Friday, January 15th, 2021

Three Ideas from the US Senate

There has been no shortage of political news since the New Year, and not all of it is noise. The change of control in the US Senate has lasting importance and there are already three sectors where we can identify an impact: two where something happened and one where it didn’t.

The first sector is Energy, where the Saudis announced a unilateral cut in crude oil production of one million barrels a day effective from February. The reason given was the acceleration in the second wave of Covid, but this doesn’t explain why the Saudi’s wanted to surprise the market. The Russians refused anything more than a token cut arguing that the rise in prices would just suck in more supply from US fracking producers, as has normally been the case.

The Saudi announcement came on January 5th, by which time opinion polls were giving the Democrats a consistent 2-4% point lead in both races for the US Senate in Georgia. Maybe the Saudis would have made the cut anyway, but maybe they took a view that the Democrats would introduce more stringent controls on fracking if they won control of all three branches of the US Government. These would almost certainly reduce the availability of finance to marginal producers. The combination of the production cut and Democrat control is a lot more powerful than either one on its own, which explains the explosive rally in the sector.

Last week also marks the date when Facebook finally lost the argument about content control and censorship and data usage. It’s not just Facebook under the microscope, but the whole of social media industry, including the web services business of Amazon. The Capitol riot is obviously a big part of this story, but the threat of increased regulation – and possibly even the partial break-up of Facebook and Google – would be little more than hot air if the Republicans still controlled the Senate. Our recommended weight for the Communications sector has just hit a two-year low. Worse still, there is on obvious support in the neutral zone. At the current rate of progress, the sector will be downgraded to underweight sometime this quarter.

The third sector is Healthcare and this is the one where nothing happened, which is a surprise. Democrat control of all three branches of government should make it much easier to impose greater price regulation on the big pharmaceutical companies and attempt wider reform of the US Healthcare system. Certainly, the fear of a Blue Wave was one of the reasons given for the underperformance of the sector in the run-up to the main elections. Our rating went from overweight in late June to underweight in mid-November. Yet, in the very week when the Blue Wave finally comes ashore, the Healthcare sector staged its first significant rally in our model since the election.

Maybe this was all fully discounted already, but perhaps there is more interesting explanation. Maybe investors think that the Democrats can take on Big Tech or Big Pharma, but they can’t do both at the same time. They tried and failed with Big Pharma last time round, while Big Tech is now bigger and its abuses are more egregious and more topical. It is too early to argue that the recent support level has definitely held, but we should know in the next month. If it does, we may see Healthcare rally as sharply as it sold off in the second half of 2020.

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Friday, December 11th, 2020

Two Big Ideas for 2021

This is our last strategy note of the year, so we want to highlight two themes which we think will be important during 2021, or at least the early part of it.  Both ideas are supported by well-developed trends, with high-conviction lead indicators, which give us confidence that they may have a longer shelf-life than the standard 6-8 week horizon we cite for our process. They are:

  • Underweight US Equities in a global equity portfolio
  • Overweight Small Caps, mainly in Europe, but also the US.

Following several conversations with clients, the first idea is clearly more controversial than the second. Almost all of them seem to bear the scars of a previous period when they went underweight US Equities and got burned. We sympathise with their pain, but the simple truth is that we haven’t shared it. For the last ten years, our process has had a significant overweight on US equities. The average for the ten years from January 2011 to date is 30% and there was only one period, from May to November 2017, when we had an extended underweight.

Every year, a selection of strategists run with this idea, some of them perma-bears, some of them not, but for the last ten years, it is has never included us. That doesn’t necessarily mean that we are going to be right in 2021, but at least we haven’t made the same mistake year after year. When we have made this call, in previous periods, we have generally got it right. For the ten years from 2001-10, we had an average underweight of 13% and there were six periods of more than six months when we had a significant underweight – sometimes down to -75%. If we reduce our model to a binary choice between US and non-US equities, it has outperformed its benchmark by an average of 0.8% p.a. over the last 25 years, with a marginal increase in risk and no extended period of underperformance.

