Friday, May 7th, 2021

So, You Want to Buy the Dip

In our last note, we set out some of the indicators that suggest we may be close to a peak in risk appetite. They include the main equity vs fixed income models denominated in both US dollars and euros, US High Yield vs US Treasuries at maximum overweight, Gold vs a balanced portfolio at maximum underweight and cyclical equity sectors at peak exposure relative to defensives in Japan, the UK, and the US. Trying to pinpoint the peak in real time remains as pointless as ever, but the performance of Nasdaq in the last two weeks, after some spectacular earnings from Big Tech, may be another indicator that risk-appetite is peaking.

Almost every client we speak to is hoping for a correction so that they can increase their equity exposure. Hope is a poor basis for prediction, but this could easily become a self-fulfilling prophecy. After the phenomenal performance of the last 12 months, a correction in global equities does not require significant selling pressure. All it needs is an absence of buyers. There will almost certainly be a catalyst, but in our view, this will just give narrative cover to something that was likely to happen anyway.

So, our first recommendation is that investors should welcome the correction when it comes and not overanalyse the reasons for it. They should specify their reaction function in advance. The tactical trigger can be expressed in terms of an absolute level on a broad equity index or as a percentage drawdown from the peak. If you have waited all year for an opportunity to buy the dip, make sure you actually do so when it happens. It also makes sense to do it in stages: say one third of your budget after a 6% drawdown, followed by another at 9% and another at 12%, if we get that far.

Our second recommendation is that investors should be clear about their objectives. Buying the dip is an exercise in market timing. Combining it with a change in your regional allocation within equities will only add complexity to the trade. If you want to reduce your exposure to Emerging Markets and Japan, as we recommend, or increase exposure to Europe, you should be doing that now, irrespective of your view on the possibility of a global correction.

Our third recommendation is that investors should apply the same logic to sector strategy. Reducing exposure to US Small Caps and increasing exposure to Financials does not depend on timing the correction. We are already neutral on US Technology and Consumer Discretionary, two of the sectors which would be most impacted by a correction. If you are still overweight, we think you should reduce this, not because a correction is coming, but because they are already not as risk-efficient as you think. The same logic applies to our views on Technology in Europe and Asia as well.

The only exception to this rule is defensive sectors in the US and Europe. We are currently underweight, but we would expect to increase exposure after a correction because these sectors would become more risk-efficient on a relative basis. However, it seems a pity to wait until after the correction to increase exposure to low beta sectors which would suffer less. If we had to pick one sector where we are prepared to front run our recommendation it would be Telecoms in Europe.

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Friday, April 23rd, 2021

There Will Be A Correction

The normal rules of financial markets can be suspended for a while, but not indefinitely. What goes up must eventually come down. There will come a day when the Fed and even the ECB have to taper, and the impact of a fiscal package as large as the current US proposal will start to fade. The problem for the bears that it could take any awfully long time to arrive; the problem for the bulls is that it could be next week – not in the real economy perhaps – but certainly in the willingness of market participants to keep on discounting these events into the future.

Trying to forecast the timing of these turning points is a fool’s errand. Imagining that one can identify a reason and quantify the potential downside as well is quite literally delusional. All we can do is watch the data and react as soon as we see the problem. There are any number of risk indicators that strategists observe at a time like this. In this note we focus on a few of our favourites, all of which tell a story of risk appetite close to its maximum, if not actually at maximum overweight.

The main dollar-denominated equity versus fixed income model peaked at 96% equity on 19th February. It fell to 74% in early March and has bounced back to 84% at the last reading. This peak is slightly below the average peak for last 25 years, but is clearly within the normal range. There have been occasions when the indicator has reached a peak, then fallen back and regained a level close to 100% (e.g. 2013 and 2017) but it has never done it from a level below 80%. However, we cannot say for definite that this won’t be the first time.

The euro-denominated model is at 98% equity and has been at this level, without any wobble, since the middle of February. The euro model normally lags the US model by about two weeks, but the current episode is more than a timing difference. It must be regarded as a divergence, brought about by a weak euro, which makes overseas equities – particularly the US – more attractive to European investors. However, now that euro has begun to strengthen against the dollar, the two indicators should start to converge again. This probably means that the EUR model has to adjust downwards.

