Merrill Lynch's latest monthly fund manager survey is unequivocal: US stocks are expensive – go to Europe and emerging markets for better value. They're right, so why do US markets look poised to outperform?
Europe, which has been strong lately, has seen equity allocations hit their third-highest level on record. Money managers are also heavily overweighting emerging markets, where allocations are near five-year highs. In contrast, managers are noticeably underweight the US, where allocations are near nine-year lows.
When sentiment and positioning get lopsided, the risk of a near-term reversal rises. Fat Pitch blogger Urban Carmel notes how emerging market allocations hit their second-lowest level in history in January 2016, just prior to a furious rally. Allocations rose way above historical norms in October, just before a double-digit correction. The region outperformed after being underweighted in January, but now managers are piling in once more.
European stats are similar. Europe usually outperforms when everyone hates it and underperforms when everyone loves it, so today’s high levels of exposure don’t augur well for coming months. In contrast, US allocations have fallen to levels similar to those seen in late 2007 and early 2015; both times, the US subsequently outperformed.
Europe isn’t pricey and the fundamentals are improving, but it’s hard to disagree with Merrill’s conclusion that the recent outperformance “seems due for a pause, especially versus the US”.
Is European value just an illusion?
Not everyone sees European stocks as cheap. Rob Lovelace of the $1.5 trillion Capital Group, one of the world's biggest asset managers, told the Financial Times last week that Europe's value is illusory. Is he right?
Lovelace argues Europe only looks cheap because technology stocks, which typically attract higher valuations, are thin on the ground. Strip out the technology sector and Europe looks “basically the same” as the US.
Accounting for sector differences certainly narrows the valuation differential, although it doesn’t erase it. However, Lovelace neglects to mention that US profit margins and earnings are at all-time highs, while Europe’s are only now taking off, having gone nowhere since the global financial crisis. European earnings have much further room to grow and have a strong chance of surpassing 2017 analyst estimates.
Although StockTake has already cautioned that heady sentiment puts Europe at risk of near-term underperformance, the longer-term picture is brighter. US indices have been busy surpassing all-time records since hitting fresh all-time highs in 2013, but the Euro Stoxx 600 remains below 2000's peak.
Improving technicals confirm the improving fundamentals. Currently, the index is hovering below the 400 level, which marked tops in 2000, 2007 and 2015. A "decisive" move above this level, to quote Merrill Lynch technical analyst Stephen Suttmeier, "would confirm a 17-year base and break out into a secular bull market with plenty of upside potential".
Correction time for US stocks?
After a long sleep, markets finally reawoke to the reality of political risk last Wednesday, with the S&P 500 suffering its biggest fall in eight months as Donald Trump’s presidency lurched from one crisis to the next. Time for a proper correction?
Well, a pullback is overdue. The S&P 500 hasn’t experienced a 5 per cent decline since last July, the longest dip-free streak since 1996.
Buying any dip remains the obvious trade, however. Firstly, during this long bull market, traders have become conditioned to see every dip as a buying opportunity; this time is unlikely to be different.
Secondly, history shows it’s almost invariably profitable to take an optimistic view when markets dip after a long period of calm. The aforementioned Urban Carmel found 11 previous instances where markets experienced a similarly long streak without a 5 per cent decline. Only once, way back in 1966, did the ending of the 5 per cent streak lead to a bear market.
Rating fund managers’ gambling skills
Most fund managers underperform the market, but many are actually pretty good gamblers.
A new study, “Are mutual fund managers good gamblers?”, examines if fund managers are any good when it comes to buying so-called lottery stocks – long-shot investments that rarely pay off but which pay off big when they do come good.
Research shows ordinary investors badly underperform because they invest disproportionately in such stocks but rarely find the winning tickets. However, the new study shows lottery stocks bought by fund managers tend to do really well.
The funds themselves “persistently outperform” funds that avoid lottery stocks, although the difference is “modest” compared to the outperformance of the lottery stocks.
If these gambling fund managers are so good at picking lottery stocks, why don’t they invest more money in them? Institutional constraints likely prohibit them; they may also be afraid to do so. Professionals can profit by increasing their allocations in lottery stocks, the study concludes, and should have “a bit more confidence in their own ‘gambling’ skill”.
