Why The Financial Sector Matters To Equity Investors

When it comes to global equity returns, the financial sector matters for one simple reason: financial stocks dominate global stock exchanges. Looking at the MSCI All Country World Index, which includes the 23 developed countries in the MSCI World Index and the 23 emerging countries in the MSCI Emerging Markets Index, nearly 23% of all stocks are financial stocks (552 stocks out of a total of 2449 stocks). Financials account for 7.5% more of the index than the second largest sector (industrials) and 8.5% more of the index than the third largest sector (consumer discretionary). There are more financial stocks than there are energy, health care, utility and telecom stocks combined. Surprisingly, financials almost equally dominate developed market indices as they do emerging market indices. 21.2% of all developed market stocks are financial stocks and 25.1% of all emerging market stocks are financial stocks. Out of the 46 country indices, just about two-thirds have more (or equal) financial stocks than any other sector. If you are are on the lookout for MSCI Country indices where financials aren't the dominate player, then look here (in alphabetical order): Canada, Chile, Czech Republic, Denmark, Finland, France, Germany, Japan, Korea, Mexico, Netherlands, New Zealand, Norway, Peru, Russia, Sweden, and Taiwan. 

With all of this in mind, the chart below is even more remarkable, The MSCI All Country World Index has increased by 52% over the past five years. During this time, the financial sector has underperformed by over 17%. 

Beware European Cyclicals

GaveKal Capital’s Jennifer Thomson examines recent trends in European cyclical stocks, suggesting caution may be warranted when considering investment in this group.

Margin Debt Stays Elevated In August - Just Below All-Time Highs

NYSE margin debt still hasn't surpassed the all-time high made in in February but it is very close! Margin debt rose by about $3 billion in August and is only $2 billion below the all-time high set in February. Net margin debt inched higher and set another all-time high in August. Last month, we noted how curiously margin debt was acting. This latest data point didn't do anything to curb our curiosity.

Examining Narrowing Stock Market Leadership From a Contribution Perspective

We've written extensively so far this week about the narrowing leadership in the global stock market. We've taken the tack of showing how nearly 30% of stocks in the euro area are in a bear market, to showing how US health care companies are the only remaining leadership group, to showing how the largest 50% of the market cap of the MSCI World Index (only 159 stocks out of 1615 total) are by far outperforming the smallest 50% of stocks (the remaining 1465 stocks). Just to hammer this point in, we'll attempt to show in a different way how market leadership has narrowed so far this year.

In the below table we show the yearly price change of the MSCI World Index since 2007. We then show how much of the performance was attributable to the top 100 contributors for that year and how much was attributable to the rest of the index (the bottom 1500 or so companies, depending on the year). In the rightmost column we show the percent of companies that contributed positively in each year (i.e. the percent of companies that had positive performance). A few observations to take note of are as follows:

• Since 2007 there have only been three years in which the contribution of the top 100 contributors was positive while the cumulative contribution from the rest of the World Index was negative (2007, 2011, and 2014)
• 2007 marked the top of the last bull market while 2011 suffered a nearly 20% correction
• So far in 2014 only 54% of companies have posted positive nominal performance
• In each year that the World Index posted a strong advance (2009, 2010, 2012, 2013) greater than 70% of companies posted positive performance
• In each year that the World Index displayed significant market weakness (2007, 2008, 2011) the number of companies with positive performance was 52.5% or less

In sum, so far this year we have the MSCI World Index up about 2.5%. The top 100 contributors have contributed 4% of that total while the bottom 1515 contributors have contributed -1.4%. Moreover, only 54% of stocks have even gained this year, which is the lowest number since 2011, a year in which the stock market fell by nearly 20% at its trough. These data points are a mirror image of observations in years of strong market advances (2009, 2010, 2012, 2013) and suggest a significant amount of weakness under the surface of headline index prices.

Copper is Breaking Down Again and What it Means for EM Stocks

As noted here on Monday, it appears copper prices are about to take another significant leg down. The price of copper has now decisively broken through the rising support line in what appears to be a continuation of the longer-term downtrend that started back in 2011. The metal price has yet to take out the low of 2.95 achieved in March, but based on recent history that day is not far off.

Assuming copper prices do make a new low then, what would that mean for EM stocks? Based on the last two charts below depicting copper prices on the left axis and the MSCI EM price index on the right axis, we should expect another leg down in copper to coincide with more weakness in EM stocks. The third chart offers a shorter-term view of the relationship and from this perspective it appears that EM stocks have gotten ahead of themselves.

