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Market Strategy: Evidence over Emotion

Erica Szczech - May 15, 2017
Use evidence over emotion. While visiting with friends over the weekend, the consistent theme of conversation was the expectation that the volatility in the current administration would end up roiling the markets and causing folks to back away from e

Canaccord Genuity's Tony Dwyer presents: 

 

Use evidence over emotion. While visiting with friends over the weekend, the consistent theme of conversation was the expectation that the volatility in the current administration would end up roiling the markets and causing folks to back away from equities. On the surface, this fear seems very rational given all the problems thus far with the president’s agenda, culminating around the Comey firing last week. The only problem with the thought process is that it isn’t working. If we gave you the political headlines that have taken place thus far during the Trump Administration, many would have expected extreme volatility in the markets. While the volatility around Washington has made for great headlines and influenced how investors “think,” it hasn’t mattered one bit to how investors “act." The evidence is very clear – market volatility remains near a record low.

 

Why is market volatility so low? The reason for this is clear – the market correlates most closely to the direction of earnings, and that direction remains positive with no sign of recession for the foreseeable future. If any cycle has proven you need a recession for a significant and sustainable drop in equities, it is this one. We have seen multiple levels of a European debt crisis, a commodity-driven emerging currency crisis, a global populist movement in Brexit and Trump, a near hard landing in China, and increasing tensions on the Korean peninsula. All of these seemingly huge events provide evidence that investors should use every correction as an opportunity to become more offensively positioned absent a sign of a recession that causes a significant and sustainable drop in EPS.

 

MOACs drive recession timing – and it still isn’t close. By now, everyone has heard of the MOAB ("Mother Of All Bombs") dropped in Afghanistan, and today we highlight the market version – “the Mother Of All Charts (MOAC) in determining the timing of a recession:

 

  • Historically low Real Fed Funds rate. Over the past 60 years, there has not been a recession without the Real Fed Funds Rate using the Core PCE being at 3% or above (Figure 1), yet the current level remains in negative territory at -0.69%. That said, over the last 30 years, the increased leverage in the U.S. economy has caused the level it takes to generate a recession to be lower each cycle, and in this cycle should be no different. It may be lower than 3%, but a recession remains HIGHLY UNLIKELY while the Real Fed Funds Rate remains in negative territory.
  • Positive yield curve. While many try to figure out the absolute level of rates that would be high enough to generate a recession, history has shown that isn’t the most important determinant to recession. The key determinant of recession is the level of short-term rates that cause long-term interest rates to reflect recession fears, as reflected by an inversion of the yield curve. Using the current Fed dot plot and assuming a 2.5% U.S. Treasury 10-year Note yield, the curve doesn’t invert until the second half of 2018, and the mean inversion lasts 15 months, which suggests no recession until 2020.

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