Teun Draaisma, the co-head of European equity research at Morgan Stanley became infamous in Wall Street circles when he issued a full house sell signal in June of 2007, just weeks before the credit crisis began to spiral out of control. Draaisma and his team are not afraid to issue short term calls on the market and place a large emphasis on risk management and sentiment indicators (you can see why I like his stuff). Draaisma became bullish in November of 2008 and turned cautious in April 2009. Many of Draaisma’s calls have been similar to my own. His current out look is not far off. He obviously reads TPC:
The consensus opinion has been consistently two months late, this year. In March, most people talked about insufficient policy responses and Great Depression II. In May, the consensus focused on the mountains of uninvested cash that were going to chase the market higher in the near term. And
now, the consensus view is that the market will be rangebound and go sideways for the next few months. In those instances, the consensus has proved to be an accurate description of what had happened in the preceding two months, rather than a good forecast. In our view, markets are unlikely to trade sideways in a narrow range, especially when most expect them to do so. Being long volatility may be the best way to play this, currently. We would characterize the consensus as being very macro and short-term focused, with low conviction levels. As a gross generalization, hedge funds are long and long-onlies are underinvested.
We aim to keep an open mind, be nimble, follow the models, and, most important, explore the middle ground. Unfortunately, we have less conviction than usual on the market direction outlook. None of the aspects that matters to us in deciding on market direction is giving us a clear steer, including our MTIs, sentiment, valuations and fundamentals. We are keeping an open mind and are waiting for a stronger
signal to take a stance on market direction, either way. On the positive side, policy initiatives have been successful, and risk of a profound economic crisis is off the table; on the negative side, the trough in earnings and US house prices is still too far away, in our judgment, to justify a very bullish market outlook.
Therefore, we follow our models closely and explore the middle ground, where we believe there are plenty of opportunities to make money beyond the market direction call.
1) We follow our models and go from underweight to neutral equities
With the passing of the stress test in May (when the S&P 500 was at 929) and several banks paying back TARP money in June (when the S&P 500 was closing in on 950) it became clear to even the biggest bears that things had improved. Yet, at the time we decided not to chase the rally, as our Market Timing Indicators (MTIs) still gave us a sell signal at the end of May. Our Combined Market Timing Indicator (CMTI) was at 0.3 standard deviations above zero, suggesting only a 47% chance of up markets in the next 6 months, and both the Risk and Fundamentals components were giving a rare double sell signal, which had been followed 14 out of 18 times by down markets. In addition, sentiment surveys had turned more positive, with the AAII survey for instance showing 11% more bulls than bears. See Making Utilities Our Largest Overweight, 11 May 2009 and A Finely Balanced Outlook, 10 June 2009 for our thoughts at the time.
Some things have improved in recent weeks. US 10 year bond yields have fallen from 3.95% on 10 June to 3.48% on 29 June (latest 3.51%). Sentiment as measured by AAII bulls minus bears fell from +11 on 4 June to -21 on 25 June (latest -7). MSCI Europe equity prices were down 6% between 2 June peak and 23 June low (still down 5.1% from 2 June peak now). In addition, the Risk indicator component in our MTIs has
moved from “sell” to “neutral”, as at the end of June. Our Market Timing Indicators (MTIs) continue to suggest a 47% chance of up markets in the next 6 months. Other positive fundamentals in the past few weeks include the ECB tender, and central banks signaling they won’t hike rates that soon. Moving 5% from government bonds to equities. As a result, we are moving 5% from bonds to equities, so that we go to 5%
OW cash, neutral equities, 5% UW bonds. Our MSCI Europe fair value target remains 850, based on 12x normalized earnings, and our bull case index target is 1200, based on 35-year average P/E and ROE values, which we could approach if the cycle resembles normality for a little while longer. The latest MSCI Europe reading is 901.
What could change our mind, either way? We are not turning outright bullish, as there are still plenty of uncertainties related to US housing, European earnings, the European banking system, the default cycle, Chinese growth, and policy action. We would consider turning more positive if we get comfort that the trough in earnings and US house prices is getting closer, and if our MTIs give us an outright buy signal
(CMTI < -0.5). We would consider turning more bearish if rates go up by too much, if the growth outlook deteriorates, or if our MTIs give us an outright sell signal (CMTI > +0.5).
2) We focus on the middle ground rather than high or low beta
We introduced the notion that it is time to move on from the macro to the micro. The last two years have been very exciting macro times, with markets going down and then up, in a big way. Macro and the next big
market move has become everyone’s favourite investment topic. The macro hedge fund category, for instance, has gone from pretty much the least popular to the most popular category over the past 2 years. Whenever there is an excessive focus on something, it is probably time to move on. We suspect it is time
to move on to the micro of sectors, stocks and styles. Most investors want to buy either high or low beta, banks or pharma, US or EM, leaving a large middle ground of interesting investments untouched.
But what does “the middle ground” concept really mean? In today’s piece, we list some concrete ways to implement the middle ground idea. As always, we try to identify where sentiment or valuations are at extremes.
1. Regional equity allocation: Japan and Europe.
2. Sectors: some defensives, some inflation hedges.
3. Reliable growth stocks for the medium term.
Afterthought: is it really different this time? Let’s also consider the outlook for the next few years. At the end of a recession, it must frequently feel that “it’s different this time” and that, because of the structural problems du jour, the economy cannot resume a normal growth cycle. Indeed, we too are highly skeptical that a new multi-year bull market is upon us. We expect economic growth to be stop-go, as authorities at some point try to withdraw stimulus and restore public finances, leading to a multi-year period of subtrend growth and higher volatility in growth and inflation. We observe, though, that no one believes in the V-shape recovery right now, just as no one believed in successful policy action in Q1 of this year. And after a recession, don’t we almost always enter a normal growth cycle anyway, against all odds? Even in Japan between 1993 and 1996, the recovery must have looked pretty decent! The structural problems may only come back to the fore when policymakers change tack again, or inflation runs out of hand, or rates rise by too much. This idea that “it’s not different this time, either” is one we will continue to mull over.
Nice thoughts from Draaisma and Morgan Stanley.