Clear And Present Danger

There are four developments in the fixed income markets that represent a clear and present danger for stocks.  First,  high yield spreads continue to widen, diverging from the upward movement in stocks prices.  In the chart below we plot high yield spreads against the S&P 500 over the last ten years. Until today the equity market seemed unfazed by the widening in spreads.



Second, inflation expectations derived by comparing 10-tear nominal US Treasuries against the 10-year TIPS show a recent big drop.  This is likely due to the recent strength in the USD, but regardless of the reason, the drop in inflation expectations is undoing much of the reflationary work the Fed has tried to achieve.  Should inflation expectations fall below 2%, the danger signal would intensify.




Third, 10-year bonds around the global are taking another leg down.



Fourth, the spread between 30-year and 10-year US Treausry bonds is narrowing to new five year lows.  The last time the long end of the yield curve was this flat was in the first few months of 2009.

The Largest Stocks Are Carrying The MSCI World Index

The 50 largest stocks in the MSCI World Index account for roughly 28% of the total market cap of the MSCI World Index. So for a market-cap weighted index such as the MSCI World, the movement of the largest 50 stocks (out of 1615 total stocks) can have an outsized effect on the performance of the index as a whole at certain times.

In US dollar terms, the MSCI World Index is up 3.32% year-to-date. Weighted by market cap, the largest 50 stocks are up 6.92% and the remaining 1465 stocks are up just 1.46% year-to-date (as of 9/23 close). As the chart below shows, market action in 2014 has been reminiscent of market action in 2012, albeit slightly less dramatic. The gray area in the chart is the performance difference between the largest 50 stocks and the smallest 1465 stocks expressed as percentage using the MSCI World Index price level as the denominator in the calculation. As you can see, we are at the largest difference between the two groups of stocks since October 2012. The gap closed in 2013 as the rest of the MSCI World Index rallied more than the largest 50 stocks.  The question facing investors now is whether or not the gap closes again because the smaller stocks rally faster than the larger stocks or if the gap closes as the largest 50 stocks fall in price?



If we want to take this analysis one step further we can look at the performance of the largest 159 stocks (accounting for 49.92% of the total market cap of the MSCI World Index) vs the smallest 1465 (accounting for 50.08% of the total market cap of the MSCI World Index). Here the dichotomy of returns is even more pronounced. In fact, the performance difference between these two groups of stocks hasn't been wider at any point in the 5+ year bull market. As you can see in the chart below, the largest 50% of stocks started outperforming at the same time as the largest 50 stocks did in 2012, however, they have held on to their gains for three straight years and have since increased their outperformance relative to the smallest 50% of stocks recently.



The last thing to note is that off the March 6th, 2009 lows, the smallest stocks in the MSCI World substantially outperformed the largest stocks. Something to keep in mind the next time there is a cyclical low in place.

Why Knowledge is Undervalued

GaveKal Capital’s Steve Vannelli outlines the academic foundations, philosophy and process behind the GaveKal Knowledge Leaders Strategy.

Bull Market Mirage

On an equal weighted basis, the MSCI World index is up 2.58% YTD, is down 3.39% QTD and down 3.01% MTD.  The equal weight index gives us a better idea of our chances of picking stocks that outperform. 

Performance of MSCI World Sectors

Next let's delve a little deeper in the internals of the market to give some context to the performance of the market in general.   To set the table let me show the geographic breakdown of the MSCI World index.  Roughly 44% of the 1,610 companies in the MSCI World Index are domiciled in North America, while 27.6% of companies are located in Europe and 28.2% are located in Asia.

Geographic Breakdown of MSCI World Index

 Let’s start with a comparison between the main geographies that comprise the MSCI World index.

North America.

On equal weight basis, North America is up 6.33% YTD, with the health care sector in the lead. 

Performance of MSCI North America Sectors

When we drill down and look and the percent of companies outperforming the MSCI World index, we can see that 55% of North American companies are outperforming YTD, with the highest rates of outperformance in the defensive utility and health care sectors.

Percent of MSCI North America Outperforming MSCI World Index

Europe

Performance in Europe has been comparatively worse.  On average, European stocks are down 3.05% YTD, -7.58% QTD and -3.34% MTD.  Here again, health care (and other defensive sectors) have led performance.

Performance of MSCI Europe Index

Only 34% of companies in Europe have outperformed the MSCI World index this year, which indicates the odds of picking outperforming stocks have been quite low.  

Percent of Companies Outperforming MSCI World Index

Asia

The average company in Asia has fared somewhat better than Europe, but still not close to the performance of North America.

