14 May 2014

Macro Strategy Update

Come Back On St Leger Day?

Executive Summary: Notwithstanding the title of our article, do not read too much into the seasonal weakness theories. There is also nothing to suggest that a bear market is imminent as economic numbers from the developed economies continue to be positive. Recent breadth indicators and sector rotation in the US has highlighted investors’ preference for reduced risk-taking. Tail risks in the form of a Chinese slowdown are still present and as such, we continue to be cautious and will remain neutral from an asset allocation perspective. We will seek opportunities to increase our allocation to developed markets and continue to monitor emerging markets for compelling reasons to invest there.

Portfolio Positions: Our portfolios have remained slightly overweight in safe assets since the end of January. Given positive data points from developed economies, we still seek an overweight in portfolio positions in these countries. However, we will be preparing ahead, and seeking opportunities in EMs to add to our portfolios when growth characteristics and valuations become compelling.


Seasonal Weakness
Around this time every year, the media would invariably feature commentary about “sell in May and go away”, on the very simple basis that May through September are typically seasonally weak months, where stock market returns have historically performed worse than the other months of the year. The full version of this old trading adage actually originated from the City, London; “Sell in May and go away, come back on St Leger Day”. The St Leger Stakes is the oldest of Britain’s five horseracing classics and is usually run on the second Saturday of September. To add to the seasonal weakness story, there is also the “World Cup” effect every four years where there is a supposed correlation between football and negative market returns as all attention gets turned towards twenty-two men and a ball on a field.

However, there is no reason to be worried. Research has shown that contrary to popular belief, the months of June to August have on average, performed decently well even though the assumption of low volumes and a lack of market participants can make for a lackluster market period (Fig 1).

Fig 1. Long Term Historical Monthly Returns for S&P 500 Index

Sector Rotation
Looking at the S&P 500, it appears that the bull market trend remains intact. It is after all still in an uptrend and on a year to date basis, higher than where it closed at the end of 2013. However, there are signs that market internals remain weak, and that the market has increasingly been supported by defensive sectors that have rallied in recent months. Since the early February bottom, consumer staples and utilities have outperformed the market (Fig 2).

Image courtesy of Stockcharts.com

Fig 2. Market Performance and Defensive Sectors

Bulls and Credit Spreads
Participation in the current market rally is also weak, something which we have highlighted for a while. The Bullish Percent Index is a breadth indicator which is based on the number of stocks with bullish buy signals. This index has slowly been decreasing since the beginning of the year. In addition, spreads between the highest and lowest rated junk bonds have continued to rise, signaling a preference of credit deemed to be “safer” within the high yield space (Fig 3).

Image courtesy of Stockcharts.com

Fig 3. S∓P 500 Bullish Percent Index and Junk Yield Spreads

No Bear Market
Despite our caution, we are not forecasting a full-fledged bear market (15- 20% decline) for the equity market. Presently, we see little signs of a bear market, or a recession that could trigger one. The US economy continues on its recovery path despite reporting weak Q1 GDP numbers which were explained away as weather related. Recent durable goods orders, consumer confidence and jobs numbers point to better Q2 growth. As such, the odds of a recession have fallen and more importantly, the Morgan Stanley Cyclicals Index is still in an uptrend and continues to outperform the market (Fig 4). Leading and coincident economic indicators for the US are also in an uptrend and do not show a slowdown in the economy (Fig 5).

Image courtesy of Stockcharts.com

Fig 4. Cyclicals continue to outperform the market

Fig 5. Leading and Coincident Economic Indicators for the US still in an Uptrend

Tail Risks Remain
China has had to grapple with slowing growth and risks undershooting its target of 7.5% for 2014. Private sector manufacturing PMI has been negative since the beginning of the year, and has been confirmed by industrial output numbers which have peaked in August 2013 and has been trending downwards ever since. Components of the unofficial ‘Li Keqiang index’ (rail freight volume, loan growth and electricity output) have also indicated slowing growth. Despite the Chinese push from an export-based to a consumption-based economy, retail sales growth is also taking a slight breather (Fig 6).

Fig 6. Li Keqiang Index Components and Chinese Retail Sales Growth

However, what is more important for investors is how the Chinese stock market reacted to this “new normal”. Chinese equities have been quite resilient to the downside since 2013. The index has tested key support levels during the past 18 months and the selling pressure has not increased despite slower economic growth prospects (Fig 7). It is likely that the market has discounted the slowdown and is comfortable with the new pace of growth. This is potentially bullish for Chinese and emerging market equities in general, given the large weightage of China in the emerging market space. Any change in investor positioning can propel this oversold market higher.

Image courtesy of Stockcharts.com

Fig 7. Chinese Equity Market Testing Key Support Level Five Times


At the start of 2014, we highlighted that it would be a challenging year as investors grapple with policy changes and differing economic growth prospects. Notwithstanding the title of our article, do not get jittery with the seasonal weakness theories. There is also nothing to suggest an impending bear market as economic numbers from the developed economies continue to be positive. However, given that tail risks remain, we continue to be cautious and remain neutral from an asset allocation perspective. We will seek opportunities to increase our allocation to developed markets and continue to monitor emerging markets for compelling reasons to invest there.

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