Smoke and Fire

  • The equity bull market became over-extended. There is still downside risk at this point. However, the correction should be rapid. Our investment year will begin in February.
  • We are witnessing a demonstration of the new investment landscape. The problem is not anxiety about growth and financial stress in the developed economies. The polarisation between global growth and domestic value is finished. Industrial cyclicals should be at least as vulnerable as commodity-sensitive stocks. The sources of equity beta in Europe are changing.

Recommended sector and market asset allocation

We have discussed the problem for some time. The equity bull market became over-extended. The speed of market correction emphasises the over-extension. The same logic of correction is at work in the fixed income space: higher risk credit became overextended. We do not mistake the catalysts for the causes. This is an unlikely context for crisis in the emerging world, in China in particular. The period of danger for the EW lies beyond this phase of strengthening of the growth of world output and trade. Moreover, currency depreciation, although a symptom of stress, is also as safety valve. This is a mini-panic of over-extension.

We have been assuming a conventional setback of the 5% type, implying that the S&P500 will move back to the 1760-80 zone in order to unwind entirely the year-end rally. However, we are aware that the sell-off could extend further, if only because so many investors are positioned in the same manner. At this point we think that it is “too late to sell, too early to buy”. What seems clear to us is that the correction is going to be rapid. We think that the phase of sell-off should be exhausted by the end of this week, coinciding with the Chinese New Year. In all probability, our next note will announce the reduction of our portfolio liquidity ratio. Our investment year will begin in February. By mid-February prior trends should be re-established. We have no reason to change our objectives for the year.

Markets are providing a practical demonstration of the change in the investment climate. The sources of equity beta are changing in Europe. The problem is not anxiety about growth and financial stress in the developed economies. This correction should confirm that the polarisation between secure global growth and domestic value in the European space is finished. Accordingly, the dispersion of sector performance should be much lower than was the case in equivalent phases of market decline in recent years.

Weightings and asset allocation for the MSCI Europe Universe

17/01/2014 Neutral weight in MSCI (%) 2-yr beta values
(vs MSCI)
Tactical sector rating Recommended allocation (%)
Consumer Discretionary 9.9 1.1 OW 14
Automobiles & Components 3.0 1.6 OW 4
Consumer Durables & Apparel 2.7 1.2 OW 3
Consumer Services 0.9 0.9 OW 2
Media 1.9 0.8 OW 3
Retailing 1.3 0.9 OW 2
Consumer Staples 14.1 0.5 UW 9
Food & Staples Retailing 1.7 0.8 UW 1
Fod Beverage & Tobacco 10.7 0.5 UW 7
Household & Personal Product 1.8 0.5 UW 1
Energy 9.4 1.0 N 9
Financials 21.6 1.5 OW 23
Banks 11.0 1.5 N 11
Diversified Financials 4.0 1.6 OW 5
Insurance 5.6 1.4 OW 7
Real Estate 1.0 1.1 UW 0
healthcare 12.7 0.5 N 13
Healthcare Equipment & Services 1.2 0.4 N 1
Pharmaceuticals & Biotechnology 11.5 0.5 N 12
Industrials 11.6 1.1 OW 12
Capital Goods 9.0 1.2 OW 10
Commercial Services & Suppy 1.4 0.8 N 1
Transportation 1.2 1.0 OW 2
Information Technology 3.1 1.0 OW 4
Software & Services 1.4 0.9 OW 2
Technology & Hardware Equipment 0.9 1.2 OW 1
Semiconducors 0.9 1.0 OW 1
Materials 8.1 1.3 N 8
Telecommunication services 5.5 0.8 OW 6
Utilities 3.9 0.9 UW 3
Exposure to risk
(beta value)
Lquidity ratio   5%    
* The exposure to risk is measured by the weighted average of 2-y betas.
We manage the liquidity ratio within a 0-10% rank.
Source: Kepler Cheuvreux