This is the August 2015 investment conditions report. It includes both a written version and audio commentary.
Listen To The August 2015 Investment Conditions Audio Commentary
The audio commentary is an integral part of the Investment Conditions report as it provides additional context to the written report.
This commentary is 17 minutes.
August 2015 Investment Conditions
Favorable investment conditions can be thought of as favorable weather. Just as you don’t launch a sail boat when heavy storms are likely, there are favorable investing conditions when the sun is shining and there is a tailwind that raises the likelihood of positive portfolio returns.
Monitoring investment conditions is helpful for scaling exposure to risky assets such as stocks as favorable investment conditions generally align with positive investment returns while unfavorable investment conditions have generally been associated with sub-par investment returns.
In this report, investment conditions are segmented into three areas:
- Market valuations – measure how inexpensive or pricey the global stock market is.
- Market internals – measure market trends and momentum and the level fear and greed exhibited by investors.
- Economic and central bank trends – measure the anticipated direction of the economy based on purchaser managers indices (“PMI”) and how accommodating central banks are in terms of their interest rate policies.
Market valuations, market internals and economic and central bank trends can be thought of as traffic stoplights that are each individually flashing red, green or yellow.
When all three are red as they were in early 2008, that warrants extreme caution and a more conservative investment approach.
When all three are green as they were in late 2009 coming out of the Great Recession, then that provides an opportunity to increase portfolio risk and generate higher returns.
Currently, all three investment conditions are yellow for the reasons described below.
Investment Conditions Are Neutral (Yellow)
Investment conditions remain neutral as of early August 2015. Global equity valuations as measured by the MSCI All Country World Index remain near their twenty year averages, although the U.S. market continues to be overvalued.
Shorter-term market trends rebounded a bit in July but are consistent with a neutral rating for market internals as indicated by global momentum and sentiment data.
Some measures of U.S. market internals deteriorated in July but most remain in neutral territory, but given the U.S. market is overvalued, the risk of a sell-off is above average if internals deteriorate further.
On the economic front, evidence from monthly Purchasing Manager Indices data suggests the global economic expansion continues albeit at its slow to moderate pace.
Valuations, market internals and economic and central bank trends all rated YELLOW. This suggests investors should keep their exposure to stocks in line with their long-term target allocation.
This is a change from the recommendation for the December through May period when the recommendation was to be overweight stocks relative to your long-term target. Investment conditions are now less favorable than they were earlier this year.
It is important to recognize stock markets are part of a complex adaptive system which means unexpected market sell-offs can occur irrespective of investment conditions.
Investors should never have such a large allocation to stocks that their lifestyle or retirement plans would be seriously undermined due to unexpected severe market losses.
You can get more detail on my current allocation and holdings on my Portfolio Profile page.
The remainder of the report provides an overview of market returns and more detail regarding market valuations, market internals and economic and central bank trends.
Global stock markets were mixed in July. While the MSCI All Country World Index posted a 0.9% gain led by a rebound in developed markets, emerging markets sold off sharply for the month and are now negative year-to-date.
MSCI All Country World Index Returns For the Periods Ending July 31, 2015
60% of the countries (i.e. 28 out of 46) that comprise the MSCI All Country World Index posted a positive total return for the month in local currency terms.
74% of the countries (i.e. 34 out of 46) that comprise the MSCI All Country World Index achieved positive returns year-to-date in local currency terms.
Hungary is the best performing market year-to-date, gaining 42% while Greece is the worst performer declining 19%.
Bond Market Returns
U.S. and European interest rates declined in July allowing those regions to post solid bond returns for the month.
The Barclays Multiverse and Global Aggregate Indices, a measure of global bond performance, were also positive for the month.
Both global bond indices remain in negative territory year-to-date on an unhedged basis in U.S. dollar terms due to the strength of the dollar year-to-date.
The following provides an overview of bond market returns.
Fixed Income Returns For the Periods Ending July 31, 2015
In the U.S., non-investment grade spreads over Treasuries widened during the month leading to losses for the high yield bond sector. U.S. high yield bonds are now yielding close to 7%.
