As we near the end of the first month of 2013, I am seeing some significant changes in how equity markets are moving and operating. The risk on/risk off approach of these markets, characterised by rapid in-and-out moves by hedge funds and aggressive money managers, seems to be abating.
This change comes as worries about the eurozone and its potential breakup recede. Concern seems to have eased after the European Central Bank assured investors that it will continue to bolster Europe’s banks. Germany’s agreement to work adroitly to support a smooth transfer to a more stringent eurozone fiscal union also helped assuage investors. In the United States, the idea that “only macro matters” receded after the US Congress managed to avoid a broad-based income tax increase.
Individual company fundamentals return to vogue: US corporate earnings continue to represent a growing part of the US economy, as they have since 2009. But as we watch fourth quarter profit reports, we see that the market has been increasingly rewarding the companies that report earnings and revenue upside surprises and punishing those that disappoint. In the previous three years, individual company results seemed to be ignored in favour of toggling between two strategies: add risk or remove risk.
Correlations decline: One notable feature of a risk on/risk off market is that correlations among markets, among sectors, among countries and between stocks are very high. At various times, correlations reached levels that indicated that individual company fundamentals mattered little and that investors were concerned only with being in or out of the market. In 2012 and already in 2013, we have seen those correlations fall significantly.
Playing catch-up: In 2012, the market kept rising on low volume despite the market scepticism that was predominant throughout the year. Hedge funds and more than 45% of active equity managers offered lower returns that fell behind broad market averages. There was cash everywhere as conservative positioning took over. And everyone was waiting for a dip, which hardly ever came. Now these huge cash hoards appear to be coming back into the market.
Asset allocation shift: In 2012, pension funds and major tactical asset allocators were overweight bonds and cash. Those conservative players were punished by a positive, upward-moving market. Now those allocations, seem to be moving more toward equities as the models seem to indicate better total return characteristics in “risk assets” than in other more conservative assets.
Volatility falls: Violent lurching is often characteristic of downward markets. In 2012, however, markets moved higher and volatility receded significantly. Investors who ply these fluctuations in the market have less going in their favour these days.
Confidence rises: Market exuberance, in addition to earnings and fundamentals, also moves markets. Now that some of the uncertainty surrounding the fiscal cliff and the eurozone has lifted, individual and corporate investors are feeling better and confidence has risen.
Economic fundamentals supportive of profit gains: The US economy has been growing for almost four years. We are finally seeing some of its weaker parts pick up steam. The housing sector, which is very important to the labour market, has been hobbled by excess inventory for four years. The sector has shown new life as construction and prices rise in tandem. Many workers are needed to complete a single-family home. So as housing demand rises so too does labour participation. More jobs give consumers more money to spend. That money fuels economic growth and corporate profits.
The very concentrated and short-term stock investing of yesterday seems to be fading as a new mentality takes over. Headlines emanating from Madrid, Athens and Washington have also dissipated. Investors today seem more positive and more driven by individual company and sector performance.
If this trend continues, it should move in favour of fundamental investors who look at which companies have the best products, pricing and balance sheets.
James Swanson is chief investment strategist at MFS
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