Friday, September 27th, 2019

Six Sector Ideas

When the asset allocation picture is confused as it is at the moment, there are essentially two options. The first is do nothing. The second is to concentrate on stock and sector selection. Doing nothing is not a bad option, particularly as we are just about to start the third quarter results season, but nobody pays for research which recommends no change. Our recommendations could be implemented immediately, but because they relate to sectors, the timing of this note allows investors to prepare their shortlist of stocks in advance of the deluge of earnings announcements.

Before we get into the detail on sectors, we need a quick word on the main asset allocation models – sterling, dollar and euro. At first glance, an increase in the recommended weight of equities should be good news. However, this was driven by profit-taking in fixed income after a strong summer. Together with a spike in fixed income volatility, it reduced the hurdle rate that equities need to beat in order to be risk-efficient. The bad news is that the return from equities has risen only slightly and may be peaking. In other words, a temporary reduction in the return per unit of risk in fixed income does not necessarily lead to an improvement in the risk-adjusted returns of equities, even though the relative performance improves for a bit.

The rest of this note focuses on sectors rated underweight where we see potential for an upgrade in the near future, and on overweight sectors which are vulnerable to a downgrade. Our job is to highlight these situations. We will let others supply the narrative.

Potential upgrades: UK Telecom has been rated underweight for most of the last three years, but has now broken above the 26-week and 52-week moving averages (MAV) and has a high-conviction lead indicator, which is sloping upwards and is much better than it was four weeks ago. This has everything we look for when evaluating the potential for an upgrade. Eurozone Materials are still technically in a downtrend that has lasted since Q1 2016, but are above both MAVs and have an upward-sloping lead indicator with good (as opposed to high) conviction. Another two good weeks could see it break out of the downtrend and challenge for an upgrade by the end of October. Japanese Materials is not the biggest sector in the world, but we have recently upgraded Japan to overweight and the sector has the same technical characteristics as the others that we like.

Potential downgrades: US Staples and Pan-European Consumer Goods are both trading below their 26-week MAV and have high conviction downward-sloping lead indicators. European Consumer Goods are rated overweight and are still well-above their 52-week MAV, but have suffered a sharp reversal in the last month. US Staples are downgraded to neutral this week and are just about to break down through their 52-week MAV. Essentially these are the same stories about a month apart. Chinese Financials have all the negative signals we look for – below both MAVs with a high conviction, downward-sloping lead indicator. They were downgraded to neutral four weeks ago. Investors may not have much direct exposure, but this could be telling us that the shadow-banking system is in trouble following the devaluation of the renminbi, and that is potentially a very important message.

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