Equity Downside Risk Dashboard
Atlas Capital Advisors
The Atlas Capital Equity Downside Risk Dashboard provides an indication of the risk of a large general decline in stock prices. The dashboard shows for five indicators the historical percentile of the indicator relative to the period since 1967, as well as the average for the five. A high historical percentile indicates favorable conditions for equity investors, while low percentiles indicate unfavorable conditions. Each indicator on its own has some bearing on the outlook for the stock market, but the combination has more predictive power than any independently. Equity downside risk is elevated when the combined dashboard is below the 35th percentile. Historically, when that was the case, investors would have experienced a higher investment return in cash than in stocks.
Atlas Capital maintains a database of the important economic information for the world’s largest economies. The indicator is the GDP-weighted trend of this data over the prior year. A positive trend in the global economic data (high percentile in our chart) tends to lead to future gains for equity investors. The large and sustained equity bear markets of the past were typically accompanied by a deterioration in global economic data.
This indicator is a composite of the prior year trend in inflation metrics of the fourteen countries for which we track economic data. Sustained increases in inflation (a low percentile on our chart) have typically led to losses for equity investors.
Credit Spread Trend
Credit spreads are the difference between the interest rate paid by non-government borrows and the interest rate paid by the government. Increases in credit spreads (a low percentile on our chart) indicate that investors are becoming more concerned about risk of default by borrowers.
This is a composite of the “price-to-something” metrics for global equities, including the ratio of price to trailing earnings, projected earnings, sales, cash flow and other metrics. Bad Value (a low percentile on this dashboard) is not a reliable signal to exit the stock market, on its own. But the great bear markets in the past usually began when Value was stretched and then economic growth faltered.
This is a measure of how much equity prices have changed over the prior year. A higher increase in stock prices leads to a higher percentile on our chart. Rising prices are an indication of positive sentiment among investors.
The average percentile of the five dashboard items is a more reliable downside risk metric than any single dashboard item. A reading below 35% indicates heightened downside risk.
May 2023 Assessment
We consider average dashboard readings below 35% as indicating heightened downside risk for equity investors. In this cycle, our equity dashboard fell below 35% near the end of 2021 and remained in the danger zone until January 2023. The most important dashboard signal is the first one, the trend in the global economic data, which is slightly negative at present, improving from a historically negative trend in 2022. All of the other dashboard items have moved to neutral readings, other than inflation. Inflation has a favorable positive percentile in our dashboard because the inflation rate has fallen since last year. The overall dashboard average remains in neutral territory. Improved trends in inflation, equity prices and credit spreads were the most important components of the dashboard improvement.
Although the dashboard is no longer signaling high equity downside risk, we believe some caution about the equity market is warranted. The more positive signals from equity price and credit spread movements could be transitory. Interest rate hikes by central bankers and tighter financial conditions as banks reckon with deposit outflows have probably not yet had their full impact on economic growth.