Market Valuations – YELLOW
Global stock market valuations remain in line with their twenty year average as measured by the earnings yield for the MSCI ACWI Index. As of August 1, 2015, the ACWI earnings yield was 5.3%.
The sell-off in emerging markets during July improved valuations as reflected in the earnings yield for the MSCI Emerging Market Index, which ended the month with an earnings yield of 7.4%. The exception is Latin America which saw its valuations increase during the month despite the market sell-off.
Valuations in the U.S. remain lofty with both earnings yields and cyclically-adjusted price-to-earnings ratios above average.
The following table provides an overview of valuations for various regions and select countries. The higher the yield in terms of earnings and dividends, the more attractive the valuation.
Valuations as of August 1, 2015
Market Internals – YELLOW
Market valuations are helpful in assessing the long-term potential for stocks, but they are not particularly useful in determining market direction in the short to intermediate time frames.
Markets can stay overvalued for long periods of time and investors can leave a lot of money on the table if they rely exclusively on asset class valuations to determine their investment strategy.
Market internals, on the other hand, when combined with market valuations are useful for determining stock market performance over shorter time periods.
Market internals include market trends (i.e. its direction), momentum (i.e. the velocity of change) and sentiment (the level of fear and greed).
Short-term global market trends improved in at the beginning of August with 50% of global stock markets above their 50 day moving average compared to 9% at the beginning of July.
Markets remain choppy.
When more than 50% of global stock markets are above their 50 day moving average the MSCI AC World Index has returned 11.0% per annum versus -13.2% per annum when more than 50% of global stock markets are below their 50 day moving average.
59% of global stock markets are above their 200 day moving average compared with 52% at the beginning of July.
63% of stock markets have rising 200 day moving averages down from 74% at the beginning of July. That is the lowest percentage since 2012 indicating trends have deteriorated somewhat. to 76% in May and 67% in April.
The MSCI All Country World Index level remains just over 1% above its 200 day moving average.
The intermediate to longer-term uptrend remains in place as evidenced by the percentage of markets above their 200 day moving averages and those with rising 200 day moving averages.
Trends measure the direction of stock markets while momentum measures the rate of change—are stock climbing or falling at an increasing or decreasing rate. Currently, global momentum is neutral.
A number of U.S. equity market internals deteriorated in July which is a cause for concern given the above average valuations for U.S. stocks. For example, the trading volume of stocks falling has exceeded the trading volume climbing for the first time since late 2012.
Most U.S. momentum, sentiment and trend indicators remain in neutral territory but U.S. market internals are certainly less healthy than they were a year ago.
Economic and Central Bank Trends – YELLOW
The most robust data set for understanding global economic growth trends is Purchaser Manager Indices (PMIs), which are monthly surveys of businesses conducted by Markit and other providers.
There are both Manufacturing and Services PMI surveys conducted each month. Generally, a reading above 50 suggests an economy is expanding while a reading below 50 suggests an economy is contracting.
This report focuses on Manufacturing PMIs as they have a longer and more accurate history of predicting global recessions.
The following table provides an overview of global PMI as well as select region and countries.
PMI Data As of August 1, 2015
The JPM Global PMI composite index continues to hover slightly below its long-term average of 51.4 as it has for several months. As of the end of July, the Global PMI was 51.0, the same level it was the previous month.
The Global PMI has been in expansion territory (i.e. above a reading of 50) for 32 months.
The number of countries in expansion mode with PMI’s above 50 reached is 66% down from 71% last month.
55% of countries posted a positive monthly change in PMI and 45% of countries show a positive year-over-year change in PMI. Both are improvements over last month.
Emerging markets remains weak in terms of their economic outlook with PMI below 50 on a regional basis.
Central banks remain accommodative throughout the world.
All three segments of investment conditions are rated YELLOW, suggesting a neutral outlook on the stock market and that investors should keep their allocation to higher risk, more volatile assets such as stocks consistent with their long-term target allocation.
Sources: Markit, MSCI, Ned Davis Research and ISM