Intech: Markets Tipping to Extremes

 In Market and Investment Insights

Key Takeaways

  • Based on Intech’s fourth quarter Equity Market Stress Monitor report, five major market indexes are sitting on the extreme ends of major risk indicators.
  • When key market indicators diverge significantly from their historic norms, it’s an indication of market stress – and the potential for increased volatility.
  • The next year could be marked by asymmetric risk: Incremental gains in asset prices are probable, but they are likely to be smaller in magnitude than the low probability, but significant, negative tail event should volatility return.

Old habits die hard; true in life but also in markets, which eventually revert to the mean.

As of the end of the fourth quarter, five of the major market indexes – including the Standard & Poor’s 500 and MSCI World – deviated from their typical levels on three out of five key equity-market risk metrics: correlation of returns, dispersion of returns, and index efficiency. The MSCI Europe Index has all five of its equity-risk metrics at extreme values – indicating that it is one of the most ‘stressed’ indexes.

This suggests that the next year could be marked by asymmetric risk: Incremental gains in asset prices are probable, but they are likely to be smaller in magnitude.

While there are times when markets will deviate from their usual patterns, they eventually revert to their old ways. Depending on the severity of the diversion, the move back can be abrupt and dramatic – and accompanied by substantial volatility.

Intech has been observing and applying the relationship between risk and market stability for decades. Rather than rely solely on backward-facing measures, such as standard deviation, investors can monitor market stability, or lack thereof, by noting where an index’s risk sits relative to its historic norms.

For all five metrics, the normal range is 40% to 60%. Anything higher or lower signals potential market instability, with extremes in the tails (i.e., less than 20% or more than 80%) indicating greater risk.

Take capital concentration, which measures how capital is distributed among stocks in an index. For the S&P 500, the largest 50 stocks typically account for half of the index capitalization. When large-cap concentration exceeds that, it suggests a bubble is potentially looming. But too little concentration isn’t good either; it’s indicative of excessive groupthink among smaller stocks. (As of the end of December, three of the five major indexes were still near the typical range, but the MSCI EAFE and MSCI Europe tilted toward smaller-cap stocks.)

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Recently, all five indexes exhibited an extremely low correlation of returns, which is to say that the idiosyncratic traits of stocks are driving returns more so than they have historically. This has been good for active managers, who have a better shot beating the market when correlations are low. Yet, it’s also reason for investors to be wary, as the trend could reverse if volatility increases.

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Today’s markets are also marked by unusually low dispersion of returns for all five indexes; in other words, stock returns relative to the benchmark are converging. So while active managers may have an easier time spotting winners and losers (because of low correlations) they need to take incrementally more risk to achieve excess returns (because of low dispersion).

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To gauge market risk at the portfolio level, Intech tracks index efficiency. This proprietary indicator looks at how much beta (market exposure) is required to construct an efficient portfolio (outperforming the index with less risk) by owning a selection of index constituents. A year ago, the S&P 500 hovered near its historic norm for this indicator, but it and other major indexes have since swung toward extreme beta levels. That means managers need to take on more beta risk in order to achieve above-market returns.

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Historically, investors react to unexpected negative news with more urgency than they do positive surprises. Changes in this pattern, as measured by the skewness of returns, indicate whether the market is abnormally bearish or bullish. From the perspective of risk management, both extremes can be problematic. Not surprisingly, the five major indexes are currently tilted toward bullishness, with the MSCI Europe approaching exuberance, and the S&P 500 in the right tail of extreme bullishness.

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Seeing Risk from All Angles

No single metric tells the whole story. When combined, however, they create a mosaic of market risk. When more indicators veer from the norm – and this pattern unfolds across global indexes – it’s reason for investors to take note.

Looking across major indexes, the picture is one of suppressed global equity risk today, but many risk indicators monitored by Intech are diverging significantly from their average historical levels, and that intensifies the likelihood of greater volatility down the road.


Learn more about Intech’s equity-market risk metrics and analysis by downloading the full report here.

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