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Five ways to test markets’ temperature as summer draws to a close

by LLB Reporter
30th Aug 22 11:02 am

Fed chair Jay Powell’s refusal to pivot on monetary policy, and failure to dangle the prospect of interest rate cuts in 2023, is leaving markets with a late case of summertime blues.

Investors must now decide whether the strong rally in stock markets since June is the beginning of a new upward surge or simply a wicked bear trap that will lure the unwary into suffering fresh portfolio pain. Following five easy-to-follow indicators may be able to help them gauge which way the wind is blowing as autumn approaches and, at the moment, all five look delicately poised.

As the dust settles following Jay Powell’s Jackson Hole speech on Friday, AJ Bell investment director Russ Mould comments on the end-of-summer outlook for investors, highlighting five ways that may help to assess the direction of travel into the autumn.

Dr Copper: The industrial metal is so called because its malleability, ductility and use in everything from cars to housing to domestic appliances make it a great barometer for global economic health. Copper’s one-third plunge to barely $7,000 a tonne from north of $10,000 this summer fits with the view that a recession is coming, but the metal is now back above $8,000. Further gains would help to reaffirm investors’ faith in the equity market rally (although it could also warn of stagflation), while further weakness would stoke fears of an economic slowdown and a recession.

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 and AIM indices are among the worst performing global indices in 2022 and America’s Russell 2000 is still in bear market territory, even after a 14% gain from its June nadir.

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 may therefore be of some relief to bulls that America’s Dow Jones Transports is 10% above its lows, but if that benchmark starts to lose steam once more then there could be trouble ahead.

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 want to see the US-listed iShares iBoxx High Yield Corporate Bond ETF perform well. The bad news is the tracker is trading below $80 level. Prior dives below that threshold signalled wider market volatility in 2008, 2015, 2020 and early 2022 so a recovery here is a matter of some urgency.

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, tending to fare less well when trading is choppy and there are big swings up and down. America’s VIX, the so-called ‘fear index,’ stands modestly above its lifetime average of 19. That suggests sentiment is slightly bearish, especially as the reading is moving higher in the wake of Mr Powell’s speech in Wyoming. Perversely, that is probably a good thing for stocks, and it fits neatly with the advancing copper price and the rallies in small caps and transport stocks.

“However, junk bonds’ struggles may suggest that something could yet test the latest risk-asset rally. After all, markets are often at their most dangerous just when making money looks easiest and the gloss is coming off the narrative of a near-term central bank policy pivot. During the summer, that story helped markets ignore lofty inflation, weak economic data, plunging consumer confidence, the withdrawal of monetary stimulus, absence of fiscal stimulus and elevated geopolitical tensions in Eastern Europe, the Middle East and South-East Asia.

“Bulls will counter these are no longer ‘news’ items as they dominate the front pages of the mainstream press, let alone the financial sections, every day.

“Equally, bears will assert that the farrago involving Bed Bath and Beyond, the launch of a leveraged, single-stock exchange-traded fund (ETF) that tracks the share price of Tesla and a renewed surge in meme stocks such as AMC do not feel like the sort of activity that usually calls a market bottom.”

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