Markets are complicated. Simplify and keep it REAL. Here is how…
REAL is a practical and simple to follow risk-on/risk-off framework to monitor market conditions. REAL is an acronym to monitor changes in Rates, Earnings breadth, Availability of credit, and Liquidity waves. Consider this a dimmer, not an on-off switch. When most components are worsening, be fearful. Vice versa, when most components are improving, be greedy.
Let’s dive in.
Rates: A practical risk-free rate is the 10-year U.S. treasury. As the 10-year goes up, future cash flows are worth less and vice versa. Higher rates make big-ticket purchases less affordable. After a meteoric rise, the rate of interest rate rise has slowed. However, the high absolute levels of rates are a headwind and likely to slow economic activity over the coming months. NEGATIVE
Chart 1 - Nominal and Real U.S. 10 Year Treasury Yield
Source – JP Morgan
Earnings Breadth: When earnings for a wide range and breadth of companies in disparate industries are rising, economic and market expansion has momentum. After bottoming late last year, earnings revisions are positive and revision breadth is improving. The number of companies and industries where earnings are improving is also rising. This is a positive development and suggests the market advance is durable. POSITIVE
Chart 2 - S&P Earnings Breadth
Source – Morgan Stanley
Availability of Credit: Credit is the grease that keeps the economic wheel turning. As economic uncertainty rises, banks reduce the amount they lend, and charge higher rates. Individuals and businesses with lower credit scores find it harder to get loans. Similarly, investors demand an above-average compensation to own risky investments. This is reflected in rising credit spreads or rising cost of money (see chart 3). The higher spread eventually cascades all the way to every corner of the market, regardless of the underlying quality, and compresses the valuation of all assets. When credit becomes scarce, the grease dries, the economic wheel stops turning, and markets fall.
Credit spreads peaked late last year (chart 3) and have continued to drop – despite bank troubles. This is a positive development and indicates credit is more freely available compared to 2022 and the cost of high-risk loans has fallen. POSITIVE
Chart 3 – Credit Spreads
Source – Federal Reserve of St. Louis
Liquidity waves: Liquidity moves markets. When the Fed provides liquidity via Quantitative Easing, investors rush in and take risk. Equity market goes up. When the Fed stops, the opposite happens. In 2022, liquidity contracted at the fastest rate in history. Now, while liquidity is still negative (chart 4), we are improving from deeply negative levels and conditions are ‘less bad’. On an absolute basis, liquidity is well above pre-covid levels. NEUTRAL
Chart 4 - Liquidity
Source – Canaccord Genuity
Two out of the four components of the REAL framework are positive and improving, one is negative, and another neutral. Remember, this is a dimmer, not an on-off switch. When most components are worsening, be fearful. When most components are improving, be greedy.
Today, with more positives than negatives, the REAL framework reflects fundamental improvement.
Markets are complicated. Simplify and keep it real.
I am an investor and these are my personal thoughts on investing, behavioral finance, markets, and sports viewed through the prism of a Latticework