NN IP: Are markets as calm as they seem?

Another boring week in markets. The world is moving and certainly not less complex than it has been in the past. However, it seems that economic, political and behavioural cross-currents below the surface currently create a rare calmness at the surface of global capital markets. As can be seen in Figure 1, volatility in both equity (VIX) and bond markets (MOVE) has fallen back to around record-low levels. Although some might worry that such calmness represents complacency, it has to be noted that counterbalancing forces of different origin and in time-varying strengths can occasionally fall in place to create such a serene environment. In such a situation it is not homogenous ignorance of ever present uncertainty (in other words, many being complacent), but just a fascinating interaction of the different components in the system that cause stability to emerge temporarily.

It still means that the low-volatility environment will probably fade again at some point, but makes it far less straightforward (than in the complacency case) that this will happen with a bang. If a majority of investors is underestimating future uncertainty, the reconfirmation of its existence can easily escalate in risk-averse herding behaviour and a large market shock. However, if the smoothness of the market surface has emerged on the back of diversified views of investors and widely diverging trends in asset classes, sectors and individual securities, then such a shocking aftermath is less likely. A gradual normalization in overall market volatility might then be a more probable follow-up.

Looking at the behaviour of markets today, it is indeed pretty clear that many different trends remain visible below the surface. Equity and government bond markets might have been relatively steady in their evolution year-to-date, but other asset classes have moved very differently and have also been much more volatile. Both global (listed) real estate and commodities have had very divergent return dynamics than equities and bonds. Moreover, substantial up- and down-cycles have occurred since the start of the year (see Figure 2). Also, within the equity market substantial divergences have been visible between regions, sectors and even individual stocks, as cross-correlations between all these metrics have come down so far this year. Swings in European and emerging market equities have been much bigger than in global equities, while both regions have also substantially outperformed the other regions in the world.

Within equity sectors a large performance differential is visible so far this year. Non-commodity and growth-oriented sectors have done very well. Especially technology (+14% ytd), but also consumer discretionary (+6% ytd) and industrials (+6% ytd) have done substantially better than e.g. financials (flat) and energy (-13% ytd!) which have suffered from flatter yield curves and softer commodity prices.

The strong performance of the technology sector has also created a new worry of complacency, as some have started to compare the bull-run in this sector with the IT-bubble of the late 1990s. Some anecdotes (the Snapchat IPO for example) might look similar, but it remains hard to compare the "old" IT days with current times. Back then, many of the IT companies were not making profits and were priced for explosive future profit growth. Now the tech sector is making hefty profits and is trading in line with market valuations and at best somewhat at the upper end of its valuation range of the last decade. To show the difference with the late 1990s, Figure 3 compares the evolution of the price/earnings (PE) ratio of the tech sector today (in orange) with the PE of 18 years ago (in purple). Not only were tech PEs much higher on average in the 1990's, but they also accelerated exponentially in the last two years of the bubble (1998-2000). Basically, the unsustainable IT bubble only really started to blow up after the notorious rescue of the LTCM hedge fund in the autumn of 1998 (translating into substantial Fed rate cuts), while having traded at higher PE levels than seen today for at least another 2 years.

So yes, technology stocks have done very well recently and their valuation is higher than seen in recent years. But no, the complacency of tech investors today is not (yet) comparable to what happened during the IT bubble in the 1990s. Profits are far better and increasing while valuations are in line with the broader market today and much lower than two decades ago.