Five ways to take the markets’ temperature

Russ Mould
19 August 2021

“The FTSE 100 continues to paddle very gently upwards, having reached an 18-month high in August, but the UK’s benchmark index still stands some 8% below its May 2018 peak of 7,779, in contrast to America’s S&P 500 and Europe’s Stoxx 600 which can point to a series of new all-time highs over the summer,” says AJ Bell Investment Director Russ Mould. “Yet the FTSE 250 and FTSE Small Cap indices trade at or close to their best-ever marks and the FTSE AIM All-Share is very close so instead of focusing on the misbegotten FTSE 100 perhaps investors need to step back and look at the wider picture.

“The make-up of the FTSE 100 means it is a bit of an odd index, with its exposure to the some of the more unpredictable (miners and oils), indigestible (banks) and stodgy (drinks, tobacco, food retailers) sectors. 

“To fathom what is really going on with equity markets and assess whether leading indices can keep rolling higher or whether something is about to sneak up and derail them. 

“One way of doing this is to deploy five tried-and-trusted tests – even if all investors must accept that the past is no guarantee for the future.

“Intriguingly, all of them look fairly inconclusive right now. Copper, transport stocks and small-caps are trading off their highs, high-yield bonds have stopped setting new peaks and volatility appears to have bottomed.

“Perhaps this reflects growing uncertainty over central bank policy, as interest rate hikes handsomely outpace cuts on a global basis and the US Federal Reserve openly debates a taper of its Quantitative Easing scheme (after Canada, New Zealand and Australia have already tapered or stopped adding to their QE stimulus schemes). Perhaps it reflects concern over inflation, whether it is ‘transitory’ or not and – if not – whether it could force central banks’ hands. And in some cases, it may reflect lofty valuations in popular arenas, such as the USA, or sectors, such as technology.

“It may just be summertime lassitude, but this quintet of indicators does not shout out that a fresh bullish surge is a certainty.”

1.    Dr Copper. The industrial metal is so called because its malleability, ductility and use in everything from cars to housing to domestic appliances mane it a great barometer for global economic health. Copper’s stunning surge over the past year looks to be fizzling out a little, as the metal is 12% off its highs. A fresh advance in copper would help to reaffirm investors’ faith that the inflation/reflation trade is the right one, while further weakness would raise fears of an economic slowdown and even the worst of all worlds, stagflation.

Source: Refinitiv data

2.    Small caps. Market minnows are an excellent indicator of risk appetite - they tend to outperform when investors are bullish and fall faster than the broader market when they are bearish. The UK’s FTSE Small Cap may be setting new highs, but America’s Russell 2000 is not.

Source: Refinitiv data

3.    The transportation indices. The old theory goes that if the transports are not performing, the industrials cannot do so either, as if nothing is being shipped, nothing is being sold. It is therefore of some concern to see America’s Dow Jones Transports brushing up against the buffers. Bullish investors will feel happier if that Transports can start steaming higher once more.

Source: Refinitiv data

4.    Junk bonds. High-yield bonds lie at the riskier end of the fixed-income spectrum as their more pejorative name of ‘junk’ bonds would suggest. The issuers have creaky balance sheets, volatile cash flows or both and they need to pay a higher coupon as a result to attract buyers of the paper. They can trade a bit like equity, such is their risk profile, so bulls of stock markets will be pleased to see the US-listed iShares iBoxx High Yield Corporate Bond ETF performing well, even if it is no longer racking up fresh highs for the tear. This solid showing may be down to the ongoing reach for yield in a low-rates world, but the tracker is not close to going below the $80 level, a move which proved to be a harbinger of wider market volatility in 2008, 2015 and 2020.

Source: Refinitiv data

5.    Volatility. Volatility can be the friend of the investor – it can provide chances to sell stock expensively or buy it cheaply – but history shows that stock indices progress best when they make serene progress and a series of modest gains and tend to fare less well when trading is choppy and there are big swings up and down. At 22, America’s VIX, the so-called ‘fear index,’ stands just above its lifetime average of 19, The reading is creeping up, just as copper, small caps and the transports are creeping down, or at least showing less vim and vigour than they were. This may just be a case of the summertime blues, but it could be a sign that something is about the give the bull equity market its latest test, be it inflation, the pandemic, central bank policy or (every bit as likely) an exogenous event.

Source: Refinitiv data

Russ Mould
Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993, he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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