Europe bulls wrong-footed by market falls


Global markets have been slapped around of late, with Europe bearing the brunt of the selling. Escalating geopolitical tensions, particularly in Russia, have hit equities, but the performance of other assets indicates more is at play.

One might have expected oil and gold prices to rise, as Russia is a big energy producer and gold is seen as a safe-haven asset. Instead, both have dropped in recent months.

Perhaps the main reason for the equity declines – Germany’s Dax has fallen 10 per cent since June, making it an official correction – is that wrong-footed investors were unprepared for the unexpected. In June, Merrill Lynch’s monthly fund manager survey found a net 43 per cent were overweight Europe, the second-highest weighting since 2007. Europe had been the most-favoured region for 10 consecutive months.

This was despite rising valuations.

Bespoke Investment Group recently cautioned that the Euro Stoxx 600 traded on a hefty 21 times trailing earnings. Forward estimates look optimistic, given continued drops in European corporate revenues. Similarly, Barclays data indicates Germany’s cyclically adjusted price/earnings ratio is only slightly cheaper than the US, one of the priciest markets in the world.

By last week, just 14 per cent of MSCI Europe stocks traded above their 50-day moving averages. That’s the most oversold reading in a year, and one confirming a welcome diminution of investor froth. Correction time in the US? US declines have been more modest, although there is no shortage of commentators predicting further bloodshed.

Certainly, a decline is overdue. It’s been six months since a 5 per cent pullback – more than twice as long as the historical average. Don’t assume a 10 per cent correction is inevitable, however. It’s been almost three years since stocks corrected, which is abnormally long, but it’s also a technicality, given markets fell 9.9 per cent in 2012.

Markets are up 55 per cent since then, which is actually “fairly typical” outside of recessions, Deutsche Bank said last week. Corrections tend to happen in clusters, it says, usually near recessions and very rarely when unemployment figures are falling. During the long business cycles of the 1960s, 1980s, 1990s and 2000s, market rallies averaged 110 per cent and lasted four years.

In short, says Deutsche, unless a negative economic shock occurs, expect a quick rebound.

Rate hikes do not spell doom US investors are also preoccupied with the threat of rising interest rates, now that a 2015 hike is increasingly likely. Rising rates need not spell doom, however.

Blackstone’s Byron Wien recently cited a Ned Davis Research study which found that the S&P 500 typically falls by about 5 per cent following the first rate rise before rebounding higher.

Similarly, money manager Barry Ritholtz notes stocks have advanced in about 75 per cent of rate-rising periods. These stock gains averaged 21 per cent, and usually occurred when inflation was subdued and rates were increasing from low levels.

As for the periods where rates rose and stocks fell, this tended to happen in recessionary and inflationary environments.

Today’s environment mirrors the former case, says Ritholtz, indicating rising rates shouldn’t damage either the economy or equity markets.

Bulls relieved by earnings Investors may be fighting worries on multiple fronts, but the earnings picture has at least provided some comfort.

About 70 per cent of S&P 500 companies reporting so far have beaten estimates.

In itself, that’s no cause for celebration – company guidance is invariably conservative, allowing the vast majority to beat low-balled estimates. Barclays notes that over the past four quarters, estimates fell an average of 6 per cent in the run-up to earnings.

In the first quarter of 2014, estimates fell by 7.5 per cent.

In the latest quarter, however, estimates declined by a more lowly 3.5 per cent, with many analysts deciding against any downward revisions.

Now, it’s not as if companies are blowing past estimates. Still, the earnings beat rate is remaining consistently high, despite more minor estimate adjustments, so bulls can only hope earnings season continues in this vein.

Hedge funds continue to disappoint on results side It’s shaping up to be yet another bad year for hedge funds.

A quarter have lost money this year, data provider Preqin estimated recently, with overall gains averaging just 3.2 per cent.

Hedge fund managers don’t expect the situation to improve, two-thirds saying they expected gains of less than 6 per cent in 2014.

Their investors, however, remain hopeful – of 100 investors polled by Preqin, not one expected managers to record flat or negative returns.

Ignorance is bliss, but very costly, given hedge funds’ steep fees.

Given they have underperformed every year since 2008, investors’ blind optimism and seemingly endless patience is getting increasingly difficult to understand.

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