The model’s current recommendation is an underweight of -18%. Technically, this is still in neutral territory, so this note is more of a warm-up than a definitive call, but the view has suddenly deteriorated over the last month and we are now close to our two-year low. The lead indicator has also switched from stable to deteriorating and the quality of the signal has increased from no conviction to just below high-conviction. Stepping back from the detail, we have no difficulty in reconciling this change with the global rotation away from growth towards value and with forecasts for a weaker dollar. Our model was also underweight US equities in the recovery from the last two recessions – from May to November 2009 and from July 2003 to May 2005 (including a few weeks in neutral territory).

Our second idea is really simple. If you believe that the global economy is going to recover in 2021 and that the rotation towards value will continue, you should increase your exposure to Small Caps. Other parts of the equity universe may respond better to a recovery and others may do better from the rotation, but few will do as well from both. There is a sequencing problem in trying to play these themes purely via sector selection. Will Financials outperform before Energy? Can banks continue to outperform if yield curves don’t steepen. Is it sensible to be overweight Energy and Materials at the same time? If commodity prices start to rise, is it necessary to take profits from Industrials? What definition of value do you use to capture the recovery potential of the hospitality sector? Should we fund these positions via a big underweight in defensives like Consumer Staples and Telecom or from Technology? Is Healthcare already oversold?

All these questions drop away when investors commit to a broad exposure to Small Caps funded by a reduction in large caps, spread pro-rata across all sectors.

We have recently moved to overweight in European Small Caps and we expect to upgrade in the US in the very near future. In both regions we have high-conviction, improving lead indicators. Both charts are challenging long-term downtrends which have been in place since early 2017. This may require some short-term consolidation in January, but if they break these downtrends, there is the potential for the recommended weight of Small Caps to challenge its all-time high later in the year. For Europe, this would imply an overweight of 80%, versus 70% for the US. Just like the underweight in US Equities, the previous recoveries in 2003-04 and 2009 also featured a substantial overweight in Small Caps in both regions.

In conclusion: these ideas are not forecasts. They are just extrapolations of how we expect our process to behave. If it doesn’t behave like this, we will tell you. If we are right, we will do our best to keep you in the trade and to tell you when it is about to stop working.

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Friday, November 27th, 2020

How the World Turns

In our last report, we explained how we looked at the topic of sector rotation within equities, using three metrics:

  • Rotation: the gross total change in recommended sector weights resulting from our weekly rebalancing. We quote this as a four-week moving average (MAV);
  • Inflection: the point at which the 10-week MAV of the sector’s recommended weight (equivalent to 50 days) moves from a positive to a negative gradient or vice versa;
  • Persistence: the tendency for sectors maintain their position relative to other sectors; specifically, the number of consecutive weeks a sector spends in the top or bottom three of our recommendations.

This report is a survey of what’s happening on the ground in real time, and perhaps more importantly, what isn’t happening or hasn’t happened yet. The bandwagon of style rotation is starting to roll very fast, which carries its own set of risks. The last report focussed on the US and Pan Europe, so this one spends more time on the other regions, Japan, China, the UK and the Eurozone.

Inflection points: By definition, this is a lagging indicator, but it highlights the point that there many occasions when a sector looks as though it may change direction, but doesn’t. Using our models, there are only five regional sectors where we can identify an inflection point within the last four weeks. They are UK Financials from down to up, Japanese Consumer Services and Utilities from down to up, US and China Consumer Discretionary from up to down. There are another four where the signal is likely to change in the next four weeks: Chinese Energy and Financials from flat to up, UK Energy and Consumer Goods from flat to up. Other candidates, like Eurozone Financials, may well turn up in the near future, but the inflection point in the 10-week MAV is unlikely to happen before next year.

Most of the inflection points on the downside, particularly in Healthcare, Technology and Utilities, actually happened in September and October in our models, so we are slightly puzzled as to why everyone else has just woken up to them. The previous wave of upward inflection points for Industrials and Small Caps in certain regions happened in July and August and is old news as far as we are concerned. A cynic might suspect that many strategists missed the rotation in its sector form and have rebadged it in terms of style and factors, some three months later.

