Thursday, November 7, 2013

The bulls' European refuge

My inner trader has been relatively cautious in the past few weeks on US equities (see A soft November, but wait for the Santa rally), as the technical picture continues to deteriorate. Consider this chart of the relative performance of the Russell 2000 small cap stocks against the large cap SPX. Small caps violated a relative uptrend line and started to roll over, indicating that the bears are gaining the upper hand.

As well, defensive sectors like Consumer Staple stocks are starting to outperform, which is another telltale sign that the risk-off trade is becoming dominant.

The other signs that the risk-on trade is rolling over is everywhere. The chart below shows two measures of the risk-on/risk-off trade. The first is the Tiffany/WalMart pair (in black) and the second is the Consumer Discretionary/Consumer Staple pair (in purple). Both are turning down, indicating that bullish enthusiasm is softening.

Uncertainty over China
Globally, I have also been cautious about China because of the political uncertainties surrounding the Third Plenary this weekend (see What Li Keqiang's 7.2% growth stall speed means and The stakes are rising for China's Third Plenary). There will no doubt be some volatility as we hear the policy announcements as the plenary wraps up early next week.

Given the uncertainties involved, both in the nature and scope of the announcements as well as the likely market reaction, my inclination is to stand aside for now.

Still risk-on in Europe
On the other hand, European equities continue to show signs that the bulls remain in control. Compare and contrast, for example, this chart of the relative performance of European small caps to European large caps to the US chart above. This spells "risk-on" to me!

Also consider other key risk-on/risk-off indicators in Europe. Here is the 10-year chart of the relative performance of Greek stocks (yes, that Greece) to eurozone equities, as measured by the Euro STOXX 50. The long term pattern shows that Greek stocks rallied through a relative downtrend line and they appear to be staging a relative bottom against eurozone stocks. The short term picture, shown by the red arrow, is equally encouraging as Greek stocks continue to outperform in the last few months.

Here is the same 10-year relative performance chart of Spanish stocks against the Euro STOXX 50, which shows a similar relative bottoming pattern.

Here is Italy. While the Italian MIB Index remains in a relative downtrend against the Euro STOXX 50, it is also displaying a similar relative bottoming pattern as Greece and Spain.

Draghi: Whatever it takes...
Despite the equity market's sell-the-news reaction to the ECB rate cut decision, Mario Draghi seemed to be sticking by his "whatever it takes" pledge to rescue the euro and eurozone in his statements (see FT Alphaville's coverage The ECB rate cut: the analyst reaction). The ECB appeared to be relative relaxed over inflationary expectations and open to the prospect of further LTRO programs. You can't get too much more dovish than that.

Financial tail-risk is fast disappearing because of the ECB. Here is the 10-year chart of the relative performance of European financials relative to the market. The technical pattern is similar to the ones seen for the relative performance of other eurozone peripheral markets. Financials have rallied out of a relative downtrend and their performance is starting to turn up.

By contrast, consider this chart of the relative performance of US financials against the SPX. Sure, they bottomed and rallied out of a relative downtrend line and started to outperform. But why is their relative performance starting to roll over again?

Rally not yet overdone
My preliminary conclusion is therefore investors should look towards Europe for their equity commitments as both the short and longer term picture are supportive of further gains. There is the caveat, however, that European equities have rallied a lot and they may be no longer be cheap.

Ed Yardeni addressed this issue with his chart of European forward P/E ratios, which have now recovered to their pre-Lehman Crash levels.

He concluded that there may be further upside because European growth is likely to push earnings upward:
The question is whether there is more upside for the region’s valuation multiples.

I think there might be, but forward earnings, which has been flat-lining since 2011, as I noted yesterday, needs to show some signs of life. That, in turn, requires that European economic indicators show that the region’s economy hasn’t just bottomed, but is actually recovering. The latest batch of these indicators does show a recovery, but a slow-paced one that may already have been discounted by the rebound in valuation multiples.
So there you are. Even for the cautious about stocks, Europe might be a place to hide.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

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