The increased volatility in the markets since January 29 has caused many investors to reconsider the current market risk. While volume remains high, the reality that fundamental financial health of companies could make more of a difference has caused many investors to seek other investment solutions, primarily debt in emerging markets. While not indicative of a coming crash, certain metrics of the US equity markets should be considered in a risk assessment. The S&P 500’s consolidated Quick Ratio (measure of companies’ ability to pay short-term debt) has narrowed to 0.31, down from 0.74 at the end of 2017. Working capital has had similar declines to about half of what it was at the end of last year. Company leverage has decreased (an improvement) as long-term debt has been paid down. This accounts for the decline in working capital and quick ratio as CFOs have started to paydown long-term debt ahead of rising interest rates; however, this has come with a rise in current liabilities. Overall, the S&P 500 remains on the weaker side of its historical averages for most financial ratios. This speaks to the weak recovery of the last 9 years. Stock market highs mask the underlying financial issues still experienced by companies. A combination of low interest rates and financial engineering have helped bring equity markets to new highs, but have done less to shore up the underpinnings that could help companies weather the next recession. The low debt to equity ratio and the high interest rate coverage ratio are positives, but this could quickly change as interest rates rise. Another risk is falling Price Earnings (PE) ratios. This occurs as interest rates rise and earnings contract. The historical range for the S&P 500 has been in the 10-20 range, but we haven’t seen a PE below 13 since 1989. Since 1990, we’ve seen average PE ratios over 20 more than under 20. This trend followed the drop of interest rates and the rise in technology stocks as a dominate sector. With interest rates rising and tech companies becoming larger and more mature, the trend may start to settle back down to a lower PE average. Unless earnings increase to offset this, companies will be challenged to keep prices at current levels. Given investment flows migrating offshore and the headwinds facing US equity markets, investors should understand the risks of maintaining a long-only portfolio. Absolute return strategies, like those employed by Stone Toro, become increasingly attractive when market risks rise. Additionally, increased volatility gives these strategies more opportunities to harvest gains from price movements.
Friday’s jitters over rising interest rates continue to press down on markets that seem determined to regain previous highs. At the March 16 close, the S&P 500 rose 0.17% for the day to 2,752.01, down 1.27% for the week. The MSCI AWCI remained flat for the day ending at 522.474, down 0.57% for the week. Fixed Income was down for the day with AGG dropping 0.05% and treasuries declining as the 10-year rate rose 3 bps to 2.85%. Over the past week, the 2-10 treasury spread narrowed by 9 bps as investors consider the risk of recession from the Federal Reserve increasing interest rates in 2018.