mercoledì 17 febbraio 2010

Momentum indicators still say overweight equity

An excerpt form our latest Top Down Outlook. Go on our website for a 1 month free trial.

Following the sell-offs of recent weeks, major international equity markets continue brandishing negative performances since the beginning of 2010: The S&P500 has declined by 3,55%, the DJ Eurostoxx by 8,22%, the Nikkei by 4,3% and the FTSE100 by 4,99%. Emerging markets as a whole also have kindled negative performances in 2010: the MSCI Asia fell by 5,9%, the MSCI European emerging by 3,8% and MSCI Latin America by 3,7%.
Even renowned strategists and economists now differ on the outlook of equity markets over the next few months, especially with regard to the S&P500. Barton Biggs, chief global strategist at Morgan Stanley from 2003 to 2007, and now head of the hedge fund Traxis Partners, recently said that valuations are ok, and that there are a number of good opportunities on the market. Last September, Biggs said that the S&P500 may climb to 1350 in 2010. However, according to New York University Professor Nouriel Roubini, the stock market will be flat or almost unchanged at the end of the year. More pessimistic is the outlook depicted by Jeremy Grantham, chief investment strategist at Grantham Mayo Van Otterloo & Co, who said investors should underweigh stock because the S&P500 is above what he believes to be its fair value at 850.
As we indicated in 11 January’s “Global Strategy Weekly” , we believed that the S&P500 was slightly overvalued at the beginning of the year according to our long-term valuation model, which analyses the average earnings for the past 10 years, the average earnings annual growth rate and the average P/E for the past 30 years. Following last week’s sell off, investors may now expect a compound return of 6% in the coming 10 years, slightly below the actual historical average return of 7%, but above the average of 5.4% predicted by the model in the past.

Nonetheless, we have also maintained a BUY rating on many equity markets; especially those in emerging countries (see 1 February’s “Global Strategy Weekly – Equity Emerging Markets Outlook”). Among the equity markets in developed countries, we have a BUY recommendation on the Nasdaq 100. In 1 February’s report, we have underlined all the fundamental reasons behind our decision to confirm our rating on those markets. However, an important reason for this rating is that we are great followers of momentum strategies and these markets are still in an upward trend. In this week’s “Global Strategy Weekly”, we will be analyzing what the most popular momentum strategies say on the perspectives of major international financial markets.
Momentum strategies have been the subject of a long series of working papers in academic literature that indicate how they are able to generate significant extra yields. One important report by Jegadeesh and Titman, "Returns to buying winners and selling losers: Implications for stock market efficiency", published in The Journal of Finance (1993, Issue 1), prominently demonstrates this theory. In this report, the two authors affirmed that the strategy of buying securities which, during the last period (3 to 12 months earlier) had achieved the best performance, gained positive abnormal returns during the period 1965/1989 in the U.S. market. For instance, the strategy which selects stocks based on their past 6-month returns and holds them for 6 months realizes a compounded excess return of 12.01% per year on average. This is an important verification by the two authors that these returns were not due to the presence of systemic risk or a delayed reaction to common factors. This study was followed in subsequent years by several reports related to other international equity markets that found similar results.
Leaving aside what might be the causes of these results, we are going to examine the results of a very simple momentum strategy with reference to the major international asset classes. We will take some Eurizon’s mutual funds (Eurizon is one of the bigger asset managers in Italy) as a benchmark, not in order to judge their goodness, but in order to assess the actual return achievable by an Italian investor in the past 11 years using momentum strategy. We evaluated 10 mutual funds that invest in different asset classes: as regards the stock markets, we considered funds invested in Asia, Europe, Japan, Italy, North America and Nasdaq100; and as regards bond markets, we considered funds invested in Euro medium/long-term Government Bonds, Euro short term bonds, US Dollar bonds and emerging markets bonds. The strategy consists of: at the end of the month to buy the 3 mutual funds (out of 10) with the best year-over-year performance and keep them in the portfolio until the end of the following month, and then make a new selection. The chart below indicates that such a strategy would have granted an investor a performance close to 60% from 1999, compared to 6% which would be recorded dividing the initial investment in equal shares in each of the funds.

Considering the 30 major asset classes identified among the Italians ETF (stock markets, bonds and commodities), the six financial markets that this strategy suggests as overweight now are: equity Eastern Europe, equity Latin America, equity Emerging Asia, equity Africa, equity China and the Nasdaq 100. With the exception of China, which we do not include in our portfolio due to fears of excessive credit growth in 2009 (as we explained in 19 December’s Top Down Outlook), these are the asset classes that we overweighed in our Top Down Portfolio (Equity emerging Asia has been recommended since 19 December, the whole of the other equity markets since the inception of the portfolio on 5 December).
Choosing these assets would appear to go against the trend of recent weeks, which saw major stock markets trend downwards. However, this should not come as a surprise when considering that the buy or sell indications of momentum strategies lags behind the reversal of the trend. On the contrary, the decline of recent weeks afforded investors, who had not entered the equity markets in recent months, to possibly invest with a better risk/return profile than at the beginning of the year. In fact, after the fall, most of the stock markets were brought closer to what is seen as a watershed between upward and downward trends: the 10-month moving average. In the following table, we have highlighted the results of a very simple trading system: buy an equity index when the closing price is greater than the 10-month moving average and exit the market when the closing price is lower. Performances using this simple strategy are rather positive (we did not consider the gains from bond markets in the months when we were not investing in equity markets).
We have also highlighted the distance of the current close from the 10-month moving average. A combination of the two previous strategies could be used to buy equity markets currently indicated by the momentum strategy, setting a stop loss below their respective 10-month moving averages to limit losses in the case of reversal of the long-term upward trend.

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