Risk Appetite Returns, But Will It Last?

Broad indices are back in positive territory for the year, as investor sentiment turns to risk-on. Earnings season has gotten off to a good start. So far, with 10% of S&P 500 companies reporting, 88% have beaten earnings estimates and 84% have out-paced revenue expectations. Both figures are above the 5-year average for earnings and revenue. The VIX volatility index has declined 38% in the last two weeks, which is the 7th largest volatility crash in history. What typically happens next? The S&P 500 forward returns have been positive 1 year later 87% of the time with an average return of 17.2%. The Nasdaq Composite Index has been higher for 12 consecutive trading days. The S&P 500 Index has gained more than 9% over the last 10 days. Both are rare occurrences and point to higher returns moving forward.  The change in risk appetite is visible across several key metrics. The High Yield Spread Index, which measures High Yield bond yields versus safer Treasury yields, has dropped to the same level as February 20th, before the conflict in the Middle East began. Stocks making new lows on the New York Stock Exchange is down below 50, which is seen as a low risk environment. The number of stocks on the S&P 500 trading above their respective 200-day moving average is back up to 61%, which hadn't been the case since the beginning of March. The move in equities off their lows has been the strongest since 1982. As long as the conflict in the Middle East does not spiral further, the rest of the year could prove a strong year for equities.  There's a nice setup for equity markets to continue running, but, per usual, there's the occasional weekend dustup in the Middle East to deal with on a Monday. Markets look to open lower this morning as Iran suddenly declared the Strait of Hormuz closed and fired on Indian ships passing through the Strait. The U.S. intercepted one of the Iranian ships and tensions are now elevated. Most retail investors are still bearish, despite the recovery. Risk appetite among retail investors, as measured by flows into leveraged US equity ETFs, is at an 18-year low. In addition, the AAII's survey showed that the week ending April 30th was a 1-year bearish high allocation of more than 59% in the negative market view camp. This coincides with the decline in leveraged ETF appetite that the backdrop for continued positive returns in equities remains healthy.  Despite the higher inflation reading from a couple of weeks ago, the bond market is signaling a cooling of inflation. The 1-year spread between nominal Treasury Yields and real yields on Inflation-linked Treasuries has plummeted over the last week from 5.3% to 3.5%. The year-over-year CPI reading for March was +3.3%, just under the historical CPI average of 3.5%. If the 1-year breakeven is correct, we should see the April year-over-year reading come in at 3.5-3.6%. After the start of the conflict, oil reached a 4-year high of $112/barrel. However, since tensions have eased, oil had retreated 20% back down to $93/barrel. We could see another move higher in oil following this weekend's activities, but any pause or final resolution in the conflict could bring the price of gas at the pump lower. A decline of inflation in the May reading could put rate cuts by the Fed back on the table. Get ready for more temporary shocks to equities as the conflict in the Middle East reaches its 7th week, but stay invested as forward returns are likely to be higher in the coming months.

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