk again by going long developed market equities.

Financial markets are going through the tectonic shifts of quantitative tightening and a mature US bull market, so the notions of “Risk ON – Risk OFF” can no longer be applied for calling markets. We therefore need to assess markets by combining fundamentals, market dynamics and technical frameworks that enable us to be ready to take advantage of market opportunities.


[1] The CBOE Volatility Index, which measures the stock market’s expectation of volatility implied by S&P 500 index options, calculated and published by the Chicago Board Options Exchange

[2] Commodities Futures Trading Commission