Mind the skew – stocks may not yet have peaked

Mind the skew – stocks may not yet have peaked

09-01-2020 | 月次アウトルック
A curious skew in historical stock returns means global equities may have some upside left, says strategist Peter van der Welle.
  • Peter van der Welle
    van der Welle
    Strategist Global Macro team

Speed read

  • MSCI World Index rose 30% in 2019, so can the rally last?
  • Research shows a skew where strong years are repeated
  • Potential bear capitulation helps but headwinds include Iran

Some investors fear that the current bull market cannot possibly last, as a slew of new geopolitical issues led by a potential war with Iran and the threat of an overdue recession may eventually put the brake on stock market records.

However, research shows that a year of stellar returns – the MSCI World Index rose 30% in 2019 – is often repeated in the following year, due to a number of positive factors. This means 2020 could prove to be just as successful for stocks, despite the headwinds.

“Geopolitical uncertainty has been given new impetus with the killing of Iranian General Qasem Soleimani,” says Van der Welle, a strategist with Robeco’s Global Macro multi-asset team. “Meanwhile, the prospects of a Phase One trade deal between the US and China, and a subsequent recovery in the global manufacturing sector, look fully priced in.”


Haven’t seen the highs yet

“But our base case remains that we haven’t yet seen the highs in the equity market for this bull run. As we have argued in recent months, we expect a recovery in earnings around Q2 2020. In the meantime, dovish central banks are providing support to compensate for a delayed recovery in fundamentals.”

“Bull markets typically die because euphoria is eventually stymied by central bank overtightening. While we see pockets of exuberance, central banks appear unwilling to take the proverbial punchbowl away. Although inflation could prove to be a market risk in the second half of 2020, it is unlikely to reverse the rising tide for risky assets just yet.”

A significant reason to be optimistic is ‘the skew’ – a phenomenon seen in stock markets going back to 1900. Global equities have on average posted annual returns of 8% since then. But the historical return distribution is highly skewed; returns of more than 20% in a calendar year have occurred 20% of the time since the turn of the 20th century.

The frequency of what global equities have returned each year since 1900.

The cluster effect

“Interestingly, lopsided positive returns tend to cluster,” Van der Welle says. “Of those 24 years since 1900 with returns in excess of 20%, high returns were generated in subsequent years. For instance, 1921 (a 27.5% return) was followed by a 27.7% return in 1922, and the 36.1% return seen in 1985 was followed by a 38.2% return in 1986.”

“Moreover, the years with clustered equity returns of above 20% had a common feature: the year preceding the cluster was typically negative for the stock market, with 1927 being the only exception. For instance, 1920 saw a loss of 26.8%, while 1984 was a flattish year, falling 0.1%.”

“In general, looking at all those periods that had a combination of a year with returns that were below the historical average (not just outright negative equity returns) followed by a stellar +20% year, we had an average return in the second year of 14.5%.”

“So, given that we have recorded a performance of more than 20% in 2019, and this was preceded by a below historical average return year in 2018, the 30.0% return for the MSCI World was not exceptional; it is close to the average recorded since 1900. Moreover, it can’t be ruled out that 2020 could be another year of returns above the historical average.”

Will history rhyme?

Will history therefore rhyme again in 2020 and generate another double-digit performance year, as the historical track record suggests in this situation? “We must be cautious here, as the number of observations is rather small and does not allow for rigorous inferences,” warns Van der Welle.

“Nevertheless, the presence of skew underpins our base case that we will likely see new stock market highs before a global recession enters the stage. By nature, investors are keen to tilt their portfolios towards assets that have upside risk and a subsequent asymmetric pay-off. As a result, investors want to pay a premium for assets with upside risk (positive skew).”

“Upside risk materialized as a result of the large sell-off we witnessed back in Q4 2018. Clearly, in 2019 investors were willing to pay for upside risk, evidenced by the fact that multiple expansion generated the bulk of the total equity return. It might seem at this stage that the market has got ahead of itself but, like in 1921, it was a year in which the losses of the previous year were largely recouped.”

Don’t forget the fundamentals

Investors should also factor in more routine metrics such as valuation, fundamentals and sentiment indicators, Van der Welle says. “First, from a relative valuation perspective, the global equity risk premium is still above historical averages, and the case for European and Japanese equities from an equity risk premium perspective is even stronger,” he explains.

“Second, from a sentiment angle, positioning is still unproblematic. US retail investors and hedge funds have become less bearish; the recent bumper year for stocks has potentially maximized the fear of missing out among this investor segment and beyond. Further capitulation by the bears could propel equities higher into 2020.”

“That’s not to say that another year of strong returns is guaranteed. Risks to our bullish base case scenario are the fact that US equity markets look richly priced, and geopolitical risk is potentially no longer ebbing, as we had expected going into 2020.”

“The recent negative surprise in the ISM manufacturing index, which dropped back to 47.2, indicating contraction, already hints that reflation into 2020 is unlikely to be smooth. Therefore, high expectations regarding a recovery in fundamentals could be tested further in the near term.”


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