Day Hagan Research Update




Risk-on remains in control. Global markets continue to improve and outperform domestic markets.


Neil Leeson


February 10, 2017


Both investor and consumer sentiment measures are extremely optimistic on the markets and the economy. Investors have clearly been voting with their dollars to side with risk-on assets over those that are typically considered risk-off (below). The chart below shows that since early 2016, despite a few bumps along the way, risk-on assets like cyclical stocks and high yield bonds have outperformed risk-off assets, including traditionally defensive sectors (staples, utilities, telecom and health care) and the so-called safety stocks within them.

The S&P 500 Index gained over 11% last year and is up over 3% so far this year. As shown below, risk-on assets have typically had a higher correlation to the broad equity market than risk-off assets. Recently, however, risk-off assets have had a stronger correlation to the broad market. My view is that if the two correlation lines below approach equilibrium, as they did in the 1990s, it would suggest that the market is expanding with healthy participation. We have seen varied leadership over the past several months, but the best and most prolonged secular bull markets are supported by broad leadership. Currently, nine of 11 S&P 500 sectors are positive on the year (those nine sectors represent over 90% of the S&P 500 index), suggesting that we are "broadening" out, which is a very supportive factor for this secular bull market.


As I write this blog, many of the major U.S. indexes are breaking out to new highs and out of narrow trading ranges that started in mid-January. And many sectors appear poised to move higher as well. Nonetheless, when evaluating the major sectors utilizing a more weight-of-the-evidence approach, we find a very mixed picture. In fact, not much seems to have changed since the start of 2017: 1) Trend and breadth measures are strong, 2) five of 11 sectors are long-term overbought, 3) sentiment is extremely optimistic, both from on a broad market perspective and in aggregate, and 4) valuation metrics suggest that this market, and many sectors, are at historically overvalued extremes.

As shown in the table, several indicators do suggest that the upside is limited in many areas of the market. However, our approach does give more weight to trend factors when evaluating the attractiveness. And no matter how hard we may want to, we have to remain disciplined and not fight the trend. We continue to participate in this market through broader market ETFs, because we seek more diversification and the ability to spread allocation amongst all of the sectors—since the correlations between risk-on and risk-off assets are moving towards equilibrium.


As shown last week, global markets are showing aggregate trend strength. The chart below illustrates that just over 80% of major global equity markets are trading above their respective 50-day moving averages. If we look at longer-term mean reversion metrics (one-year daily z-score over rolling five-year periods) for those markets, nearly half of the markets have now become oversold! It was less than a month ago when only a handful of markets were overbought.

One of the best-performing international ETFs this year has been EPOL, the iShares MSCI Poland Capped ETF, which has gained over 14% YTD. As shown on the first chart in this blog, the Polish Zloty is considered a risk-on asset. As shown on the chart below, the Polish currency has gained almost 3% in the past month, and has contributed 37% of the monthly gain in EPOL. In sum, dollar weakness has added substantial fuel to dollar-denominated ETFs.

As we mentioned before, the dollar's direction remains key for both U.S. and international investments. The S&P 500 index is comprised of many companies that do business outside the U.S., and dollar strength hampers their ability to export goods and remain competitive. On a purchasing power parity basis, the U.S. dollar remains significantly overvalued based on data through 12/16. However, given dollar weakness since the start of the year, I suspect that this measure has subsided a little since then. Nevertheless, we still believe that the upside for the dollar remains limited given this chart, and that investors should continue to invest in the non-hedged international ETFs.


We are currently allocated to both broad European and Emerging Market ETFs. And we are looking to add more exposure to those markets exhibiting the best relative strength and absolute trend strength. Additionally, we are monitoring currency trends to find those funds where the currency is working for us and not against us. From a valuation perspective, both Europe and Emerging Market equities are trading at fair value, supporting their relative attractiveness.

In addition to those two areas, we are looking at further international exposure to more country specific markets such as South Korea, Japan, Norway, Australia and Taiwan.

One of the major reasons why global markets have done so well over the past several weeks is because of the weakness in the U.S. dollar. UUP, the bullish dollar ETF, is down nearly 2% on the year. As we have written in the past, dollar-denominated international ETFs do well when the currency is working in your favor (relative dollar weakness). In general, in all three major regions (Latin America, Asia, and Europe) the dollar has weakened substantially this year, providing a tailwind to those dollar-denominated ETFs.

We continue to look for opportunities.

Have a wonderful week,

Neil Leeson
Day Hagan Investment Committee Consultant
Day Hagan Asset Management

— Written 2.8.2017

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