QAP Monthly Review July 2015

July was one of the more exciting months. Although the last few weeks might have been stressful for equity investors, by the end of the month, July turned out to be favorable for investors with offensive equity positioning.

US and European equities moved higher in July. At the end of June, we found in a short study that the volatility differences between US and European stocks was in extreme territory. We suggested this could be an indication for a market turning point and subsequently increasing stock markets, more so for European than for US equities. Since then, US equities added +2.2% while Eurozone equities moved up +3.8%. At the same time, volatility in each region dropped and the difference between the two markets also came down.

Main drivers behind last month’s good performance of our equity market approach which is diversified across single strategies and geographies, was the selection of the NASDAQ in the US index rotation strategy, the choice of the MDAX, and the sector selection in Europe. Five of the six selected sectors ranked in the upper half of all 18 available sectors in July. The high market exposure of this strategy’s overlay also contributed nicely. For European sectors as well as for their US peers the indication within each rotation changed from defensive to offensive, at the same time. In our historical data, we could not find another similar occurrence.

 

End of the China Story?

While the Greek crisis eased on a compromise for a new rescue package, fear on China’s economic health came into the focus of investors. At the beginning of the month, we wrote that the movements of German and Chinese equity indices from each one’s high to low, were remarkably synchronous (see the blog post). During that time, the Greek debt crisis was still escalating and it was not obvious what caused the slide in the Chinese stock market. With one of the lowest valuations overall (measured by forward PE), from that perspective Chinese equities did not pose a strong downward risk. By the end of June, our Emerging Market rotation strategy determined to add China as the second position behind India. On purpose, the Chinese equity market is represented by the Hong Kong market in all our strategies. The enormous fluctuations that have been observed and might have been caused by the underlying market infrastructure of the domestic exchanges in China, could be largely avoided by allocating to the Hang Seng instead of allocating to the CSI, for example. The Hong Kong index fell 17% from its peak to its low. The German DAX fell 13%. An obvious relation might be justified by the high degree of export dependency of the German economy. However, a 10% share of exports to China, together with an upward tendency of the US dollar cannot serve as a full explanation for the synchronous slide of both markets, especially not when the less export dependent Euro Stoxx 50 mirrored the DAX performance. Since hitting their lows in Mid-July, Hong Kong equities moved higher by 5%, the DAX is up by 6%.

 

Outlook:

In the last few months, we saw equity markets increasing (at least in the US) but with relatively high volatility and remarkable drawdowns on the back of very favorable indication from our models and on good economic data. Currently, the indicator readings seem to get a bit worse, and also the economic picture weakens.

Already in our annual review for 2014, we worried about the absence of wage increases and inflation effects in the US job market recovery. Further US economic data in the last few weeks did not exhibit a strong growth environment. Falling oil prices also contribute to lower expected inflation numbers. The FED already scheduled their first rate increase for 2015. These factors combine to a real threat of an inverted yield curve. We are getting closer to the worst case scenario, a deflation. The price of gold exhibits this danger, as far as the metal serves any meaningful indication.

According to the phrase “a miss is as good as a mile”, we stay committed to our systematic approaches. The models show more negative conditions compared to the last few months but no signal for leaving the equity market has been received, so far.