Friday, February 26th, 2021

The Pandemic Isn’t Over Yet

Judging by recent price action at the long end of the US Treasury market, there is an overwhelming consensus that the end of the pandemic is in sight. This is supported by a fantastic rally in copper and crude oil. Equities are moving in sympathy, with Technology underperforming and Financials outperforming. These sector tilts are replicated all over the world, apart from China, suggesting that investors believe that the recovery will be global and synchronised. Most investors are not trying to be precise on timing, but they do believe in an uninterrupted, upward trajectory for the global economy. It is a clear and consistent narrative. However, we are increasingly concerned that it would fail a reality-check.

A brief glance at the John Hopkins University data on Covid-19 by country www.ourworldindata.org/coronavirus-data shows that daily infections in the EU have stopped falling. More worryingly, daily infections have been rising in France. The current 7-day average is 323 per million compared with a low of 162 in the first week of December. In Italy, they have stopped falling and started to tick upwards, with 229 vs 198 two weeks ago, and in Germany they have been flat-lining at 90 for the last 10 days, having previously fallen every day since the middle of January. This gloomy assessment is offset by better data in Spain and other countries, which previously had much higher infection rates, but the fact remains that the three largest economies in the Eurozone may have to tighten their lockdowns before they ease them. Any announcement of further restrictions is likely to send a shockwave through European bond and equity markets.

The counter argument says that the vaccination programme is about to accelerate dramatically across Europe. Leaving aside the issues of supply difficulties and anti-vaxers, the John Hopkins data also suggest that vaccination on its own is not enough to bring down infection rates. Israel has the most successful vaccination programme, but its daily new cases are still running at 415 per million. The UK rate has fallen from a peak of 852 in early January to 155 now, but the UK has had one of the strictest lockdown regimes in the world over that period. We are not epidemiologists and make no attempt to model the impact of new variants of the virus, but our simple assessment is that countries with slow vaccination programmes and relatively lax lockdown regimes will probably have to tighten them if more infectious variants become prevalent.

And so, we come the elephant in the room, what are the chances of the downward trajectory in US infections being reversed? The short answer is that we don’t know. The current infection rate is 218, down from a high of 754 in January. There is no sign of any break in the downtrend and the US already has a faster vaccination programme than the EU and lower exposure to new variants. But it may only need a significant cluster of a new variant in a large state to change the headlines and have investors start to question their bullish assumptions.

Our investment conclusions are as follows: 1) The vaccines work and will eventually deliver a safe environment in which the global economy can be rebuilt. 2) It is increasingly unlikely that the economic recovery will be synchronized across all regions. Asia is already recovering; the US and the UK are probably on the right track, but there is a problem in the EU. 3) A significant tightening of lockdowns in the EU would reverse the bond sell-off we have just seen – certainly in Europe and probably in the US.

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Friday, February 12th, 2021

Tickets to the Moon

“Small Caps to the Moon” is the sort of headline which makes nervous investors think that it’s time to leave the party. Our research suggests that small cap outperformance is not a particularly reliable indicator of equity market peaks. For the US, it worked in March 2000, and April 2002, but it gave a disastrous false positive in November 2003 and was completely silent about the 2008 crash. The evidence has continued to be mixed since then.

Timing the index is not really the point of this article. We want to highlight the fact that Small Caps are #1 in both the US and in Europe – which doesn’t happen very often – and to work out how we got here and what happens next. Our models currently recommend an overweight of 67% in the US and 63% in Europe, a three-year high in both cases. The US all-time high was 89% in April 2002, but the recommendation typically peaks at about 75%, so there may not be much further to go. However, sectors can continue to outperform after our recommendation has peaked – just with lower momentum or less risk-efficiency.

The outlook for European Small Caps is more bullish. The typical peak is around 90% overweight and it very rarely peaks below 75%, so we have high confidence that this rally will continue (subject to all the usual pandemic caveats). The main reason for the difference between the US and Europe is the relative performance and weight of the Tech sector in each index.

