Friday, May 29th, 2020

Re-Configuring the S&P Sectors

If someone were designing the S&P 500 today, they would not produce an index where the largest single sector accounted for almost 27% of market capitalisation and was over 10x the size of the smallest. Nor would they allow a situation where the bottom three sectors (excluding REITs) were only just larger than the smallest of the remaining sectors. Even after the removal of Alphabet and Facebook, Technology is 10x the market capitalisation of Materials and almost twice as large as Healthcare, the second ranked sector. Energy is now just 3.0% and Utilities are 3.2%. Some of these extreme differences may unwind as the economy returns to normal after the pandemic, but this was already a problem before the virus struck. Eventually, there will have to be major changes and we may as well start thinking about them.

First, the Technology sector will have to be split. We think there should be a new Software and IT Services sector and that the rest of the Technology sector be renamed Hardware and Equipment. Second, Materials, Utilities and Energy need to be combined with other sectors. We would put Materials with Industrials and Energy with Utilities. All this can be done without changing any of the industry categories which the S&P currently uses, thereby retaining full backwards compatibility. The third change is not so important, but we would also clean up the Healthcare sector, by taking Care Providers out and putting them into Consumer Staples. The resulting index would have 10 sectors instead of the current 11. Excluding REITs, the weight of the other nine sectors would range from 6.0% (Utilities and Energy) to 14.7% (Software and Services). Apart from these outliers, the weight of the other sectors would range between 10.1% and 12.0% of the index.

It all sounds very technical and abstract – the sort of thing that quants obsess about – but there is a real point to this. Under the current system, it is very difficult to get a sector-based model to outperform, hence the current fashion for factor-based investing. We have no problem with factors, but a good classification system would naturally group together companies with similar characteristics and separate those with different ones. Hardware and semiconductors are fundamentally different businesses from software and IT services. They outperform at different stages of the cycle. Energy and Utilities will increasingly be dominated by the impact of environmental legislation and parts of these two industries will probably merge or overlap over the medium term.

The second reason for rearranging the sectors is that risk control is more effective and simpler when dealing with nine or ten sectors of broadly equal size. Sophisticated investors don’t need this help, but retail investors (and their advisers) do. If they don’t understand how the US market is structured – and the reason why – there is a danger that their portfolios will be poorly diversified. Alternatively, they may be pressured into buying complicated and expensive investment products that they really don’t understand.

The third reason for doing this, is that it works. Over the last five years, the S&P has generated a total return of 155%, compared with 162% generated by our risk-adjusted momentum process, using the current sector definitions. The same process using the new definitions would have produced 174%, equivalent to annual outperformance of 2.5% vs 0.9%. This comes with slightly higher volatility and slightly bigger maximum drawdown, but the Sharp ratio is 0.63 vs 0.53 for the index. Well-designed sectors make portfolio management easier and the potential rewards are worth the short-term dislocation.

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Friday, May 15th, 2020

No Read Across in EM

Like many other commentators, we are becoming more concerned about the situation in EM Sovereign Bonds, but our reasoning is significantly different. The conventional bear case is straightforward: the pandemic recession will wipe out at least one year’s worth of growth; the slowdown in the US will crimp their export earnings and this will be worse if the country is reliant on oil exports; the strength of the dollar will make those debts more expensive to service as their own currencies depreciate. We don’t disagree with any of this, but while this is a good top-level analysis of what is happening in Latin America and the frontier markets of Africa, it is less applicable to the rest of EMEA and most of Asia.

It would be foolish to dismiss the risk of default, but for many frontier markets China is the largest single external creditor, ahead of official agencies and US private sector bank / bond funds. Imposing harsh penalties for dollar-denominated defaults will only drive these countries further towards China, which is not what the US State Department wants. The borrowers may not want to go there, but they know it is a useful negotiating card. All in all, we still think that a well-diversified portfolio, such as the main ETF, will provide a better total return over the next 2-3 years, than a US domestic portfolio of equivalent credit quality.

However, in the short-term there is one critical difference: The Federal Reserve is not going to buy the dollar-denominated obligations of a foreign government. As of this week, it has begun buying Investment Grade bonds issued by US domestic borrowers and there is already speculation that, if the situation gets really bad, it may even extend to High Yield. But in our view, buying EM bonds will always be a step too far. The medium-term total return may be superior, but the short-term downside is definitely worse. For this reason, we expect our model to downgrade EM Bonds to underweight in the near future.

