The Volatility Genie

  • A market bounce does not mean revival of investor confidence in Europe. This phase of market correction will be an affair of several months, not of weeks, and will be characterised by quite dramatic market swings. We should not be impatient. We should allow Wall Street to celebrate new highs for major US equity indices over the next couple of weeks, but we do not think they are going far. Profit-taking has characterised this investment year and there are few good reasons to doubt the intentions of the Fed. We expect the year’s high for US equity to be established this month in the area of 2020-50 for the SPX. From here the next phase of market decline should unfold.
  • Capital preservation through this period will not be best assured by a simple “all defensive” strategy. We are upgrading Media to OW because the decline in the sector‘s relative profit growth appears to be at an end. We are downgrading the Materials sector of the MSCI universe to UW.

Recommended sector and market asset allocation

Our interpretation has not changed. This period of correction of equity values is characterised by quite dramatic market swings. The context of super-low inflation encourages divergence of opinion within the investment world. It has become fashionable to argue that neither the ECB nor the Fed will do what they say. Many investors want to believe that the ECB will engage in government bond QE sooner or later. They do not want to believe that the Fed will raise US$ rates next year. These attitudes promise to create disturbances. The ECB is not the BoJ. Sell the market rallies. Do not panic in the phases of market decline.

US equity indices are back to their highest levels of the bull market. The trend-following money is positive again. America’s reporting season is a favourable influence. We should allow Wall Street to celebrate new highs for major US equity indices over the next couple of weeks, but we do not think they are going far. Ultimately, we expect the profit-takers to prevail in this month of November because profit-taking has characterised this entire investment year and because we have few good reasons to doubt the intentions of the Fed. We are not expecting to see the S&P500 trade above 2050-2060. We think that the year’s high for US equity will probably be established soon, in the area of 2020-50 for the SPX. From here the next phase of market decline should unfold. We should not be impatient. This phase of market correction will be an affair of several months, not of weeks. As for Europe, a market bounce does not signal restoration of investor confidence. Still, for a week or two we should allow markets the benefit of the doubt, thanks to American influence. The area 3100-3200 on the DJ ES 50 is for profit-taking. We think that it is going to be difficult for markets to move beyond this threshold. We would wait to sell.

We are making an adjustment to our sector asset allocation that illustrates the argument that capital preservation through this period will not be best assured by a simple “all defensive” strategy. We are upgrading the Media sector from N to OW. The decline in the relative profit growth of Media appears to be at an end. We are downgrading the Materials sector of the MSCI universe from N to UW. Its two principal components are Chemicals and Metals-Mining. We are more negative on the former than the latter because the Chemicals sector exemplifies our argument that the beneficiaries of the global growth theme within Europe’s equity universe have begun to be de-rated.

Weightings and asset allocation for the MSCI Europe Universe



03/11/2014 Neutral weight in MSCI (%) 2-yr beta values
(vs MSCI)
Tactical sector rating Recommended allocatioln (%)
Consumer Discretionary 10.0 1.1 N (UW) 10
Automobiles & Components 3.1 1.4 N 3
Consumer Durables & Apparel 2.4 1.0 UW 1
Consumer Services 1.0 1.0 OW 2
Media 2.1 0.9 OW (N) 3
Retailing 1.4 0.9 UW 1
Consumer Staples 13.5 0.7 OW 14
Food & Staples Retailing 1.1 1.0 UW 0
Fod Beverage & Tobacco 10.6 0.7 OW 12
Household & Personal Product 1.7 0.7 OW 2
Energy 8.8 1.0 N 8
Financials 22.9 1.2 OW 25
Banks 12.6 1.2 N 12
Diversified Financials 3.2 1.3 N 3
Insurance 6.0 1.1 OW 7
Real Estate 1.2 0.9 OW 2
healthcare 13.7 0.8 OW 16
Healthcare Equipment & Services 1.2 0.7 OW 2
Pharmaceuticals & Biotechnology 12.4 0.8 OW 14
Industrials 10.9 1.1 UW 8
Capital Goods 8.3 1.1 UW 5
Commercial Services & Suppy 1.2 0.8 UW 1
Transportation 1.5 1.1 OW 2
Information Technology 3.3 1.1 OW 4
Software & Services 1.4 0.9 UW 1
Technology & Hardware Equipment 1.0 1.3 OW 2
Semiconducors 0.8 1.1 OW 1
Materials 7.5 1.1 UW (N) 6
Telecommunication services 5.1 0.9 N 5
Utilities 4.4 0.8 N 4
Exposure to risk
(beta value)
  1.00    
Lquidity ratio   6%    
* 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