Dolan: Markets At A 'Significant' Turning Point

This article was originally published here.

Strategic Outlook Summary

• Early-year volatility has given way to significant rebounds in risk assets (stocks & commodities). Global central banks stepped up efforts to support domestic economies and investors realized the world was not going to end and valuations looked attractive.
• Our global outlook has not changed materially since the start of the year, though on balance the risks have increased to the downside. We continue to expect a volatile, back-and-forth evolution to risk markets and continue to favor a pro-active investing approach: buying risk assets on weakness and taking profit/reducing exposure on gains.
• Markets appear to be at a significant turning point and we would currently be extremely protective of any gains from risk-longs established at lower levels. We would also look to pro-actively reduce exposure on current and remaining strength, maintaining a core position of risk-long exposure.
• We look for a near-term reversal of recent gains as another opportunity to re-enter long-risk positions at lower levels in coming months. We anticipate that expected market downside volatility will once again give way to more opportunistic investing and more optimistic outcomes.

Global Economic Outlook

Following a weak 4Q and a disappointing 1Q, the global outlook remains exceptionally tenuous. In its World Economic Outlook released April 12, the International Monetary Fund (IMF) cut its forecast for world output by 0.2% to 3.2% (prior 3.4% and down from 3.6% six months ago), perilously close to the 3.0% level that is considered the threshold for a global recession.

While bleak on its face, the IMF forecasts do not represent a materially significant downgrade from expectations that were in place at the beginning of the year. And to the extent that the IMF has arguably been behind the curve in marking down global economic performance over the last year, they may simply be catching up to the market’s current reality. That said, the IMF’s views are not to be discounted lightly.

For our view, this means the risks to the global outlook remain biased to the downside, though our baseline scenario is for more of the same: muddling through on the backs of consumers in a very-low interest rate environment. (See the chart below for the latest IMF global growth projections.)

IMF World Economic Outlook-April 2016

Source: IMF, World Economic Outlook, April 2016

Market Outlook

Asset Allocation Strategy—Stay Pro-active: Our overall asset allocation view remains unchanged from January, namely that continued extremely-low global interest rates will favor stocks over bonds for the remainder of the year. Extreme volatility at the start of the year certainly challenged that view, with stocks losing ground early and bonds benefitting from investors seeking safety.

At the same time, we suggested a more pro-active, tactical investing approach to take advantage of expected market swings. Such an approach worked well in 1Q, where buying stocks on weakness, especially Emerging Market (EM) shares, has borne fruit. Markets are now at a significant inflection point, where stock rebounds may begin to falter, and risk sentiment may yet again weaken, potentially leading to another bout of downside volatility.

Overall, we would continue to favor a pro-active, tactical approach to markets, expecting further cyclical, back-and-forth price action. Given the balance of risks facing the global outlook, we still don’t anticipate a sustained trend, one way or the other. Instead we look for further choppy, short-term price action and favor taking profit on strength, and buying on weakness.

Developed Market (DM) Stocks: Extreme weakness at the start of the year has largely reversed overall, and pro-active buying on that weakness may have yielded gains for investors following such a strategy. The question now is whether those gains will continue. Obviously we cannot say for sure, so we would now suggest being equally pro-active in defending those gains, using both stop loss orders to mitigate downside risk and seeking to realize partial gains on current and remaining strength.

Reducing exposure in the current rebound can allow investors to subsequently take advantage of downside pullbacks, re-entering similar long positions at lower costs, while maintaining a core long-exposure in case markets continue directly higher.

In terms of the technical analysis outlook, the near-term picture is at a significant inflection point. The MSCI All-World Index (DM & EM stocks) has now achieved the measured move objective for the double bottom pattern formed in Jan/Feb as seen below.

Source: Bloomberg; DriveWealth

The trend indicator ADX (white line in bottom panel) is not in ‘trending’ territory, and the stochastics reading (middle panel) is not confirming recent new price highs, suggesting recent gains may reverse. Conversely, continued strength may inspire further gains, turning the momentum study higher and sending the ADX into a ‘trending’ condition—hence our observation that markets are at a critical turning point.

Given the balance of risks facing the global economy, and the recent return of P/E valuations to recent stall levels (around 19 for the S&P 500), we are hard pressed to make the case for further direct gains in stock markets. Instead, we would look for a medium term (several weeks-two months) top to develop in stock indexes, potentially moving into a sideways consolidation, but more likely relapsing lower before stabilizing again.

As the year progresses, we are cautiously optimistic that the global environment will improve and corporate profits will stabilize. Interest rates will remain exceptionally low for the next year at least. For those reasons we seek to maintain a core long exposure to global stocks, even while navigating the short-term volatility. We only hope that Jan/Feb weakness is not the only opportunity to buy-on-dips this year.