So, does this mean we should also move to an underweight in EM Equities? We don’t think so. The main reason is that the big weights in the EM equity index come from Asia, not Latin America, especially now that China is partially included. Many of these countries run current account surpluses, which may even grow because they are net-oil importers. They also dealt with the pandemic earlier and more effectively than the US or Europe, so the hit to their domestic economies has been smaller. There is a chance that GDP in these countries may be back to its previous peak by the end of 2021, whereas for Europe and the US, this date is probably 2022 at the earliest.

The formal logic of our process highlights an important point. The realised volatility of the EM Equity index is now materially lower than any other region – not just in local currency, not just relative to its own history – but in absolute US dollar terms. Investors appear to believe that investing in EM Equities is less risky than the US at the moment. Of course, the market may be wrong, but the evidence suggests that Asian governments and banks have been more effective at containing the virus and its economic side-effects. The read-across from bonds to equities may work in Latin America and frontier markets, but investors should be careful before they treat Taiwan or China like Brazil or Mexico.

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Friday, May 1st, 2020

No Crystal Ball

Without a crystal ball, we cannot know whether there will be a second and deadlier wave of the pandemic later this year, or whether this crisis has left us more vulnerable to one of the major geo-political or financial risks that we thought we had contained. It may be that we recover from the virus only to realise that too much damage has been done to the global economy to allow any hope of a quick recovery, that earnings multiples for 2022 are too high, and that the equity market will have to refinance the balance sheet of the entire corporate sector.

There is no point in trying to forecast all of this. It is much better to rely on the stock market’s role as an indicator of sentiment – a forward-looking aggregation of future risk and return, with its own internal and sometimes mistaken logic. Our probability models have been doing this successfully for the last 15 years of live-running. We outperform on a risk-adjusted basis and in absolute terms, and are still doing so. However, the speed of recent moves has led us to introduce a new version of the model, which looks at daily – not weekly data. The reason is that central banks round the world are far more proactive than they were, when we started. Apart from the change in time-period, everything else is the same.

As of 30th April, the US equity / bond model suggests that we ought to have an 65% weight in US equities with 35% in US 7-10 year Treasuries. The simple model does not hold cash and is not allowed to play the yield curve. All we want is something which will tell us what to do with our exposure to equity risk in real-time. It is a trading view; it is absolutely not a strategic asset allocation tool. The question is whether we should be adding or reducing; so, we place as much emphasis on whether the indicator is rising, falling or trending sideways and whether is above or below its short-term moving average (MAV).

Here, we run into a problem because if we show output as a simple probability, we get a long series of zero-percent weights in equities, followed by a gradual improvement from zero to 5% and then a sudden acceleration as we get through a level around 10%. It is potentially misleading to put an MAV through this data, if they are constrained by a zero-boundary. However, we can change the way we display the results by recasting the output as the difference between the current run-rate of equity returns and the risk-efficient hurdle rate, all divided by the realised volatility of the equity index: (run-rate minus hurdle) / equity volatility. The underlying calculations are exactly the same, but the display is different. Everything is measured in standard deviations, not percentage probabilities.

If we look at the evolution of this signal since the beginning of this year, we find that it was at a high level in early January but that it fell decisively below its 20-day MAV on 24th January, when the S&P 500 closed at 3,295, just short of its eventual high of 3,386 on February 19th. The message was that investors should stop buying, even if they were happy to hold. On 21st February, when the S&P closed at 3,338. the indicator fell decisively below zero and was also significantly below its MAV, which was the signal to start selling. By the time the index fell below 3,000, on 6th March, the signal was at -2.90 and 1.49 below its MAV. The primary signal remained negative until 29th April, but it moved decisively above its MAV on 24th March, when the index closed at 2,447. At the very least, this was the signal to stop selling, even if investors were too shell-shocked to start buying.

So, where do we go from here? There are three similar episodes we can look at – the summer of 2008, between the collapse of Bear Stearns and the onset of the Lehman crisis, the early part of 2002, after 9/11 but before the US decided to invade Iraq, and the summer of 1998 as the Russian debt crisis morphed into the LTCM crisis.

In 2008, the primary signal was deeply negative and below its MAV in mid-March, just before JP Morgan rescued Bear Stearns. On 1st April, it decisively overtook its MAV and then rose to a peak of about 1.50 in mid-May. The primary signal dropped below zero in early June and remained negative for the rest of the year. It was above its MAV between July 22nd and September 4th. An investor who followed this signal would have bought at 1,351 and sold at 1,236 – a loss of 9% – but would have been out of equities long before the major collapse, which started on September 29th.

