Sooner or later a market downturn will arrive – here’s how to spot it first

Predicting the next downturn has always been a popular sport in the investment world. Over the past nine years, however, it’s one that has left egg on a lot of faces. For all the economic and political turbulence of the post-financial crisis years, and the umpteen occasions on which a sharp correction looked all but inevitable, we’re now deep into the eighth year of a bull market.

The interim period hasn’t been smooth – not by a long shot. We’ve had the ongoing fallout from the financial crisis, multiple terrorist atrocities, the eurozone crisis, three UK general elections, the EU referendum and the rise of Donald Trump to the White House.

There have been several market sell-offs since then, of course, including a fall in January 2016 that was technically a correction but was too swift to be classed as a bear market.

But predictions of a crash have been confounded time and again by a bull market that has often looked distinctly precarious. Much of this is down to the macro environment, with the rise of central bank programmes such as quantitative easing (QE), which has inflated asset prices and distorted the markets’ cycle.

Indeed, a downturn looked as though it was on the cards during the ‘taper tantrum’ in 2013, when indications that central banks would tighten their monetary policies caused sharp losses in both stock and bond markets. But that didn’t materialise, adding to the long list of recent occasions on which surefire predictions of a downturn have proved wide of the mark.

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Yet investment houses – and, increasingly, private investors – have access to vast amounts of information with which to work out when markets can be expected to take a tumble. Data such as GDP growth, employment, trade balances, credit spreads, industrial capacity, yield curves, financial asset prices and even sentiment indicators are among those used to highlight the current stage of the cycle and provide a clue as to where the next turbulence may come from.

Economic stages

By ‘cycle’, we refer to the broad stages of peak, recession, trough and recovery (or expansion). Identifying each stage can be straightforward enough. The problem often lies in working out how long it will last, when it will end and what will follow it. No two business cycles are identical and phenomena such as double-dip recessions mean they aren’t even always sequential.

One of the best-known tools is the Investment Clock developed on the back of research by Trevor Greetham, head of multi-asset at Royal London (see diagram). The clock offers a visual guide to the correlation between business cycle and asset behaviour.

‘When global growth is strong and unemployment rates are falling, we are in the top half of the clock, where stocks and commodities tend to do well, along with credit markets and cyclical equity sectors like technology,’ he explains. ‘When inflation is falling, we are on the left hand side where financial assets, including government bonds, do well, along with interest rate-sensitive sectors of the market such as the consumer discretionary sector.’

Investment managers tend to have their own favoured and tested indicators. Patrick Schotanus, investment strategist at Kames Capital, says it is ‘impossible to determine from forecasts which variables work best’ in highlighting the maturity of any cycle. He looks in particular at yield curves, macro indicators such as purchasing managers index (PMI) surveys, and indicators from capital markets, including the relative performance of different assets and styles as well as equity valuations.

The Kames strategists, like those of most fund firms, also use their own proprietary indicators. They are among several fund houses with an investment clock, which they employ in harness with a cycle allocator. Both attempt to assess in what phase of the cycle we are: recession (early), reflation, recovery, or overheat (late).

‘The clock uses macroeconomic data, the cycle allocator market data. Among other things, [using them in conjunction] allows us to see the difference between where the economy suggests we are in the cycle and where the markets tell us we are,’ says Schotanus.

Ben Lofthouse, manager of the Henderson International Income Trust, also favours a select set of indicators that he has found useful in determining asset allocations. He looks in particular at three measures – valuations, monetary policy and the bond yield curve. The latter indicator particularly concerns the spread between 10-year and two-year durations.

Given that bonds tend to be more in demand (and yields therefore tend to fall) when the economic environment is more challenging, history suggests that when the long end of the yield curve (10 years) is lower than the short end (two years), the market is anticipating a downturn in growth.

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‘In the current environment this indicator is perhaps the most problematic, due to very low prevailing rates, some of which are negative, and the bond-buying programmes of central banks,’ says Lofthouse.

There is of course a danger in relying on the wrong indicators, or reading them inaccurately. Some of the most widely used data may be irrelevant or even out-of-date, for example.

Over-reliance on US data

‘The most common indicators quoted relate to the US, mainly due to the large number of available data sets over long periods of time – but I think this reliance risks dating forecasters, because China has such a large influence on the world economy now,’ says Lofthouse.

Reading too much into political developments is a particularly common pitfall. While events such as elections can trigger short-term volatility, recent history suggests their impact on stock markets is rarely lasting.

‘Geopolitical “crises” are poor indicators,’ according to Alan Steel, chairman of Alan Steel Asset Management. ‘Ned Davis Research developed a list of all such crises back to 1900, noting the instant knee-jerk reactions in the stock markets. They then tracked index performance three, six and nine months later – and found the mean/ median results are positive.’ In other words, while indicators that can help to identifying signs of a downturn are numerous and often of enormous value to investors, they can also be unreliable or misleading.

‘In over a decade in the industry I have seen more downturns called than I can remember, and more indicators cited than I care to mention,’ says Lofthouse. ‘In summary, it is very hard to predict a market sell-off with any accuracy, so perhaps the best one can do is avoid the worst excesses of the cycle (bad businesses on high valuations), and retain some capacity to invest more when a downturn does come.’

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