Tuesday, October 14th, 2014

Of Coalmines and Canaries

The outlook for equities has darkened over the last few weeks and our recent conversations with clients have taken a more cautious, even gloomy, tone. It may just be the onset of Autumn, a run of poor economic data and a few scary headlines about Ebola as a pandemic, but investors are clearly concerned. We don’t do forecasts or try to second-guess the Fed. Instead we investigate the balance of risk and return as we see it in real time and try to describe what is happening, and why it matters.

Our US equity vs Treasuries model has just produced its lowest score for the year to date, noticeably worse than the previous lows which were on April 18th and August 8th. The main reasons for this are (1) the gradual decay in the momentum of equity returns and (2) the ongoing resilience of Treasuries, of which more later. As yet there has not been a significant change in the relative volatility of these two asset classes. In addition to the new low vs bonds, the signals from within the equity market are more concerning. This time our US sector model has a much more defensive stance.

Back in April, Harlyn’s preferred sectors in the US were Industrials #1 and Materials #2. The bottom three comprised Telecom #11, Staples #10 and Consumer Discretionary #9. It wasn’t the most consistent set of signals, but in general cyclical sectors were preferred to defensive sectors. The obvious interpretation was that equity specialists did not expect a significant market correction. Now the situation has changed. Our model still has a preference for secular growth with Healthcare at #1 and Technology at #2. But underneath that we have a group of defensives -Staples at #4, Utilities at #5 and Telecom at #6, all of which have been upgraded in recent weeks. Cyclical sectors such as Industrials are rated #10, Consumer Discretionary #8 and Materials #7 (having fallen from #3 in two weeks). The current sector stance is much more consistent with the idea of a significant setback for US equities – and therefore the rest of the world.

The other signal which we find concerning is the ranking of Small Caps in all the main equity regions. In response to client requests we have just changed all our regional models to include Small Caps as the eleventh sector. (Previously we only tracked them in the US and the UK). The message they send is not encouraging. Small Caps are #10 or #11 in the US, the UK, the Eurozone and Pan Europe. They are in the bottom two everywhere apart from Japan, where they were ranked #10 until last week. (It may be that the speed of the large cap sell-off here has left them behind). Small Caps are always a good indicator of equity managers’ attitude to risk. These models are like a chorus of canaries tweeting that there is gas in the mine.

Against these signals we have traditional strategists arguing that Treasuries (and most other government bonds) are overvalued, which is true from a historical perspective. However equity bear markets tend not to start when bond markets are cheap; they start when bonds are expensive – as they were in 2008 and 2001. None of this analysis proves anything. The future is not prisoner to the present, but it looks as though equity investors believe that an accident is more likely now than they did earlier in the year.

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