Stress Signals Emerge in Rising Equity Markets

Global equity markets had their best first-half of the year performance in 33 years, largely attributable to the U.S. market. However, caution signals are popping up.

The S&P 500 Index gained 18.5% in the first six months of the year, in part propelled by technology stocks, while the MSCI World Index jumped 17.4%; yet equity markets continue to show signs of stress.

In the past quarter, the extreme deviations from normal levels seen in various measures of the Intech Equity Market Stress Monitor^® should be taken as a warning that a return to the norm may be accompanied by increases in market volatility.

How Much Beta Risk?

Significant changes last quarter in the index efficiency measure, as well as in the correlation of returns metric, indicates continued market stress and potential volatility.

The index efficiency risk metric showed the largest change since last quarter, which continued to decline significantly and is nearing the lower quartile for many equity indexes, reflecting that markets are becoming less efficient.

The drop in index efficiency offers active investors the potential to improve diversification and portfolio efficiency versus the index with less beta exposure. Strategies positioned accordingly should have benefited in May, when equity markets sold off.

Rising Correlations

The correlation of returns metric, which measures the market-weighted average pair-wise correlation of stocks in the index, substantially increased since last quarter in most developed market indexes, suggesting higher systematic risk globally.

This change is a continuation of a trend that began just over a year ago, when correlation readings were at historic lows. The rise in the correlation metric means that the underlying stocks’ returns tend to move in tandem with each other.

While strategies with lower beta exposure offer the potential for higher efficiency and reduced systematic risk, they may lag in the event of a lasting, rising equity market fueled by hopes for accommodative monetary policy and a trade truce.

Regional Breakdown

Index efficiency and correlation of returns, two of the five metrics in the Intech Equity Market Stress Monitor^®, stood out in developed equity markets, but there were regional differences across the metrics. Below we offer a synopsis of equity market stress in five major equity market indexes.

Global Equity Market: MSCI World Index

• Global developed equity markets continue to demonstrate the least amount of risk relative to other segments with just one measure, dispersion of returns, currently at extreme readings. The continued decline in risk this quarter is largely attributable to the U.S. market, as international developed markets continue to show signs of strain.
• The largest change since last quarter is in the index efficiency measure, which continued to decline significantly and is nearing the lower quartile across all historical observations. The decline has been abrupt as just a year ago it was near historically high readings. While lower readings suggest that a lower beta approach may improve diversification, extremely low readings reflects an increased risk of a more defensive positioning in a sharply rising market.
• We also observe an increase in the correlation of returns measure since last quarter, which reflects increasing systematic risk in global developed equity markets. This is a continuation of a trend that began just over a year ago, where correlation readings were at historic lows.

Non-U.S. Developed Equity Market: MSCI EAFE Index

• Non-U.S. developed equity markets continue to demonstrate signs of strain, with three of five measures at extreme levels.
• While a move to more typical levels, index efficiency declined significantly and was the biggest change across all risk measures. This is a continuation of a trend that began just over a year ago, where historical highs were reached for this measure. The decline reflects a less efficient market and increased potential for skilled active managers to deliver improved risk-adjusted returns in the current environment.
• We also observe an increase in the correlation of returns measure since last quarter, which reflects increasing systematic risk in international developed equity markets. This is a continuation of a trend that began just over a year ago, where correlation readings were at historic lows.

U.S. Equity Market: S&P 500 Index

• Our risk measures within the U.S. equity market continue to show signs of normalization this quarter with currently only two of our five measures at extreme levels.
• The largest change since last quarter is a decline in the index efficiency measure from median level to close to first quintile level. A decrease in index efficiency means that diversification could be increased through a lower beta approach. While a defensive equity approach provides some downside protection when volatility in the market picks up, it also brings along the risk of “missing out” should the market rally strongly.
• Correlation of returns continued their increase that started at the end of 2017 after reaching extreme low levels. It is now ranking above median in the U.S. market as systematic risk has been increasing steadily and we are seeing less and less differentiation between stocks’ returns.

European Equity: MSCI Europe Index

• The European equity market continues to be the developed market region where we observe the most market strain, with three of the five indicators at extreme values. In fact, skewness of returns is now nearing historically high levels and the divergence in readings between Europe and U.S. markets has reached its highest level since the mid 1990’s.
• While a move to more typical levels, index efficiency declined significantly and was the biggest change across all risk measures since last quarter. This is a continuation of a trend that began just over a year ago, where near historical highs were reached for this measure. The decline reflects a less efficient market and increased potential for skilled active managers to deliver improved risk-adjusted returns in the current environment.
• Correlation of returns continued to increase quarter over quarter, moving to more typical levels when compared to historical observations, and reflecting a continued increase in systematic risk in European equity markets. This is a continuation of a trend that began a year ago, when correlations were near the bottom decile compared to all historical observations.

Emerging Markets Equity: MSCI Emerging Markets Index

• Emerging markets continue to demonstrate more strain than developed markets, with four of five risk indicators currently at extreme levels. Unlike other regions, there were no significant changes in the indicator levels from last quarter.
• Skewness of returns now ranks in the 95^th percentile and indicates that there are signs of extreme optimism and a potential tendency to react more strongly to positive news in this segment.
• While index efficiency is relatively unchanged from last quarter, we observe a significant decline from near historically high levels a little over a year ago. A decrease in index efficiency means that diversification could be increased through a lower beta approach in this region.