Performance MSCI Asia

The equal weight basket of Asian stocks is only up 2.22% YTD and is down 2.5% QTD and- 2.88% MTD.  Once again defensive sectors have led, with health care the second best performing sector. Less than half of the companies in the MSCI Asia index have outperformed this year.

 Percent Outperforming MSCI World Index

Next let me add some detail to illustrate the tumult underneath the surface of the market.  A bear market is traditionally defined as down 20% from highs.  In the table below, I break out the performance of all stocks in the MSCI world index by grouping. 

 Performance of MSCI World index By Group

Nearly 18% of the stocks in the MSCI World index are down more than 20% over their one year highs.  A further 33% of stocks are down between 10-20%.  So, 51% of all stocks in the MSCI World index are down at least 10% from one year highs.  

Performance of MSCI Europe Index By Group

29% of European stocks are down more than 20% from one year highs, and 68% of European stocks are down more than 10% from one year highs.  The odds of picking a loser have been high in Europe.

 Performance of MSCI Asia Index by Group

18% of Asian stocks are down more than 20% from one year highs and an additional 40% are down 10-20% from one year highs.  So, 58% of all Asian stocks are down more than 10% from one year highs.

Performance of MSCI North America By Group

By contrast, only 11% of North American companies are down more than 20% and 65% of all North American companies are down less than 10% from one year highs.

Below are some charts that reinforce the point that the bull market of the last few years has been exclusively an American phenomenon.  While North America has outperformed (on a market cap weighted basis) by 20% over the last five years, Europe has underperformed by 20% and Asia by 25%.

Additionally, on a country basis, only the US and Denmark have outperformed over the last five years.  That’s only 2 out of 24 countries that have outperformed the MSCI World Index.

For comparison, many major countries have had fairly dismal performance.  For example, Japan, Germany and the UK have all underperformed significantly over the last five years.

From still another perspective, let me demonstrate the difficulty in stock picking over the last few years.  Roughly 75% of the MSCI World Index is cyclicals—companies in the consumer discretionary, financial, technology, energy, materials and industrial sectors.  Given all the fiscal/monetary stimulus of the last few years, one sure would have thought these cyclical areas would have outperformed.  That would would have been incorrect.  In the chart below I show the relative performance of all cyclicals in the MSCI World index.

So, roughly 75% of the companies in the MSCI World index have underperformed by 10% over the last four years.  This means only 25% of the stocks in the MSCI World Index have driven the performance of the whole index.  Leadership in the global equity market has been quite narrow, with cyclicals underperforming.

A very narrow slice of the global, developed equity markets have been in a bull market.  North American health care, which represents only 9.2% of the MSCI World index, and North American consumer discretionary, which is 15.8% of the MSCI World Index have carried performance over the last five years for the whole MSCI World index.

Global equity market performance has been a bit of an optical illusion the last few years, with the vast majority of stocks underperforming the index, and those that did outperform tended to be counter-cyclical.  Every day we see more evidence that even the bull market in the US is getting riskier and riskier.  Recent evidence includes fewer sectors outperforming, high yield spreads widening, small cap stocks negative on the year, flattening yield curve, etc.

Euro Area Stocks Standing Out From Japanese and US Stocks and Not in a Good Way

One of our favorite market breadth indicators measures the percent of stocks in an index that are in a bear market, which we define as down at least 20% from their 200-day high (blue line, left axis, inverted in the charts below). By this measure the major Euro area MSCI stock indices are standing out like a soar thumb in that the percent of stocks in a bear market is accelerating higher and reaching levels near 30%. Contrast this with the MSCI Japan and MSCI USA in which the percent of stocks in a bear market remain at historically low levels of 17% and 8% respectively (last two charts below). We find this breadth measure interesting because even though the prices of these Euro area indices have declined in recent weeks, the decline is still less than 10% from the recent high. For example, MSCI France is only down 7.4% and MSCI Germany is only down 8.5%. This is another case then in which the average stock is performing much worse than the headline price index would suggest.

On The Lookout For Black Swans - Skew Index On The Rise Again

The CBOE Skew Index made a 15-year, 11-month high last Friday and the 25-day moving average is on the rise again. The latest reading puts the risk-adjusted probability of a 2 standard deviation event happening in the next 30-days at 11.75%-13.10% and a 3 standard deviation event at 2.21%-2.51% for the S&P 500. The 1-quarter moving average of the Put/Call ratio is on the rise as well. It is approaching levels which has been consistent with the 1-quarter price returns for the S&P 500 turning negative. The 1-quarter change in the S&P 500 currently is at 1.61%.