investment viewpoints
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.
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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. |
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