Tuesday, February 24, 2015

Buy Europe?

The storm clouds are lifting in Europe. The FTSE 100 in the UK has rallied to an all-time high. Greek tail-risk is receding, but the drama doesn't seem to be over yet (though the Greek market seems to be washed out, see last week's post that was written before news of the deal Is it time to buy Greece?). Moreover, we are seeing more and more articles like 7 charts that will make you feel more optimistic about Europe, which are:

  1. Emerging Europe PMIs swinging up
  2. Growth in the eurozone is good for the globe
  3. Surprise! Europe is beating expectations (at a macro indicator level)
  4. GDP growing
  5. No lack of confidence in consumption
  6. Russia, the not so bad news bear
  7. Low valuations, high dividend yields

Is this the time to be jumping into European equities?

Not so fast! After giving the matter some thought, I came to a contrary conclusion of targeting the bulk of an investor`s equity exposure to the US and Asia X-Japan. Here is a chart of the relative returns of the US (SPY), Europe (FEZ) and Greater China (equal weighted FXI, EWH, EWT, EWY) relative to the MSCI All-Country World Index (ACWI). These relative returns are useful in that they all use ETFs trading in USD so there are no currency effects.

Stay long the US
As the chart shows, the US market has been in a steady relative uptrend against global stocks since 2010 and there is no technical sign that that relative uptrend is likely to be broken. Further, the latest BoAML shows that institutional managers have pulled back from their US weights and they are roughly neutrally weighted in US stocks, which can give them more room to run.

Eurozone crowded long
By contrast, institutions are highly overweight eurozone equities, which makes the contrarian more cautious about this region. Expectations are running high for the eurozone.

On a relative basis, the last time the eurozone-US relative weight spread was this level was November 2007:

The greater propensity of fund managers to overweight the eurozone compared to the US can be explained by the expectations of better than expected growth in the eurozone compared to the US:

This discrepancy has led to a spike in earnings growth expectations for European equities.

Wow, talk about heightened expectations for Europe! One wrong step and managers could all rush for the exit.

Greater China turns up
By contrast, Greater China (China, Hong Kong, South Korea, Taiwan) is starting to show a turnaround in relative performance. By way of explanation, I constructed the Greater China ETF basket is a useful way of getting exposure to China and its major Asian trading partners.This basket rallied through a multi-year relative downtrend and seems to be on its way to better relative returns. I had also highlighted the constructive chart patterns of the stock markets of China's Asian trading partners in my recent post (The 2011 pattern continues).

If we were to just focus in on Asia xJapan equity allocations as reported by the BoAML Fund Manager Survey, the greatest overweights are India, the Philippines and New Zealand, which indicates a possible contrarian long position in the Greater China theme.

When I first focused on the question of regional equity allocation, my first instinct was to think about the eurozone. Upon further study, the excessive optimism about the eurozone was a surprise to me. My conclusion is to tilt the weight of the equity portion of a portfolio towards the US and Asia xJapan.


Anonymous said...


I`m now reading interesting article - - > http://www.bloombergview.com/articles/2015-02-25/russia-s-insider-traders-know-putin-s-plans

What you think about this index mentioned in article -
Volume-Synchronized Probability of Informed Trading (VPIN).

Is it worhwhile and is it somewhere calculated automatically or manually on constant basis?

Cam Hui, CFA said...

See this critique of VPIN. It is useful but not as good as VIX in many cases.


Anonymous said...

Yes, but im looking on it directly like in bloomberg article - want to check it in russian market :)). So interesting to see current ratio, but im not quant at all and dont understand where i can find it :)).

But in usa yesm thanks for your link, see now that it is not so good,.