Probability-based investment modelling for professional and institutional investors
It easy to be overwhelmed by the speed and quantity of information in a bear market. Investors need a clear focus on what matters and what doesn’t. In any bear market, there are about 10 sector pairs (out of 45) which really drive the performance of a regional equity portfolio and the rest don’t matter very much. These pairs vary from one bear market to the next but are relatively easy to identify. There is also another set of pairs, which may be significant in market cap terms, whose relative performance cannot be easily integrated with the rest of the portfolio. US sectors which feature heavily in this list in this bear market include Financials, Healthcare and Industrials. In Europe, they are Materials, Utilities and Financials.
We wanted to get a handle on which equity regions had the most risk-averse investors, so we measured the beta of our recommended overweight and underweight sectors. We found that reality is much messier than we thought and that pre-conceived, US-centric attitudes to risk do not translate well to other regions. Our numbers suggest that Eurozone investors are the most risk averse, but the sectors they use to express this view are not the ones that US investors would choose.
The percentage of companies in the S&P500 with no drawdown in their earnings estimates is declining and just about to drop below its median for the last 15 years. The percentage where there is a drawdown of more than 20% is about to start rising, but from a low level. We are still within normal ranges on both measures, but if they move out of this, the downside is significant and the recovery takes much longer than the decline. At the sector level, we cannot make sense of the relative rankings in several cases. In particular, we think the consensus is far too optimistic about the outlook for Industrials.
We think US equities as an asset class are going to struggle against US Treasuries over the next few weeks, partly because bonds have already priced in a lot of bad news, and partly because earnings estimates for 2022 and 2023 are too high. It may take investors some time to realise this, so positioning within equities or between equites and bonds may give rise to significant timing difficulties. However, our models are really clear about the relationship between Treasuries and some sectors, like Energy. There are at least four of these sectors now and this number could rise to eight. Investors may find that using this direct approach, comparing equities against Treasuries, rather than other equities, helps to clarify their thinking.
Asset allocation is difficult at the moment, with bonds and equities falling in tandem in Q1. We are in favour of broader diversification strategies including other asset classes, but they should not be the result of hasty decisions after a bad quarter. All of our equity sector models have produced excess returns in the year to date and have a history of doing well when markets are under stress. Their best year for excess returns was 2020, during the first wave of the pandemic, and so far, 2022 is shaping up to be another good year.
The start to 2022 feels so hectic partly because the end of 2021 was so boring. The active weight in our sector models – our proxy for the risk appetite of equity investors – was at multi-year lows all through December. We think it is now close to bottom and there is no technical reason why it could not rise strongly in coming weeks. An increase of 40% in position size would only take us back to bottom of the top quartile in terms of risk-budget utilisation. We also think that the narrative of rotating from growth to value is a little simplistic. Many of these moves can be explained simply by looking at changes in estimate momentum.
The global Healthcare sector has begun to rally hard after hitting an all-time low in terms of its recommended weight relative to benchmark. It had previously been ignored because it doesn’t fit well into the current debate about growth vs value. We think it is time for another look, chiefly because the risk of price controls on US prescription drugs is much lower than previously feared. There is no time for Congress to consider this legislation before the run-up to the mid-term elections, and politicians may find that public opinion has changed after the success of anti-Covid vaccines.
Perhaps the most obvious symbol of the changes under way is the fact that Europe, not the US, has been our preferred equity region since late May. This isn’t the result of one single trend or a dramatic headline. It has happened gradually, as marginal buying shifted from the US to Europe. It is the same with the shift from industrial to consumer cyclicals. No-one doubts the coming industrial recovery, but our charts suggest it is already in the price, so investors are starting to look for the next big idea.
Nothing in the last two weeks has changed our view that a correction in global equities is coming. If you are one of those investors who has waited all year to buy the dip, we have three rules about how to do it. One, decide your tactics in advance and don’t pay too much attention to the narrative behind the correction. Two, don’t add complexity to a market timing trade by using it to rebalance your equity portfolio. Three, if you want to front run a correction, make sure you have enough defensive exposure at a sector level. Our top pick here is European Telecom.