Other indicators tell a similar story. US High Yield vs US Treasuries is at 97% High Yield. Gold vs a portfolio of 50% US Equities and 50% US Treasuries is at 0%. Looking at US equity sectors, the difference between our overweight on cyclicals (including Small Caps) and our underweight on defensives (Staples, Healthcare and Utilities) is 95% vs an average peak reading of 98% over 25 years. Japan is above its average peak and has only posted higher readings in March 2017. The UK has just posted its highest ever reading, Only the Eurozone still has further upside on this measure.

If there were a correction in risk assets next week, we would look at all these indicators and say it was obvious in hindsight. Looking forward in real time, there is nothing to indicate that it has to happen immediately. However, there are two areas where we think that investors ought to de-risk their portfolios now: US Small Caps and Eurozone periphery bonds.

US Small Caps’ most recent peak was at 75% overweight on 19th March. They have a history of putting in a false peak about 2-3 months before the final peak, which is typically 5% higher. However, the decline after the final peak is often very steep and the subsequent trough never happens before we fall into underweight territory. Illiquidity is your friend on the way up, but a terrible enemy on the way down.

The difference between our overweight on Italian bonds and our underweight on German bonds peaked at its highest ever reading of 164% on March 12th. It has since fallen to 89%, as German bunds have rallied and Italian has fallen slightly. Like US Small Caps, it is a bad idea to hang around in this position once the peak has been passed; the trough never happens before the indicator is deep in negative territory.

So far, the implication of this piece is that a correction is something to be avoided, if possible. Almost every client we speak to regards this as a buying opportunity, on the basis that the fiscal and monetary support now in place will continue until well into 2022, at least. We agree with the basic idea, but we want to make two points.

First, there is no point in hanging on to stale bull positions, simply because you don’t want to have any more cash in your portfolio. If you intend to buy the dip, make sure that you have enough cash at your disposal to make a difference.

Second, the correction is unlikely to happen without a proximate cause. There has to be a headline which shakes the cosy consensus and removes investors’ faith in a benign medium-term outlook. If you are determined to buy the dip, please make sure that you have war-gamed the following scenarios amongst others: Russian troops crossing into the Ukraine, China announcing a naval blockade of Taiwan, Japan cancelling the Olympic Games because of a surge Covid cases or a health emergency affecting President Biden. If you are happy with your current portfolio as the jumping-off for addressing these situations, you don’t need to do anything.

If not…

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Friday, March 26th, 2021

To See Ourselves as Others Do

One result of the slow rollout of vaccinations in Europe is that there are far fewer analysts calling for an overweight position in Eurozone equities relative to the US. We were never that convinced by the idea, preferring to concentrate on the UK and, until recently, Emerging Markets. Because of the way we structure our process, we pay almost no attention to valuations, no matter whether they are based on earnings, cashflow, assets or dividends. Hence, we were never seduced by the relative valuation argument.

There are two problems with the valuation argument. Firstly, there were – and still are – plenty of cheap stocks in America. This means that US investors can safely rotate away from growth into value, without crossing the Atlantic –Second, however much we say that investment is a global process, investors cannot easily transfer their equity management process from one region to another. What works in the US does not necessarily work in Europe. A significant shift in equity allocation from the US to Europe requires either a significant increase in in-house expertise or devolving a material part of the portfolio to external managers. These are strategic, not tactical, decisions and require a clear business rationale. This is where Europe, and in particular the Eurozone, has a major problem.

In one sentence, the problem is as follows. Over the last 10 years, there has not been any five-year period when diversifying part of an equity portfolio from the US into the Eurozone index would have provided a superior risk-adjusted return – let alone a superior total return – when compared with 100% exposure to the US. Worse still, there is no five-year period where any systematic approach to dynamic regional allocation would have met either of these two objectives. For the whole of the period, which includes data from 2005-2020, all US investors would have been better off they had had no exposure to the broad Eurozone equity index. This is a truly damning statistic.

The other two large equity regions, Japan and Asia ex Japan, each have one five-year period when a buy and hold strategy would have produced a better risk-adjusted return. If we look at dynamic allocation processes, Japan has produced a superior risk-adjusted return in 9 out of the10 periods, if we follow a risk-averse, mean-reversion strategy – i.e. buy Japan when it has underperformed, but only after demanding an excess return to compensate for higher volatility. In other words, the Japanese index has provided all of the tactical asset allocation opportunities that US investors are supposed to want from the Eurozone.