In 2002, the primary signal peaked at 1.14 in late March. The narrative at the time was that the Fed and OPEC had combined to flood the world with liquidity and oil and that the US was coming out of recession. It dropped below zero on 12th April 2002, having been well below its MAV for the previous five days, as it become apparent that the US was going to retaliate against Iraq. Though there were rallies, the signal remained below zero through till October, when there were hopes – subsequently disappointed – that diplomatic efforts could avoid conflict.

In 1998, the primary signal rose to 1.63 in late July, as investors hoped that the Asian debt crisis and the Russian devaluation were behind them. As it became apparent that the collapse of Long Term Capital Management was unavoidable, the signal fell below zero on 31st July and bottomed at -3.02 in early September, as Alan Greenspan cut interest rates dramatically.

Conclusions: The average of these three episodes suggests that the primary signal will hit a local peak at about 1.40, compared with the current reading of 0.38 (30th April 2020). At the current rate of progress, it will take another 10 trading days to get there. If the index is going to get back to its previous high, the peak in the signal will have to be higher and later. Based on these numbers, our view is that there will be a period of significant resistance and tactical profit-taking as the index approaches this level. We do not think that it will regain its previous high at the first attempt.

What happens next is unforecastable, but we will be able to observe and react in real-time., An investor who had followed the equity weighting recommended by the primary signal would have outperformed a 50/50 control portfolio by an average of 10.8% over the three periods covered by this analysis. The average volatility was 420bps lower and the drawdown in each case was about half of that suffered by the control portfolio. In the current crisis, the model has outperformed by 5.4% so far, for volatility that is 750 bps lower and a drawdown which is less than a third of that suffered by the benchmark.

Daily models are available for the other major markets: Japan; UK; Eurozone and China. Apart from China, the recent signals have been very like those generated by the US model. The outperformance statistics are also similar.

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Friday, April 17th, 2020

Income in Dollars, Please

This note is intended for our European clients. It would never really occur to US investors to take their income in any other currency. The yield on their government bonds is still higher than most other developed markets and they have many other domestic fixed income options. Even when they lend to foreign issuers in order to get a better spread, they have no need to step away from their own currency,

Eurozone investors are not so lucky. The yield on most of their host government bonds is miniscule, if not actually negative. The spread over Bunds is often unstable, and while this may throw up trading opportunities, it is not helpful when it comes to planning an income. Unlike the US, corporate investment grade issuance is too concentrated in the Financials sector. The main reason for ultra-low yields on government bonds has been the balance sheet weakness of the Eurozone banks, and these low yields also explain the banks’ poor earnings power. If investors try to stay in euros and diversify away from core-Eurozone government bonds, they end up exposed to over-indebted governments or thinly-capitalised financial institutions – or both. There are simply not enough non-financial, investment grade credits.

Many euro-denominated investors are reluctant to buy dollar-denominated debt without hedging the currency exposure, which frequently removes almost all of the yield pick-up. We have always argued against this strategy, believing that there is enough liquidity to allow investors to move in and out of US dollar fixed income based its total return in euros, but we accept that this is still regarded as unorthodox. Even with a hedge, we believe it makes sense to increase exposure to dollar-denominated credit. Our two preferred options are US Treasuries – at the medium to long end of the curve – and EM sovereign bonds, provided they are bought as part of a portfolio in order reduce the country specific risk.

Nobody knows what solution the governments of the eurozone will agree in order to restore financial stability to Italy and the rest of the periphery, However, uncertainty during negotiations may give rise to some nasty tail-risks, which a prudent investor should avoid, if at all possible. If those negotiations go badly wrong, there may be significant dislocation in European credit markets and an extended period of currency weakness. Owning dollar-denominated bonds in these circumstances would be a crucial risk reduction strategy.

Investors who have already done this trade should also look at their equity portfolio and consider the source currency of their dividend yield. Healthcare is the obvious sector with high dollar earnings and some pharma companies already pay their dividend in dollars. Energy is the other industry where this practice is commonplace. We have been very negative on the sector for most of the last two years, but it is hard to believe that crude oil prices can fall much lower. If the oil majors maintain their dividend this year, they will do it in future. Unlike banks, there is no regulator with the power to prevent them from paying one. There is always a trade-off between the security of the yield and the currency in which it is earned or paid.  This year, it may be better to own a riskier dividend, paid in a safer currency,

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