After a rough two months that witnessed a sharp decline in equity prices in the US, the stock market has recovered most of the losses since China announced a surprise currency devaluation on Aug. 11—an event that triggered a selling wave of risky assets around the world. It’s debatable if the worst is over. But from the vantage of the US equities, the outlook is considerably less threatening compared with the dark days from late-August through September’s close. The question is whether Mr. Market’s spiritual revival of late is a reliable indication of better days ahead vs. noise that’s distracting us from recognizing that a deteriorating trend is still underway?
The answer, of course, is that no one knows… yet. So it goes with the mother of all risk factors: the future’s still uncertain. But to the extent that we can look to the collective “wisdom” of the equity market for insight, the S&P 500’s rebound this month opens the door for wondering if the worst fears of the past two months are overbaked. If that turns out to be true, should we be surprised by the false warning via a surge volatility that appeared to signal deep trouble ahead? No, of course not. As valuable as market-based analytics are, they’re far from flawless. With that caveat out of the way, let’s take a closer look at where we stand.
As the first chart shows, the S&P 500 has enjoyed a sharp rebound so far this month. After yesterday’s strong rally, the index is again close to its 200-day moving average. It could all turn out to be a head fake, of course, and so the days and weeks ahead will probably be decisive for deciding if the recent rise is genuine or just a dead-cat bounce.
Meantime, the rear-view mirror looks substantially less ominous from a markets-based perspective. The 10-factor US Stock Market Crash Risk Index (CRI), after a string of warning signs in August and September (see here, for instance), has pulled back from the brink and is now anticipating relatively calm waters ahead in terms of the potential for severe market turbulence. As of yesterday’s close (Oct. 22), all ten of CRI’s metrics have returned to tranquil levels, including S&P 500 drawdown, which has receded from a worrisome -12% at several points last month to the current -4%.
The bear-market signal in CRI has also gone into remission as of Oct. 16, based on the Hidden Markov model data.
In short, an all-clear signal is currently emanating from the S&P 500, according to the ten indicators in CRI that attempt to offer a broad quantitative-based perspective on the level of risk in US equities.
It doesn’t hurt that the US macro profile still shows a positive trend. Althoughgrowth has slowed recently, there are no overt signs in the published numbers to date for arguing that a new recession started as of last month.
The question is whether this is the calm before the storm? No one knows, but clarity is coming. For the US economy, the October economic profile, which is still largely a mystery at this point, may prove to be decisive. The available data, however, still favors cautious optimism for expecting slow-to-moderate growth in the near term. Meantime, it’ll be valuable to see if the US stock market can hold on to its recent gains in the weeks ahead.
Don’t misunderstand: there are still plenty of risks lurking, starting with China’s slowdown, the precipitating factor that launched the recent wave of worry. Quantifying the extent and depth of the blowback for the global economy and the US remains a work in progress. But for the moment, there’s a case for thinking that Mr. Market’s darkest forecasts last month may have been excessive.
Keep in mind that the markets were signaling rough times on the eve of China’s devaluation announcement in early August, as I noted at the time. But after two months of severe stress testing, is the future less bleak than it appeared at the depths of the recent correction? Possibly, or so Mr. Market’s updated forecast advises.
The implication for investors: for anyone with a relatively low risk tolerance, a cautious stance via asset allocation is still warranted, as it has been for some time. For high-risk investors who can afford comparatively steep losses, on the other hand, the odds are looking more attractive for betting that Mr. Market’s revival has more room to run.