Rotation: It should be obvious that each region will rotate at different speeds. By far the most aggressive rotation is in the UK, which has benefitted from at least four bits of good news in the last month: the Bank of England’s guidance that it will not use negative interest rates, the resulting strength of sterling, increased likelihood of a Brexit deal and the vaccine from AstraZeneca. The gross overall change recommended by our models is 75%, compared with 64% for the Eurozone and an average of 43% for the other three regions. US, China and Japan. These numbers look high, but our models are unconstrained by any formal exposure limits, so the impact on client portfolios would be much lower.

The sectors most affected by rotation also vary from country to country. The biggest losers in the last four weeks are as follows: Consumer Discretionary in the US and China, Telecom in Japan, Technology in the UK and Eurozone. The only inflection points in the last four weeks are for US and Chinese Consumer Discretionary. The biggest gainers are Financials in the UK and the Eurozone, Small Caps in the US, Consumer Discretionary in Japan and Energy in China. Here the inflection points tend to be more recent, or still in the future, as in the case of Eurozone Financials.

We can also identify the sectors in each region which have changed the least of the last four weeks: US Energy, UK Industrials, Eurozone Telecom, Japanese Energy and Chinese Financials. This is an interesting list because it contains many companies which would naturally fall into the value category. At the very least, it suggests that future returns attributed to the value factor will not be uniformly distributed within the value universe. In other words, the value trade will work in some sectors, but not in others.

Summarising on a global sector basis: the biggest losers over the last four weeks have been Technology and Healthcare. The biggest winners have been Financials and Small Caps. The smallest movers have been Materials and Telecom. Health and Technology have been reduced in every region, but there are no sectors where there has been an increase in every region. But there are narrow misses for Financials, which have four up moves (excluding a small down move in China) and Japan (excluding Energy).

Persistence: This is a measure of how much has stayed the same at the top and bottom of the rankings for each country. This is a non-story. No region has had more than one new entrant into the top and bottom three over the last four weeks. For instance, US Technology is still in the top three. We are confident that it will drop out soon, but we made that call back in October. Most of the action has been sectors which are in the middle of the table. Our list of small movers includes several country sectors, which are in the bottom three and likely to remain there for some time to come.

Action recommendations: We agree with some of the consensus view on rotation. We are reducing exposure to Technology in every region, as well as its fellow traveller Consumer Discretionary in the US and China. Reducing exposure to Healthcare is equally important, even though in some regions the valuation is not excessive. We agree with the move to increase exposure to Financials, especially in the UK and Eurozone, but we are still reducing an underweight rather than building an overweight. We are happy to reduce the underweight in Energy, but a move to neutral would require the oil price to back to $55/bbl and stay there. If it doesn’t, the rally will fail. We agree with the move into Small Caps in the US and all of Europe, but not Japan or China, where there are better opportunities in Consumer Good/Staples, neither of which score well on a traditional value screen.

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Friday, November 13th, 2020

Rotation, Inflection & Persistence

There have been a lot of rather breathless articles, proclaiming this week as the start of a great rotation within equities. The factors cited range from the standard momentum and value categories, to some which are altogether more exotic. We have no wish to deny the validity of these calculations, but they need to be interpreted with a degree of scepticism. There is always a factor which can be identified as having had a significant influence on a particular period of stock market activity on an ex-post basis.

However, this begs three important questions. First, is it reasonable to manage your portfolio, exclusively or largely on the basis of this factor? Second, can the interaction between the behaviour of this factor and events in the real world be predicted with a reasonable level of certainty/accuracy? Third, is the factor stable in the sense that once it turns, it carries on in the same direction for long enough to allow investors to exploit it? If the answer to any of these questions is no, investors should retain their scepticism.

