9 Nov 2012

Macro Strategy Update

Volatility Hides True Market Message

The recent volatility in equities is testing investors' nerves. With the US election over, the media is now focused on the fiscal cliff, given that the status quo remains in Washington. The bears, emboldened by a 312 points loss in the Dow after the election, brought out the recession scenario again. However, digging deep for the market message reveals that the odds of a recession is not only low, but is actually decreasing. This could only mean that growth is likely to accelerate in the coming quarters and equities are likely to benefit.

Memories of the collapse of 2008 have been etched into investors' minds, especially equity investors. We have been conditioned to look at each down day as a potential start of a bear market. Yet, when a little perspective is applied and when we dig deeper into markets, the recent declines in US markets appears to be an acceptable part of a bigger rally.

The uptrend in the S&P500 since June has been broken by the recent declines. Daily moves were large (more than 2% moves to the downside) but so far the peak to trough decline is 6% (Figure 1).

Image courtesy of Stockcharts.com

Figure 1: S&P 500.

Looking at how investors are trading the market, even in recent weeks, suggests that the preference for cyclical, growth sensitive sectors remains intact (Figure 2). On an aboslute basis, the Morgan Stanley Cyclicals Index1 managed to edge out a new high in early November, even as the broad market was slipping. Even after the recent declines, the cyclical index continues to outperform the market. Clearly, investors are holding on to their growth sensitive stocks even as fiscal cliff worries and recession concerns surge.

Image courtesy of Stockcharts.com

Figure 2: Cyclical index rising and outperforming.

Meanwhile, the housing sector continues to gather momentum. Fundamental data shows that starts, sales, and home prices continue to rise (Figure 3). This has been matched by the performance of homebuilders' stocks, whose outperformance remains intact even during the recent volatility (Figure 4).

Figure 3: Key housing sector charts.

Image courtesy of Stockcharts.com

Figure 4: A solid performance by home construction equities.

Future spending by the US consumer on big ticket items is also being telegraphed by the strong showing in retailers and consumer discretionary stocks (Figure 5). The outperformance by these two sectors, even during the current correction, is notable and indicative of investors' preference for cyclicals, rather than defensive stocks (Figure 6).

Image courtesy of Stockcharts.com

Figure 5: Solid relative performance by economic sensitive retailers and consumer discretionary stocks.

Image courtesy of Stockcharts.com

Image courtesy of Stockcharts.com

Figure 6: Consumer staples struggles against broad market.

Even the manufacturing sector, which has been the weakest link, is showing signs of life, concurring with our less bad theme. Advanced indicators like the PMI New Orders index has regained positive ground (Figure 7). This is the second consecutive month of expansion for this index, and is likely to signal a return to growth for the manufacturing sector.

Figure 7: US Manufacturing PMI - New Orders Index

Hence, the odds that US economic growth may actually accelerate, rather than slip into negative territory, are rising. This runs contrary to the current thinking as the media continues to pound on the fiscal cliff story and bearish commentators get plenty of airtime. As such, the recent weakness in US equities should be viewed as a correction and a buying opportunity.

No macro analysis is complete without looking at other regions and asset classes. Again, we find little reason to panic. Asia and emerging market equities are holding up pretty well despite the declines in the US (Figure 8).

Image courtesy of Stockcharts.com

Figure 8: Emerging market and Asian equities

We can also see that, despite the worries over Europe, the outperformance of European financials remains intact (Figure 9).

Image courtesy of Stockcharts.com

Figure 9: European financials holding up well despite the recent volatility

Signals from the fixed income side remain conducive to risk taking. TED spreads (Figure 10) may be taking a breather currently, but it has fallen significantly since July. Emerging market bonds continue to show no signs of divergence during the rallies (Figure 11).

Image courtesy of Stockcharts.com

Figure 10: TED spreads

Image courtesy of Stockcharts.com

Figure 11: Emerging market bonds outperforming Treasuries

On currencies, although the US dollar has gained in recent weeks, it is largely due to the weakness of the euro. Growth currencies like the Australian dollar has held up well and is rising even during the recent correction in global equities (Figure 12).

Image courtesy of Stockcharts.com

Figure 12: Australian dollars holding up well.

Commodities remain the drag as we continue to see weakness in industrial metal prices (Figure 13). However, we remain mindful that the world may see a change in global growth characteristics - from emerging markets and commodity led to US and consumer led growth.

Image courtesy of Stockcharts.com

Figure 13: Weakness in Industrial Metal Prices

The catalyst for equities to rise would have to come from earnings. The focus of the recent third quarter earnings season has largely been on the poor and uncertain economic outlook. The good news is that the lastest PMI numbers are beginning to tell the green shoots story. Manufacturing PMI numbers in South Korea, Taiwan and China continue to show a less bad picture, indicating that the slowdown is slowly ending. Large emerging economies like Brazil, Russia, Mexico and Turkey are in an expansionary phase. With the US manufacturing cycle turning up, there is a good chance that despite the weakness in Europe, the global growth slowdown may have bottomed. An upturn in the business cycle, which will be beneficial to earnings, cannot be ruled out.


Investors may have missed the true message from the markets with the recent volatility. Hence, it is reassuring when we continue get positive macro signals and see how the economic slowdown is abating. The odds of growth resumption are rising and this is bullish.

Portfolio Positions

No change. We will need to ride the volatility and wait for the markets to eventually align with the underlying good economic numbers.

1. For more details and component stocks of the index, please refer to link.

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