CAPE TOWN - Stock markets are booming as risk-on strategies came into play since the sell-off in the final quarter of last year.
The MSCI World index recouped nearly all the losses and is currently trading just 3.4percent off its all-time high in January last year, while US stocks as measured by the S&P 500 Composite Index topped its all-time high last year.
The Chicago Board of Exchange’s volatility indicator, VIX - also termed the “fear” or anxiety indicator by the market, gradually decreased from fear at a high of 30 in December to euphoria with the index currently at the same levels before the breakout in October. The staggering performance of the stock markets means that they find themselves in very rich valuation territories again.
The Nobel Laureate Robert Shiller’s cyclically adjusted price to earnings (PE) ratio or PE10 is within 5percent of the level when the MSCI World Index peaked in January last year, while the US market’s valuation is within 6percent from its peak in 2018.
The valuations are underpinned by current consumer and business confidence, but a major concern is specifically that the US market’s valuation is at the highest levels since October 2001, while the MSCI World Index’s valuation is near the highest levels last seen in May 2008.
What it boils down to is that global equity markets are just as vulnerable as they were in January last year and in 2001 and even more vulnerable than in 2008. This, at a time when indicators suggest that the US economy is facing slower economic growth or even a recession after next year’s election.
The Gray Rhino, coined by Michele Wucker, means “why do we ignore problems when the costs and consequences of failing to act are obvious?” The combination of fully-valued or expensive stock markets and market euphoria means your financial health is prone to anxiety attacks caused by Gray Rhinos.
There are lots of other Gray Rhinos out there, while a Black Swan event - an event that comes as a surprise, has a major effect and is often inappropriately rationalised after the fact with the benefit of hindsight - cannot be excluded, specifically on the geopolitical front.
BlackRock Investment Institute’s geopolitical risk dashboard (www.blackrockblog.com/blackrock-geopolitical-risk-dashboard/) in March highlighted four top geopolitical risks of which US-China relations and European fragmentation and Brexit are the most worrying to them.
They see US-China tensions as structural and long-lasting and any trade truce should not be seen as an improvement in the overall relationship - an accidental or deliberate clash in the South China Sea and tensions over Taiwan are other risk factors.
Due to the increasing policy and economic challenges they are concerned about Europe’s manoeuvrability should the economy slip into recession.
Globally, the potential black elephant - a combination between the black swan and the proverbial elephant in the room, who does something no one predicts - is unequivocally Donald Trump. He is hell-bent on getting himself and his party re-elected next year and may do strange things to try to achieve it.
Domestically, the elephant in the room is how the political playing field, its players, referees and rules of the game will look post the upcoming election. Strange and unexpected things may happen too.
Has the time not arrived to fade risk again by adding some risk-off strategies to your portfolio?
Gold again proved its value in the risk-off strategies in the final quarter of last year when the gold price jumped $90 (R1280.31) an ounce while developed market equities as measured by the MSCI World Index in terms of US dollars ended the quarter down 14percent from the previous quarter.
After peaking at $1341 in February, the risk-on strategies saw gold lose $43 and is currently around the same levels as at the end of last year. My analysis indicates that investment demand for gold declined by as much as 50tons to 100tons in the first quarter of this year and remains low.
Consumer Staples stocks as measured by the MSCI World Staples Index in terms of US dollars also proved its value in fade-risk strategies during the sell-off in global equity markets in the fourth quarter last year by outperforming the MSCI World Index by nearly 8percent.
Risk-on strategies since the end of last year saw consumer staples underperforming by more than 3percent.
You can use the current low volatility or market euphoria to guard against potential Gray Rhino or Black Elephant strikes by adding volatility ETFs to your portfolio. iPath Series B S&P 500 VIX Short Term Futures ETN (VXXB) is one example.
During the sell-off in global equity markets in the fourth quarter, the ETF jumped to $46.99 at the end of December from $26.7 at the end of September. The risk-on strategies and lower fear factor, VIX, caused the ETF to slump to $25 currently. But beware, these funds are used primarily to capitalise on sharp market downturns. Professional assistance is crucial due to the nature of the ETF’s potential impact on your investment portfolio.
Turning points in the markets are mostly event-driven and are exacerbated by overvalued markets and complacency.
Ryk de Klerk is an independent analyst. Contact [email protected] His views expressed above are his own. You should consult your broker and/or investment adviser for advice.