RMG Weekly Reports
By Stewart Richardson / Category - Equities
European equity markets (with the exception of Germany and the UK) have significantly underperformed the US market in 2011 and so far in 2012. From a macro level, this makes perfect sense to us and we have tended to focus our bearish equity holdings in Europe over the last 12 months or so. However we are beginning to wonder just how much more European equities can underperform. The chart below, courtesy of Merrill Lynch illustrates just how oversold European equities are now relative to the US.
We would add here that if there is an imminent currency realignment in Europe then this underperformance will continue, however, aside from this event, there are fundamental reasons why the US may well start to underperform. For example:
- Long term valuation measures point to the US being significantly more expensive than Europe.
- The US economy is beginning to show signs of wilting.
- Investor sentiment in the US shows signs of real complacency compared to Europe.
- The political situation could become rancorous again in a similar fashion to last Summer just before the Autumn market selloff.
The question now is, if Europe does begin to outperform after 4 years of incredible underperformance, how can we take advantage of this?
European equities could begin to outperform in one of three ways;
- By rising more than US equities in an environment of rising equity markets.
- By rising whilst US equities are flat in a muddle through environment.
- By falling less than US equities in an environment of falling equity markets.
We are still of the view that equity markets around the world are vulnerable for reasons that we have consistently put forward in the last few months. With the tide seemingly turning towards our way of thinking, we believe that equity markets are more susceptible to falls than many think, especially if there is no imminent stimulus from either the FED or the ECB. In fact, we are beginning to think that the equity markets that have held up best this year (the US and German markets for example) may begin to match any losses sustained in the broad European markets during the next few weeks/months - this is not a consensus view, but we believe a valid view today.
As we have tried to portray in recent weeks, we are also open to the idea that central bank stimulus will come to the rescue at some point in the next month or two, and so we need to manage the risk in our bearish holdings for this potential. In fact, we are even open to the idea that something positive could emerge out of Europe. As with all of our portfolio construction work, we need to position for what we believe is a probable investment outcome without exposing the portfolio to too much risk. So, how have we done this?First, we have taken profits on our bearish Spanish equity exposure. The profits that we have generated from this holding since early March amount to over 1% of the RMG Fund. The chart below shows the Spanish equity market on a weekly basis over the last 5 years. As can be seen, Spain is trading near the lows seen in March 2009 and also at the bottom of a bearish channel formed since early 2010. This area around 6700 points may well provide some support for the Spanish market, and so we believe it is now prudent to book the profits on this investment.
We have invested a bit less than half of our profits from the bearish Spanish equity investment into investments that will benefit the portfolio if the US and UK equity markets decline over the next few months. The maximum loss that we are exposed to is 0.50% of the fund value whereas our potential reward is significantly greater if these equity markets decline in the manner we think they can.
Simply put, we have booked a great profit on our bearish Spanish equity investment, and we are risking only half of the profits on a strategy that will benefit if the US and UK equity markets decline over the next few months. The remaining half of the profit remains "in the bank".
ConclusionEquity markets appear to be fulfilling our expectations of declining in the absence of fresh central bank stimulus. European equity markets have been a significant underperformer not just for this year but throughout last year as well. We now think that if global equity markets continue to decline, then the US, German and UK markets will decline as much as the rest of Europe and therefore we believe that now the right time to switch our bearish emphasis from Spain/Europe to the US and UK. The manner in which we have done this is to take profits on our bearish Spanish investment and use half of the profit to gain a bearish exposure to the UK and the US. By executing the switch this way, we believe that we have improved the risk versus potential reward profile of the equity exposure within the RMG fund and we are limiting our losses if our bearish view proves to be incorrect.
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