Tuesday, November 3rd, 2015

Hyper, Hyper

Last week we asked the question whether this rally was for real. We argued that the legacy of weak returns and elevated risk since the beginning of the year meant that equities were still unattractive in risk-adjusted terms. One week on, with most developed regions holding or improving on recent gains, the picture still looks the same. In order to move the dial equity markets will have to achieve new highs for the year.

However, let us assume that investors want to increase their exposure to equities. Where should they look? One measure of attractiveness is the ease with which it is possible to distinguish between attractive and unattractive companies. It’s all very well to say, “Buy equities”, but unless you know which ones (or which ones to avoid) the investment process is not very far advanced. Passive investors may argue that this question is irrelevant, and in their terms it is, but we believe that strong leadership by a group of sectors or styles is one of the hallmarks of an attractive index. In other words it should be easy to identify why an index is outperforming – even if isn’t always possible to predict it.

Our proxy for this is to look at the frequency with which sectors change their rank relative to other sectors in our model. Too little change suggests a market that is illiquid or moribund or both, but too much suggests one where investors are either nervous or frenetically chasing performance. Hyperactivity is not attractive in children – or in equity markets. On average each one of our sector models has a change-score of 5.0 every week (one sector up by one place, matched by another going in the opposite direction counts as 2 points). This average is consistent across all five regions over the last two years. A look at the current score reveals the following:-
• USA, Pan Europe, and Eurozone are all at two-year highs, with scores about three times higher than their individual averages. This suggests that conditions within these regions are unsettled and that it would be difficult to implement a sector strategy consistently and with a high level of conviction.
• UK and Japan are in line with their two-year averages, which suggests that conditions are normal, and that it is possible to identify sectors which are consistently producing superior risk-adjusted returns (e.g. Utilities in Japan) or the reverse (e.g. Mining in the UK).

It’s tempting to speculate on the reasons for this stability or lack of it, but in the last resort that’s not really the point of the exercise. The object is to identify which regions offer sector strategies which can be followed consistently week after week. Based on current conditions, the UK and Japan win hands down. Yet most of the market commentary over the last month has focussed on opportunities for timing an index trade the Eurozone and the US. We think the mismatch between the change-score of these countries and the commentary indicates a lack of quality in the underlying investment thesis.

As a footnote, we would also argue that the change-score in Japan could well have been higher in view of the upcoming Post Bank IPO, which starts trading this week. If this does well in the after-market, a lot of investors may decide that Japan is (a) worth another look and (b) not as complex as it sometimes appears.

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