Friday, June 12th, 2020

Lessons from a Fast Market

Yesterday’s sell-off has forced everyone to relearn the old lesson that bears run faster than bulls. It may not be true in real life but it certainly works for equity markets. Many of the conclusions that we reached on the basis of our weekly analysis already need updating, so we have turned to the daily models which we first introduced in March. It is important to understand that these should not be used all the time. In normal levels of volatility, the weekly models perform better, but daily models are better when markets are dislocated. Defining the boundary between these two regimes is never easy, but we think most investors would agree with the statement that these are not normal conditions.

When we compare each equity region against its local government bond market (7-10 maturity) the impact of the sell-off was much worse in the UK and the US than it was in the Eurozone or Japan. Looking at our normal metric – the probability of superior risk-adjusted returns relative to bonds – both regions have broken out of the uptrends in place since late March. Both are also below the level they fell to in May when the indices were last in trouble. The move has been so violent that a short-term rebound is likely, but there is a real danger that there is further downside in the medium-term.

There is also an important sector message from the US. The most violent adjustment by far has come in Healthcare. In early May, it was ranked alongside Technology and Consumer Discretionary at the top of the table. Now, it is ranked bottom with a 13% probability of beating bonds on a risk-adjusted basis, compared with a 45% average for the other sectors. Something has changed. We think the best explanation is the opinion polls suggesting that the Democrats are likely to win the Presidential election and control of both houses of Congress. Unless these polls change, we think that Healthcare will underperform, whatever the index does over the medium-term.

The Eurozone and Japan also suffered but they have not broken down out of their uptrends and are still well above where they fell to in May. Part of the explanation may be that the yields available on government bonds are negative or close to zero, but it may also reflect the fact that investors believe that the virus is under better control in these regions. Whatever the explanation, the technical outlook for the regions is better than their Anglo-Saxon counterparts and investors need to factor this into their decision-making process.

The exception to all this is China, which is still close to its recent high and well above its short-term MAV. There is no reason why China should behave in the same way as any other region, but when it is this different, we should at least attempt to explain why. All governments and central banks are trying to support their equity markets, the difference is that China is just as happy to keep a lid on equity performance as well. We can test this by comparing our momentum models with a mean reversion model (both adjusted for the same level of risk aversion). In the four other regions, momentum models produce superior returns, but in China the mean reversion strategy works best. The gradient of outperformance is so consistent over the last year that we find it hard to believe it is not the result of active management a.k.a. financial repression.

This is not unusual behaviour for the Chinese authorities, but it means that our indicators have lost much of their signalling power, which makes us more nervous, not more reassured.

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