Monday, April 22nd, 2013

Dive, Dive, Dive

Devotees of old war movies will know that this is what the submarine captain yells when he sees the enemy destroyer bearing down upon him at full speed. The next few minutes of the film are taken up with the sound of depth charges exploding all around, close-ups of the chief engineer muttering that the hull can’t take much more of this, and the rookie lieutenant looking scared.

Please forgive the melodramatic metaphor, but nobody should be in any doubt about the urgency of the danger signal sent by equity markets last week. With the exception of Japan, our models have reduced their exposure to equities in every region and for the world index in aggregate. Unless there is an immediate policy intervention, it is likely that they will further reduce their exposure to equities in coming weeks. In early March, we said that we were concerned about the possibility of a seasonal sell-off during the second quarter (Coming Soon – Second Quarter Nerves: 04/03/2013). The price action last week was enough to make us believe that the process has begun.

The chart to watch is the relationship between Eurozone equities and German bunds. In each of the last three years the first wave of the second quarter sell-off has started in the Eurozone about three weeks before the US. This year the move out of Eurozone equities and into German bunds began in the first week of April, but it clearly accelerated last week and the contagion has now shown up in the UK and the US, and most other equity markets. During these sell-offs, the average total return from equities has underperformed bonds  by -20% in the Eurozone, -17% in the UK and -16% in the US. The period of the adjustment is typically between 18-22 weeks, which would take us through to late July.

Quite why the market for risk assets has become so predictable and so seasonal will be the topic of future blogs. Right now, investors need to understand that there is a clear and present danger and take evasive action.

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