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The Impossibly Hard to Predict Equity Market Correction

4 minute read

After equity markets hit all-time highs earlier this year, market pundits have been eager to “call the top.” We have one of the largest hedge funds in the world taking on significant short positions in the European market, an equity strategist at a bulge bracket firm calling for a potential 40% market correction “at some point” and a recent article claiming that high cross-asset correlation is a sign of an impending sharp correction. These headlines have analysts all asking the same question: should we brace for a big sell-off?

While we are wary of markets continuing to rally like they did in 2017, we highlight a potential leading indicator that many equity market participants should be focusing on: corporate high yield spreads. This indicator currently suggests that, while short-term corrections are possible, a sharp and sustained downturn is unlikely at this time.

For illustrative purposes, we use the widely quoted BarCap U.S. Corporate High Yield 10-Year Spread Index. This index is calculated by taking the Yield-to-Worst (YTW) of a basket of Corporate High Yield paper and subtracting it by the 10-year U.S. Treasury rate. In effect, this is the “risk premium” bond holders are willing to take for holding lower quality corporate debt. 

Next, we’ll define a “correction” as a 15% or more drawdown in the MSCI All-Country World Ex-USA Index USD (“ACWX”; Bloomberg ticker code: MXWDU). While most experts use a 10% mark to define a bear market (or a “correction”), such drawdowns are more difficult to predict and in our opinion, are more typical of pullbacks within a broader bull market uptrend. Furthermore, and as reference, substituting the S&P 500 Index for ACWX would only strengthen our arguments below.

Charting the ACWX and the High Yield Spread, we see that every time the market corrected by 15% (or more), spreads widened by at least 125 bps and as much as 300 bps prior to the sell-off.

High Yield Spread vs. MSCI ACWI Ex-USA Index (MXWDU)

high yield spread vs. MSCI ACWI Ex_USA Index

*Source: Bloomberg; R Squared Capital

Working backwards in time, the early 2016 correction was caused by the collapse in oil prices and the ensuing knock-on effects throughout the supply chain. Bondholders in Energy priced in the potential for bankruptcies across all sub-sectors (including pipeline companies which purportedly have stable cash flows).

The 2011 correction was due to worries of contagion from the sovereign debt crisis, both in Europe and the U.S. (credit rating downgrade). 2008 was the global financial crisis with which most readers are familiar. Important, however, is that corporate yields spiked (including home builders and financials) leading up to the 50% market correction. Similarly, the Dot-Com crash in 2000 was preceded by spreads widening by 300 bps while equity markets continued to climb higher.

All of this makes sense. Market bubbles are typically the result of “easy money” (via debt, equity (venture capital or LBOs)). Generally, the providers of this capital start to “slow their roll” before significant effects are noticed in the equity markets; higher risk aversion (and hence higher cost of capital for issuers) may also negatively impact the economy and the stock market.

In either case, while we are wary of market valuations (arguably near peak, on both absolute and relative/cyclically-adjusted basis), we don’t anticipate a major equity market correction for the following reasons:

  • High yield spreads remain low and range-bound
  • Industry verticals are not showing significant fundamental hardships
  • Global macro data suggest continued economic expansion

 

For international equity investors, we suggest keeping a close eye on corporate high yield spreads. As a potential leading indicator for equity market stress, spread widening in the 125 bps range should prompt a more defensive stance as the probability for an equity downturn increases. 

 

Interested in more R Squared Market Insights?  Download our latest market commentary.  

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As international equity investors, the team at R Squared Capital Management (former team at Julius Baer / Artio Global) utilizes fundamental and macro analysis in our quest to correctly identify structural tailwinds and headwinds at the geographic, sector and company levels.   

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FROM THE DESK OF LUIS AHN

Luis Ahn is a Partner and Analyst at R Squared Capital Management.

Prior to joining R Squared, Luis was a Senior Analyst at Bloom Tree Partners.

Luis received an MBA from The Wharton School and Bachelor of Science in Quantitative Economics and Computer Science from Tufts University. 

To view the firm biographies of RSQ, click here

Posted by Luis Ahn on Mar 15, 2018 11:38:01 AM

Topics: From the Desk of Luis Ahn, International Equity

 

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