Wednesday, April 23rd, 2014

The First Shall Be Last

The biblical quotation is not a forecast, nor is intended to prophesy death and destruction. It is however a fairly accurate description of what is going on in many of our sector models at the moment. Another way of describing this would to call it a laggards rally. In the US, Utilities have gone from #10 at the beginning of the year to #5 now. Materials was #6 and is now #1. In Europe, Utilities was #7 and is now #1, Energy was #8 and is now #5. The individual changes may not sound that significant, but they are part of a general pattern whereby almost every sector which was an overweight at the beginning of the year has seen its weight reduced, and every sector which was an underweight has seen its weight increased. In many cases, the overweight has evolved into an underweight and vice-versa. There is only one significant exception to this rule which is US Materials, where the model has increased an overweight position.

This is sector rotation on a grand scale, and it is hard to believe that it does not contain a message for the broader equity markets. The conventional explanation would be to argue that the developments referred to above represent a much-needed bout of profit-taking in sectors, such as Technology, which were starting to part company with reality. While this is clearly part of what has happened, we don’t think it’s the whole story. With one exception, everything which was an overweight has been reduced, and everything which was underweight has been increased. This does not happen very often; we normally find that one group of leaders is replaced by another without a sudden change in the aggregate level of benchmark risk.

In our earlier note (Straws in the Wind, April 8th) we highlighted the decline in active weight in our US and European sector models and said that this was “often, but not always, the precursor of a significant change in market direction.” We will have to wait and see whether this is an accurate prediction, but our models clearly suggest that equity investors are a lot more risk-averse than they were three months ago.

This is not true of the behaviour of fixed-income investors. Our Eurozone bond model suggests that they continue to increase their exposure to countries in the periphery at the expense of the core, and that they continue to increase their active weight. There is no direct equivalent of this strategy in the US dollar model. Instead, what we notice is that investors appear to have increased their exposure to Emerging Market Sovereign bonds at the same time as reducing their exposure to US High Yield. They may not have increased the aggregate level of risk, but they have been happy to substitute one high-risk category for another.

Our models suggest that equity investors do not want to take risk, while fixed income investors do. The role reversal may not be on the same scale as in the Sermon on the Mount, but it is much more powerful than the commentariat currently believes.

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