Eurozone supporters may argue that a 5-year test at the index level is too restrictive and that US investors want to gain exposure to individual sectors where the Eurozone has an advantage and to do so over a shorter time frame. It’s a fair point, so we performed exactly the same test for GICS Level 2 sub-sectors, and we cut the period from five to two years. There are only three sub-sectors (out of 17) where a buy and hold strategy, mixing US and Eurozone groups, would have provided a material improvement in risk-adjusted returns over the last 2 years. They are Utilities, Industrial Manufacturing and Energy. By contrast, there are nine sub-sectors in Asia ex Japan, and eight in Japan, which pass the same test. Approximately 50% of the Japanese and Asian equity markets have offered US investors opportunities for successful diversification, against less than 25% in the Eurozone. If US investors want to invest outside their home market, they are unlikely to come to Europe first.

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Friday, March 12th, 2021

Europe Has Second Thoughts

This is a follow-up to our previous note (The Pandemic Isn’t Over Yet, 26th February) where we noted that the Covid infection rate in the EU was starting to rise. We argued that this would quickly overturn the view that that the long end of the yield curve could rise with hindrance in the US and Europe. Since then, the rise in per capita infections has accelerated in the EU, while it continues to fall in the US. If current trends continue, the European infection rate will be twice that of the US sometime next week.

We don’t think that these trends will continue for very long because they automatically create a behavioural response: accelerated re-opening plans in Texas and other states and more stringent local lockdowns in parts of Italy and France. The point is that the infection rates very quickly feed into economic activity and financial markets. We note that the selling pressure in 10-year US Treasuries has eased significantly, and that the ECB has pledged to increase its monthly purchases of Eurozone government debt. We think there may also be an impact on European earnings estimates, which is our topic this week.

One of our lockdown projects has been to apply our probability approach to consensus earnings estimates, mainly because we wanted to prove that prices are a better indicator of future returns than fundamentals (which they are, but more of that later). However, one by-product of this is that we now have a very detailed data set covering rolling 12-month forward earnings estimates, which we can play around with. We normally calculate the probability that the earnings estimates of a particular industry group will rise faster than those of the index on a risk-adjusted basis, but we can just as easily ask whether they will beat a fixed rate, which we have set at 0% just to keep things simple.

Unsurprisingly, there is currently a 100% probability that the earnings estimates for the index of Europe ex UK, will higher in 12-months’ time than they are now. It was 0% between May and July 2020, after which it started rising in a straight line till it reached 100% in December, where it has stayed ever since. However, when we look at individual industry groups, the picture is not quite so rosy.  The average score for the 45 industry groups we cover is now 81% – down from a high of 90% in mid-February. It’s still a very good score – the average since 2003 is 62% – but it has started falling, either because the estimates for a calendar 2021 are being revised down or because those for 2022 are not being revised up. This would imply that that there is no multiplier effect in Europe as consumers start to spend their nest-egg of involuntary savings – a complete contrast to what is forecast in the USA.

Tracking the average for industries as well as the aggregate score for the index is important for two reasons. First, the average tends to turn before the aggregate. It bottomed at 10% in early May, but had already recovered to 20% in mid-July, which is when the index score first rose above zero. Second, when the difference between the average and the aggregate starts to increase, investors need to be more careful about stock and sector selection.

First the good news, the following industry groups all have a score of 100%: Energy, Materials, Chemicals, Machinery, Electricals, Trucks, Building Products, OEMs, Commercial Services, Transport, Apparel, Autos, Internet Retail, Major Banks, Regional Banks and Semiconductors. There is still a judgment call about whether the current consensus justifies their current prices, but there is universal agreement that the next 12 months will be better than the last.

Now the bad news; the following industry groups have a score of less than 50%, starting with the worst: REITs, Personal Care, Food, Pharmaceuticals, Technology Services, Other Utilities, Telecom Equipment, Healthcare Services. On the balance of probabilities, the next 12 months will be worse than the last 12 months. In addition to these, there are also industries which have seen a very significant reduction in their score since the beginning of the year. They are Telecom Incumbents, General Retail, Candy and Alcoholic Beverages.

In terms of market timing, it is too early to run for the hills. Major European companies will continue to benefit from faster growth in the US and Asia. We have already seen a response from the ECB and further fiscal stimulus should not be ruled out if the European vaccination programme continues to run into difficulties. However, there comes a time when lower estimates for individual industries start to have a cumulative impact on the index as a whole.

In the recovery phase, the gap between the first uptick in the average probability score and index aggregate was about seven weeks. Given that the first serious downtick in the average score came in mid-February, that takes us to the middle of April. This is when European companies will be thinking about what guidance to give for calendar 2021, when they announce their Q1 results. Unless there is a significant improvement in the vaccinations and infections data, many of them will have to revise their guidance down.

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