Tuesday, February 5th, 2013

Weight Watchers

January was kind. Equity markets are off to a good start this year, but Italian opinion polls and Spanish party political funding scandals suggest that there is still plenty of event risk out there. Markets never move in a straight line, so should investors be thinking about taking some risk off the table?

The answer from our asset allocation models is a clear negative. All of them have slightly increased their exposure to risk assets at the expense of bonds (corporate and sovereign) or bond proxies such as real estate. Our equity models have a similar preference for high beta regions such as the Eurozone and emerging markets, as opposed to the US and the UK. Part of this is due to the weakness of the dollar, but exchange rates are just as much an indication of risk preferences as bond spreads and equity market performance.

So what can a prudent investor do to trim his exposure to risk, if he is so inclined? Answer:  have a look at his sector exposure and the amount of active weight relative to benchmark. The power of the rally in Financials in all three regions (US, UK and Eurozone) has been reflected in the underperformance of laggards such as Telecom and Utilities.

From the beginning of November we were adding to our leaders and reducing our laggards, but this has now come to an end. As of the middle of January all three sector models have started to reduce the scale of the overweight and underweight positions. The total active weight is still above average, but it is clear that we have past a local peak and that further reductions are likely in coming weeks.

We don’t think that the equity bull market is over (certainly not relative to government bonds), but the next leg probably requires leadership from a new sector. We shall to wait and see which ones, but in the US the most likely candidates are Industrials and Health and in Europe it is Technology.

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