Assessing Market Risk As Correlations Rise, Valuations Become More Stretched

Leave it to Goldman to come out cautious on equities and overweight cash on a day when stocks rally and turn positive for the month and the Nasdaq 100 hits an all-time record high.

Here’s what the bank had to say on Friday:

“We stay defensive in our asset allocation and keep our Overweight in Cash on a 3-month basis.”

“We remain Neutral Equities on a 3- and 12-month basis. Equities have lagged credit YTD and on a 12-month horizon forecast returns are higher for equities than for credit. We remain Overweight MSCI Asia ex Japan and continue to like HSCEI calls. We still expect ‘fat and flat’ returns for equities this year and, as a result, we stay neutral in our asset allocation. With elevated equity valuations, in part due to the very low level of rates but lack of earnings growth YTD, we believe the potential for a sustained upward trend has been limited and equities are both vulnerable to ‘growth’ and ‘rate’ shocks.”

Right. They’re also apparently “vulnerable” (to the upside) to leaked Trump tapes featuring what, for any other “politician,” would almost certainly be campaign-ending “locker room talk.” As mentioned this morning, Vladimir Putin’s seemingly conciliatory stance on an oil production cut drove strength in energy helping to propel the rally.

Still, Goldman makes some important points that we think have a lot of merit and that we’ve discussed on multiple occasions before. Most importantly, the rising correlation between credit and equities is dangerous. Have a look:

(Chart: Goldman)

And here’s another look at correlations with 10-year USTs versus history:

(Chart: Goldman)

Recall that the soaring correlation between bonds and stocks leaves risk parity strats vulnerable simply because they have nowhere to go when everything is moving in the same direction. That’s what’s forced Ray Dalio to defend the celebrated strategy against charges it exacerbates selloffs.

As the Journal wrote last September after the horrific declines that played out on August 24:

“[Risk parity] managers frequently use leverage, or borrowed money, to amplify their bets, and they determine their allocations to various market subsectors by sophisticated metrics gauging risk, rather than strictly by what they think may rise or fall the most. Managers of these funds often shift their allocations of assets to maintain an equal distribution of risk. But they have drawn public criticism in recent weeks, as some analysts and hedge-fund manager Leon Cooperman of Omega Advisors Inc. blamed firms that employ risk-parity strategies for putting extra pressure on stocks by using automated trading programs that increase the selling of already-beaten-down assets.”

The problem is that central banks have suppressed volatility to unnatural levels. This allows risk parity and vol target strats to increase their exposure materially. Should volatility rebound they’ll be forced to reduce their exposure which has the potential to trigger or at least exacerbate selloffs.

Throw in the fact that multiples are elevated and you’ve a recipe for severe drawdowns:

(Chart: Goldman)

Dissipating political uncertainty should help and should rising oil prices, but there’s certainly a risk that only drives volatility that much lower, thus driving up multiples and exacerbating an already dangerous situation.

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