The U.S. stock market posted its strongest June performance in more than half a century as well as its best first-half of the year performance since 1997. However, caution looms.
The S&P 500 Index gained 18.5% year-to-date, marking the best return for the first half of the year in 22 years. However, these sharp gains do not reflect investor skittishness given the selloff in the fourth quarter of 2018 and another drawdown in May. The coalescence of several elements suggest heightened potential for increased volatility.
The Intech Equity Market Stress Monitor® suggests some caution in both U.S. and non-U.S. developed markets.
Since the start of the year, the Intech Equity Market Stress Monitor® has moved toward more typical levels, or less strain. However, the large change currently taking place calls for more prospective caution.
The five indicators of market strain help identify different risk regimes and associated tail-risk. During this quarter, equity markets have experienced significant changes, particularly in the index efficiency and correlation of returns risk metrics, which signal continued market stress and potential volatility.
The index efficiency risk metric experienced a sharp change, indicating the potential for increased volatility among global developed equity indexes. This dynamic offers active investors the potential to improve diversification and portfolio efficiency versus the index while attaining less beta exposure.
The decline has been abrupt over the one-year period, where the metric was near to a historical high. The lower readings reflect inefficiency across market indexes.
Correlation of Returns
The correlation of returns metric substantially increased across developed markets since last quarter, indicating a rise in systematic risk in global equity markets. This trend to a higher value began just over a year ago, when correlation readings were at historic lows.
As correlations rise, the underlying stocks’ returns tend to move in tandem with each other as the market begins to dominate. This phenomenon has been seen in U.S. and non-U.S. developed equity markets.
The substantial change in the two risk metrics of the Intech Equity Market Stress Monitor® portends market stress and potential volatility ahead.
In fact, as U.S. equity markets reach all-time highs, heightened levels of volatility appear to be creeping back in. The S&P 500 index returned 10.42% over the trailing one-year which was accompanied by volatility sharply increasing at times.
During the second quarter this year, the U.S. stock market experienced a drawdown of more than 6%, while during the fourth quarter of 2018 the market experienced a near 20% peak to trough decline.
Periods of higher volatility often coincide with drawdowns. Yet, over the prior one year, these volatility spikes have been short-lived and followed by sharp recoveries. While volatility and drawdowns represent distinct risk metrics, historically they have exhibited a clear link.
We believe investors should pay attention to reliable signs of strain, and seek more diversification within equities by considering different types of defensive equity strategies available. We recommend defensive equity strategies which combine alpha potential and downside protection, which create more consistent performance outcomes over different risk regimes.
Learn More by watching this two-minute video on Intech’s global equity market observations.
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