2020 | February Risk Odometer

We have moved our Current Outlook down one notch, from “Positive” to “Cautiously Positive”. Although the coronavirus has caused volatility and fear to start the year, this is not the reason for the downgrade in the outlook. The downgrade was caused by something much more concerning…weakening fundamental indicators.

The coronavirus, the respiratory virus originated in China, is scary. At the time of this writing, it has infected over 20,000 people with a death toll of over 400. The numbers continue to climb every day. The World Health Organization has declared it a medical emergency, and there is no known cure yet. News of the disease has created a classic “risk-off” episode in the markets, whereby investors sell stocks and buy safe-haven assets such as treasury bonds. The economic effects are not known yet but it will surely impact global GDP data.

The outcome of the coronavirus is a major uncertainty and markets hate uncertainty. Looking at historical instances of global disease outbreaks and other unforeseen economic casualties, markets have typically responded in a ‘V’ shaped pattern, meaning they take a quick, hard loss but recover quickly in a ‘V’ shaped pattern. The outcome this time is, by no means, a certainty, but history can give us a good guide to building probabilities. My guess is the short-term hit to economic activity will result in pent-up demand that will fuel a recovery.

The real cause for the downgrade to the Outlook is the deterioration of our fundamental indicators, Leading Economic Indicators and Earnings. Our Earnings signal, which had been positive for four years turned negative last month. It has been upgraded to neutral this month due to some better than expected earnings reports last quarter. Sitting on an inflection point, it can easily move to either positive or negative, not something it has done in four years.

This month, our Leading Economic Indicators signal turned negative for the first time in 8 years. The lagged effects of the trade war with China have continued to pile up and we are now seeing this in the deterioration of the data. Most economists are discounting the recent weakness given the improvement in the trade war (signing of Phase I). The Fed is on the same bandwagon, calling the recent weakness a “mid-cycle slowdown”, insinuating stronger growth lies ahead. Economic data is backward-looking but objective. For the first time in a long time, it is sending warning signals. This is the major cause for the downgrade in the Outlook.

Personally, I agree with the temporary slowdown argument. Unemployment rates remain low and inflation is not a problem. I believe the current administration will do everything in its power to keep the economy strong and the markets high to improve its reelection chances. Our technical indicators (Price Action, Breadth and Volatility) are all still positive and the stock market continues to trade near all-time highs. This is offsetting the weakness in fundamental indicators. Nevertheless, the current administration cannot control everything, and some fundamental warning signals are present, hence the small downgrade to our Outlook to “Cautiously Positive”.

As always, we continue to believe our Risk Odometer provides guidance in making better investment decisions because it keeps us objective and disciplined. We use this methodology and advise our clients to do the same. Emotions are our enemies in investing.

It is important to understand that our Risk Odometer is not designed to anticipate small to medium corrections, typically those in the 5-15% range. Instead, it monitors for conditions which have typically preceded larger corrections. We believe trying to anticipate small to medium corrections sounds attractive but more often results in lost opportunity than savings.

The Equity Market Risk Odometer is our guide for judging risk in the equity market. It is used as a guide for investment decisions in The Core Equity Strategy. It is composed of various indicators based on leading economic indicators, earnings, technical price action, breadth, volatility, sentiment and reportable positions from the Commodities Futures Trading Commission. Its score can range from +7 to -7. Readings greater than 1 are positive and readings less than or equal to zero are negative.

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