My overly simplistic view of the cycle within stock markets is as follows. For reasonably large periods of time, equity investors behave like a herd and stampede valuations higher across the board. In these synchronized bull markets, most faintly growth-oriented assets push higher consistently, volatility subsides and correlations increase. Call this the positive momentum phase.

Then comes the next phase – the ”what next” phase. In this cautious phase investors are at sixes and sevens. The macro picture looks promising but confused. Investors start to worry about central bankers getting all hawkish, but the data is still relatively benign. In this phase, momentum crumbles, as do correlations. In some phases, small caps outperform, in others large caps.

Then, at some point, an “event” of some form emerges, and a market view crystallizes. At this point then we either re-engage with a bullish forced march or we turn into a darker bearish market where investors build cash and wait for a sharp fall. Sometimes that sharp fall turns into a proper bear market (negative momentum), other times sentiment steadies and we’re back in the “what next2 phase.

Anyway, this long and stupidly simplistic schema is the background to my view that we are currently in phase two, the what next phase. It does not help that the virus is starting to worry investors again. And then there’s the ever-present inflation challenge plus the never-ending debate around what next for the dollar – see below.

Analysts at Deutsche Bank seem to be echoing my simple classification of the stock market with a note out this week which argues we are in a what next phase, with correlations breaking down across the board. According to the banks latest US published investor positioning report:

Large cap US equities have continued to edge higher, but small caps and other regional equities have been moving sideways to down and US equity breadth has also been weakening as less than half of S&P 500 stocks are trading above their 50dma; bond yields have declined most notably, while credit spreads have been going sideways; EM equities have been moving sideways while EM spreads have been widening; within commodities, while oil has continued to creep higher, others like copper have declined. Our measure of cross asset momentum breadth is now just below the middle of the band, reflecting this divergence in price action, a sharp contrast from the extremely positive levels earlier in the year when every asset class was firmly in strong risk-on territory. Cross asset correlations which had turned sharply positive from March to May have also moved back down in the last few weeks and are back to zero, pointing to divergence in returns across asset classes. Bond-equity return correlations in turn are also moving back towards zero after a surge into positive territory which was driven by the focus on inflation”.


In these markets, we should expect stock pickers to outperform the index trackers.

But we are also in the waiting room of investor expectations, with large institutions waiting for an event…or two …to help make up their collective minds.

One canary in the coal mine might be the strength of the US dollar. On this score Charles Ekin of Ekins Guinness claims he has spotted a signal, basing his analysis on the US Dollar Index (DXY*) which is a keenly followed index of the USD versus a basket of currencies.

Our model has been short USD for most of the last year, but recently our currency model has moved overweight the USD (green shading below) against this basket of currencies. A similar bullish USD trend first emerged in April this year as reflationary fears fed into markets. This was accompanied by a rise in US Treasury yields and a move higher in USD. However whereas 10 year US Treasury yields have moved lower again recently (from a March high of 1.74% down to 1.37% now), USD strength has re-emerged.”


In this expectant, hesitant phase two, with the dollar possibly strengthening, we might expect investors to start moving their capital towards traditional low volatility bulwarks, notably quality stocks and businesses.

That may be so but the evidence to date suggests otherwise. Arbrook runs a popular US Equities fund and although they are not a classic quality shop, they do admit to looking for businesses with a strong balance sheet and low gearing as a source of optionality. Unfortunately, the market in recent weeks hasn’t really been listening. The chart below shows “….the relative performance of the most debt-laden companies (quintile 5) and how they have outperformed the least indebted companies (quintile 1) significantly this year after underperforming for several years. What has surprised us is the magnitude has been far greater than during even the Global Financial Crisis when our latency strategy experienced a similar temporary spate of underperformance in the second half of 2009.”

Maybe H2 will be kinder to quality managers?