We will discuss these issues on a sector basis, partly because all our work can be resolved down to three factors – momentum, minimum volatility and yield – and partly because the results will show up pretty quickly at a sector level if they are significant. We use three metrics, rotation, inflection and persistence, defined as follows:

  • Rotation: the gross total change in recommended sector weights resulting from our weekly rebalancing. We quote this as a four-week moving average (MAV);
  • Inflection: the point at which the 10-week MAV of the sector’s recommended weight (equivalent to 50 days) moves from a positive to a negative gradient or vice versa;
  • Persistence: the tendency for sectors maintain their position relative to other sectors; specifically, the number of consecutive weeks a sector spends in the top or bottom three of our recommendations.

Rotation in Europe: The biggest ever spike was recorded in April 2020, as the portfolio adapted to the sudden onset of COVID-19. It was bigger even than the spike in September 2008 during the GFC. Since then, the level of rotation has been extremely low, which the longest continuous number of readings in the bottom decile. There was a small spike in the last week of October and no doubt there will be another one this week, but we would still need several more big weeks to get back to the 25-year average.

Rotation in the US: There was a big spike in March 2020, but it was not as big as the ones in August 2011, September 2001 or October 1998. Since then, this metric recorded its 25-year low in July and has consistently been in the bottom decile since. There has been a noticeable uptick in the last two weeks, but these are both below average on a weekly basis. So, there will be an increase in rotation in the US, mainly because it couldn’t get much lower. We still have a long way to go to get back to the average.

Inflection in Europe: There are only three sectors in Europe where we have observed a significant inflection point in the last three months. They are Materials, from positive to negative, in November (i.e. now), Consumer Discretionary, from negative to positive, in October and Technology, from positive to negative, in September. Sectors like Industrials and Small Caps, which are suddenly attracting a lot of interest, changed from negative to positive in June. Others like Financials, Energy and Telecom, show no sign of shifting to a positive gradient and remain in the bottom three.

Inflection in the US: There are only two US sectors which have changed direction in the last three months: Technology, from positive to negative, in September and Utilities, from negative to positive, in October. Consumer Discretionary (i.e. Amazon) may be on the turn. The 10-week MAV has stopped going up, but it hasn’t actually gone down, even the though current weekly reading is below it. Communications turned down in early August but the current reading is above the MAV, which means we have a slightly mixed signal. There is no sign of a change in the bottom two: Energy and Financials.

Persistence in Europe: The current readings for the top three are a lot lower than the for the bottom three. The average for the top three (Materials, Industrials, Utilities) is 10.7 weeks vs 45.0 for the bottom three (Energy, Financials, Telecom). This is consistent with a well-established pattern, which shows that laggards remain laggards for longer than leaders remain leaders. The 25-year average is 13 weeks for the top three vs 17 weeks for the bottom. Tech dropped out of the top three two weeks ago, after a run of 39 weeks, but Energy is still in the bottom three after 76. The highest ever score for the bottom three was 47 weeks and it looks as though we will shortly break that record.

Persistence in the US: We see the same skew towards downside persistence as we do in Europe, only not quite as pronounced – 16 weeks vs 19 weeks. Technology is still in the top three after a run of 86 weeks, which means that the average score for the top three (including Consumer Discretionary and Materials) is 39.0 weeks, but this is still lower than the score of 48.0 for the bottom three (Energy, Financials and Utilities). As in Europe, we are close to breaking the 25-year record for downside persistence, which stands at 53 weeks.

Conclusions:

  • An extended period of stability in terms of sector recommendations is coming to an end, but the level of rotation is still well below its long-run average, so there is no need to panic or to get bounced into a series of trades on the basis of factors you don’t understand.
  • We think that the rotation will be from the top to the middle and vice versa. So far, we see no indication that the long run underperformance of Energy and Financials in the US and Energy, Financials and Telecom in Europe is coming to end. There will be exceptions – possibly UK Banks, if the Bank of England continues to avoid negative interest rates and all bets on the Energy sector are off, if oil goes to $60/bbl and stays there.
  • The inflection point in Technology in both regions happened in September, long before the US elections or the vaccine announcement. The impact of the factors which are attracting so much commentary now was identified by our process two months ago.

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