Bubbles, inflation, negative breadth: which market myths matter for 2022?

Have people told you that the Great Wall of China is visible from space, or that a goldfish has a memory span of three seconds? These are common misconceptions. The financial world also perpetuates myths – and some are circulating in the press today. This issue of Simply Put, where we make macro calls with a multi-asset perspective, tests their validity.

 

Need to know Negative market breadth is more likely to indicate a forthcoming surge in volatility than an equities sell-off. Growth stocks are not in a bubble: their valuations are supported by strong earnings and low interest rates. Surging fertiliser costs could soon feed into the prices of agricultural commodities, adding to inflationary pressures.

 

Market myth #1: bad breadth befouls market returns

Our first culprit is the relationship between market breadth and price behaviour. A well-engineered chart of the NASDAQ index versus its breadth since the end of 2019 seems to unequivocally point to an upcoming correction. Yet there are several problems with such comparisons.

First, this compares a bounded indicator (the breadth can only take values between zero and 100%) to a price series, which is by definition unbounded, as prices can theoretically keep on rising. Second, so-called chart engineering is critical to creating a somewhat conclusive chart. If this chart were extended back to 2001, the same conclusion would not be so apparent. Third, a simple statistical test can easily rule out any kind of informational gain from such an indicator.

Figure 1 represents the NASDAQ and the percentage of stocks above their 200-day moving average – the market’s breadth. The low percentage of stocks driving the performance of the entire index indicates negative breadth, suggesting that the market is fragile. But this necessarily trigger negative performance?

To test this theory, we first created a binary variable, where 1 indicates that more than 50% of stocks are above their 200-day moving average and zero infers that 50% or more of the stocks are below this measure. We then looked at the index performance over the subsequent year. On average, we found that if less than 50% of the stocks were on a positive trend (above their 200-day moving average), the index’s average performance for the following year was 17%. If breadth was more than 50%, the market went on to return 11%. This tells us that negative breadth does not necessarily compromise performance.

However, negative breadth does seem to align with increased volatility and lower risk-adjusted returns. It has historically been followed by periods of high volatility (26% on the NASDAQ ), while positive breadth comes with low volatility (13%). In our view, if negative breadth can predict anything, it’s a forthcoming surge in volatility.

 

FIG 1. NASDAQ performance relative to market breadth

Source: Bloomberg, LOIM as at December 2021. For illustrative purposes only.

 

Market myth #2: growth stocks are in a bubble!

Global growth stocks have risen by about 20% so far in 2021 (see figure 2). Are they in a bubble? To test this view, we ran a cointegration test between the MSCI World Growth index and the earnings per share of its underlying stocks with US 10-year Treasury yields since 2005. Cointegration, developed by Nobel laureates Robert Engle and Clive Granger in 1987, tests whether two time series share a common trend over the long term.

Our test showed, with a 97% degree of certainty, that the performance of growth stocks can be explained by higher earnings and lower yields. In our view, growth stocks are performing as they should and fears of a bubble should be questioned. However, if earnings contract or rates increase significantly, or both, these stocks could decline.  

 

FIG 2. MSCI World Growth versus earnings

Source: Bloomberg, LOIM as at December 2021. For illustrative purposes only.

 

Market myth #3: the Fed is fuelling the stock-market rally

These days, investors dread hawkish actions by central banks, particularly the Federal Reserve (Fed). The rational is as follows: if the Fed stops buying or even starts selling bonds, interest rates will increase, increase financing costs for companies and therefore stifling their growth. Is this actually true? Is the Fed’s balance sheet really correlated to equity price movement? Further, does tapering cause equities to decrease?

To assess this theory, we ran a cointegration test between the Fed’s balance sheet and the S&P 500 index since 1995 (see figure 3). While the results are statistically insignificant, from the chart we can see two instances that highlight our point. In 2009, when the Fed increased its balance sheet to combat the financial crisis, stocks fell. Between the end of 2017 and September 2019, the Fed shrunk its balance sheet, yet stocks kept rallying. In our view, this simple analysis seems sufficient to put this myth to rest. If anything, the Fed’s balance sheet is a counter-cyclical indicator.

 

FIG 3. S&P500 returns relative to the Fed’s balance sheet

Source: Bloomberg, LOIM as at December 2021. For illustrative purposes only.

 

Market myth #4: food prices fertilise inflation in the near term

Fertiliser prices increased by about 230% in 2021, while those for agricultural goods by 35%. Looking at figure 4, these two curves could be regarded as cointegrated. It is also logical to assume that because agricultural output is extremely dependant on the price of fertiliser, an increase in its price would feed through to the prices paid for agricultural commodities.

To grow food efficiently, farmers need fertiliser. Once again, we ran a cointegration test on the data from 1994 to today. The results were inconclusive, meaning we cannot say with a high enough degree of certainty that they share the same trend. The debate remains open and prices for agricultural commodities could rise in the coming months. Markets may have underestimated this risk.

Given the heat of the inflation debate these days, food prices could intensify inflationary pressures in emerging markets – where the cost of food plays is a large component of inflation – as well in developed countries, where they amount to about 10% of consumer prices indices.

 

FIG 4. Fertiliser and agricultural commodity prices

Source: Bloomberg, LOIM as at December 2021. For illustrative purposes only.

Simply put, it is important to distinguish market myths from facts by using concrete data and robust statistical models. After investigating a series of misconceptions, we believe it will be worth keeping an eye on the volatility of stock returns and food inflation in 2022.

For professional investor use only

This document is issued by Lombard Odier Asset Management (Europe) Limited, authorised and regulated by the Financial Conduct Authority (the “FCA”), and entered on the FCA register with registration number 515393.
Lombard Odier Investment Managers (“LOIM”) is a trade name.
This document is provided for information purposes only and does not constitute an offer or a recommendation to purchase or sell any security or service. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful. This material does not contain personalized recommendations or advice and is not intended to substitute any professional advice on investment in financial products. Before entering into any transaction, an investor should consider carefully the suitability of a transaction to his/her particular circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. This document is the property of LOIM and is addressed to its recipient exclusively for their personal use. It may not be reproduced (in whole or in part), transmitted, modified, or used for any other purpose without the prior written permission of LOIM. This material contains the opinions of LOIM, as at the date of issue.
Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term "United States Person" shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income.
Source of the figures: Unless otherwise stated, figures are prepared by LOIM.
Although certain information has been obtained from public sources believed to be reliable, without independent verification, we cannot guarantee its accuracy or the completeness of all information available from public sources.
Views and opinions expressed are for informational purposes only and do not constitute a recommendation by LOIM to buy, sell or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change. They should not be construed as investment advice.
No part of this material may be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorised agent of the recipient, without Lombard Odier Asset Management (Europe) Limited prior consent. In the United Kingdom, this material is a marketing material and has been approved by Lombard Odier Asset Management (Europe) Limited  which is authorized and regulated by the FCA. ©2021 Lombard Odier IM. All rights reserved.