So much for the outlook. The more interesting question is how to identify these rallies before they get going. Is there any way of using our own data to get ahead of our recommendation? Regular readers will know that we look at many other indicators besides the simple recommended weight. One of our favourites is identifying the moment when this breaks above or below its 26-week moving average (MAV). This enabled us to identify the Small Cap rally in Europe and the US in June; so it may be helpful to review the evidence for this indicator.

In the last 25 years, there have been 950 occasions in the US where the recommended weight for a sector has crossed its MAV (850 in Europe). If you had bought or sold, as appropriate, and then held the position until the opposite crossover, your average outperformance per trade would be 1.2% in the US and 1.6% in Europe. The average holding period is 11 weeks in the US and 12 weeks in Europe, giving annualised outperformance of 5.4% and 7.3% respectively. This is before we apply any stop-loss limits or profit maximisation strategies. This is a very simple test, which highlights the fact that it is possible to get ahead of the curve on selected buy and sell recommendations. The Small Cap trades in both regions are good examples of this. Others, which have worked well, include buying Financials in September and Industrials in August, or selling Staples and Utilities in November.

Looking to the future, it is one of the reasons why we are watching Energy so carefully. It broke above its MAV in both regions in November and is still well above it, despite some recent profit-taking. So, if you missed the Small Cap rally and are searching for the next possible ticket to the Moon, don’t ignore the oil patch.

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Friday, January 29th, 2021

Fizzing or Bubbling?

It is always hard to tell the difference between the natural level of optimism that accompanies a rising market and the frantic over-trading which precedes a market top. Is it a healthy fizz or an unhealthy bubble? Given the bubble-like behaviour we have seen in GameStop this week, it is time to check out the indicators we normally use to identify when markets are overbought. In our case, it is the traditional relative strength indicator (RSI) based on weekly total returns, with thresholds of 70% (sell) and 30% (buy).

Other indicators are, of course, available, but this has done a good job over the last 18 months. For the S&P500, it first broke 70% in the week ending 20th December 2019, which was 3% below the subsequent weekly high, on 17th January 2020. The next weekly low occurred on 20th March, when the RSI fell to 20%, having closed the previous week just above 30%. Rigorous adherence to these signals would have saved a loss of 28%, or 21% if you had waited a week for confirmation of the bottom. There is, of course, a world of difference between seeing the signal and acting upon it, but that’s not the fault of the signal.

So where are we now? The current reading for the S&P 500 is 68%, having ranged between 65% and 69% this year. In other words, we are still in fizz, not bubble, territory. The same is true of all the top-level US sectors. The best score belongs to Consumer Discretionary (68%) with Technology in second place (67%). The rest are mostly clustered in a range of 62-66%, apart from Consumer Staples (53%) in last place. Again, there is no prima facie evidence of a bubble. However, the situation changes as soon as we look at US Small Caps, which have a current reading of 74% and which broke above 70% on January 8th. In the fixed income markets, US High Yield went into overbought territory in the same week and now has an RSI reading of 71%.

If investors really want to find evidence of a bubble, they should look outside the US. Emerging Market equities first broke above 70% on 27th November 2020. Apart from one week, they have been consistently at or above the sell signal since then. They now have a score of 79%. The four countries which are most influential are China, Hong Kong, Korea and Taiwan, all of which have individual scores above 70%. China has only just gone into bubble territory; Hong Kong got there on January 8th, but Korea and Taiwan have been there since late November. However. it is not completely irrational because the largest company in each market, Samsung and TSMC, is heavily exposed to semiconductors, which have seen explosive demand from the auto sector, looking to boost their electric vehicle production.

There are three other emerging markets above the 70% threshold: Indonesia and Israel, which got there last week, and India, which has been there since December 4th. These are joined by four developed markets: Japan, Australia, the Netherlands and Austria. All these RSI figures are based on dollar returns, but despite the weak dollar, there is only one country – Australia – which doesn’t also have an RSI above 70% in local currency terms. The four major EM countries are all effectively pegged to the dollar, but Japan and India aren’t. In other words, these rallies are driven by local investors, just as much as by big global funds.

Conclusion: Markets do not have to be in overbought territory before they experience a correction, but if you are worried about bubbles you should be looking at Asia, not the West. There are small pockets of risk in the US and Europe, but the immediate issue lies elsewhere.

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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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