The market volatility experienced in January has moved our Risk Odometer from +5 last month down to +2 in February. This in turn caused us to move our Current Outlook from “Positive” to “Cautiously Positive”. This will not trigger us to make dramatic investment changes, but it does put on heightened alert.
We find comfort that our longer-term fundamental indicators (Economic Indicators and Earnings) are still showing positive signs. The labor market is strong, credit spreads are tight, interest rates remain low and economic growth is above trend. Company earnings have been strong which also adds to a solid fundamental picture which should support stocks in the long run.
The deterioration in our Outlook is due to technical indicators which turned lower. Technical indicators (Technical Price Action, Breadth, Volatility) often show warning signs before fundamental indicators. This is what we are currently witnessing. Technical indicators are leading indicators, but they also have a higher probability of generating false signals. This is why we monitor both technical and fundamental indicators. Confirming signals are more reliable than unconfirmed ones. We do not ignore unconfirmed signals because they can turn into confirmed signals, but we are slower to react to them.
The recent market volatility was primarily caused by the Federal Reserve’s change in interest rate policy. The Fed is expected to begin raising rates in March to combat higher inflation the economy is experiencing. They are expected to raise them throughout 2022. The Fed has said they intend to eventually raise them to their long-term normal level of 2.5%. How far they actually go and how quickly they get there is what is causing concern with investors.
Our take is that small increases in interest rates should not have a material impact on the economy. Larger and faster rate hikes would have a bigger economic impact. Those impacts, typically, do not appear until repeated hikes have already occurred, and expectations of further hikes are likely. We are not there yet. We think the economy can continue to experience robust growth in the meantime.
Our biggest concern is higher interest rates and its impact on the economy. If Inflation remains well above the desired level for longer than expected, it could cause the Fed to raise rates more aggressively, in turn leading to an economic slowdown. We believe the Fed would be mindful of this potential outcome and wants to avoid it, therefore, it is not our base case. We are mindful of the possibility, though, and will monitor our indicators to help us navigate. We will react to a greater degree if additional indicators confirm the ones we have already witnessed.
Overall, we are “Cautiously Positive” on the markets. We were expecting higher volatility in 2022 but did not know when it would arise. So long as the economy remains strong, which we believe it will, the markets should recover. If further risk warnings surface, we will communicate and react accordingly.
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 our proprietary investment strategies. It is composed of various indicators based on leading economic indicators, earnings, technical price action, breadth and volatility. Its score can range from +5 to -5. Readings greater than 1 are positive and readings less than or equal to zero are negative.