Extreme Moves Leave Markets in Rare Territory

If you didn’t pay much attention to global markets last week, here’s what you missed…fears that the global economy is dangerously close to a recession due to the financial crisis in the eurozone and flatlining growth in the U.S. sent assets of all shapes and sizes into a tailspin.

Among the E7 and G7 countries, only two markets increased for the week—Pakistan (up 2.2 per cent) and Japan (up 0.5 per cent). Russia (down 12.2 per cent) and Indonesia (down 10.7 per cent) were the leaders in the opposite direction. The average return for the 14 countries was a 5.7 per cent decline.

Many investors have used gold and other commodities as a haven from recent volatility, buoying prices while equities sunk, but even those investments weren’t immune to the wave of selling. Silver was hit the hardest, falling nearly 24 per cent, with copper (down 16.5 per cent) and platinum (down 11.2 per cent) not far behind. Gold and oil were down roughly 9 per cent and the yellow metal was down more than $100 during intraday trading on Friday.

The U.S. dollar, in contrast, was up 2.2 per cent. Much of the dollar’s rally came after the Federal Reserve announced the creatively named “Operation Twist” on Wednesday. The Fed will sell $400 billion of short-term securities and buy an equal amount of long-term debt. The goal is to push down long-term interest rates, which would spur economic activity.

As a result of last week’s actions, the S&P 500 Index is just slightly below two standard deviations from its mean over the past 60 trading days. The MSCI Emerging Markets Index is at a similar position, just greater than two standard deviations from its mean over the same time period.

SP 500 60 day Oscillator

MSCIEM 60 day Oscillator

The two charts above illustrate how rare two standard deviation events are for these markets. Over the past 10 years, 60-day percentage changes to the downside of this magnitude have only occurred just over 5.4 per cent of the time for the S&P 500 and 4.8 per cent of the time for MSCI Emerging Markets.

This rare territory is often called “oversold” by traders and portfolio managers. That simply means too many investors have sold their holdings in a condensed timeframe, driving the price down more than its historical average.

Take a look at the gold/U.S. dollar relationship, for example. Over the past 20 trading days, gold has dropped 8.7 per cent while the U.S. dollar appreciated by 6 per cent.

Gold vs Dollar 20 day Oscillator

This week’s moves are even rarer for gold and the U.S. dollar. The U.S. dollar has experienced similar upward moves only 3.5 per cent of the time over the past decade, while similar declines in the price of gold have happened roughly 4 per cent of the time.

I point this out because markets have historically reverted back to their mean after crossing into extreme territory, creating a “buy” or “sell” signal for the asset. This gauge has proven a reliable indicator for our investment team as it seeks to limit downside risk and take profits when assets have experienced a big run.

Since mid summer, our investment team has sought to limit exposure to downside risks by raising cash levels, selling mid-caps to buy large-cap companies and downsizing positions in cyclical areas such as industrials while increasing those in more stable areas such as consumer staples. Last week’s market volatility provides an opportunity to selectively invest cash and redeploy capital.

The market’s reaction to the Fed announcement is indicative of how little confidence investors have in policymakers in controlling what appears to be an escalating situation. More than half of investors and analysts surveyed believe a global recession is imminent.

While we certainly recognise the current downside risks for the global economy, we think it’s worth noting that investor sentiment and emotions can be significant market drivers, but the maths of the market indicates we are probably at an extreme and a price reversal is likely.

One of these is the Conference Board Index of Leading Economic Indicators (LEI), which our director of research John Derrick highlighted for you in the previous week’s alert. The LEI, has historically been a good predictor of economic growth as it measures peaks and troughs in the business cycle. Despite it being one of the most volatile months for equity markets in recent memory, the LEI increased more than expected during August. In addition, initial July figures were revised upward. ISI Group said in a report on Thursday that “the LEI is not flashing any sign of an impending recession.” In addition, the firm also expects a modest gain for the September jobs report. ISI calls America’s jobs outlook “capital market’s most important economic statistic.”

These are positive developments, but we’re not out of the woods yet. The U.S. economy will continue to inch its way forward over the next one to two years and U.S. companies and consumers must adjust to this low-growth environment. It’s critical investors identify the companies that will successfully compete in this environment.

We believe America is up to the challenge.

John Derrick, director of research, contributed to this commentary.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. Standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is also known as historical volatility.

The MSCI Emerging Markets Index is a free float-adjusted market capitalisation index that is designed to measure equity market performance in the global emerging markets. The Conference Board index of leading economic indicators is an index published monthly by the Conference Board used to predict the direction of the economy’s movements in the months to come. The index is made up of 10 economic components, whose changes tend to precede changes in the overall economy. The S&P 500 Stock Index is a widely recognised capitalisation-weighted index of 500 common stock prices in U.S. companies.

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