DAY HAGAN RESEARCH UPDATE
Several areas of the U.S. markets are at or threatening new highs.
November 11, 2016
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As Don Hagan so eloquently stated in his publication titled “Underweight Emotion, Overweight Statistics” yesterday, “This is America. I’m betting we figure out how to move forward and continue to improve” despite a “crisis of confidence” for many in regard to the new President-elect. If you have followed the U.S. market since the election, you have witnessed the great rotation out of fixed-income, consumer and technology sectors into industrials, base metals (steel and copper), and defense stocks. This has been an American-based industry rotation. Yet, while we may be moving forward, the rest of the world is retrenching and struggling.
Prior to the election less than 30% of S&P 500 stocks were above their 10-day moving averages. As of yesterday, nearly 70% have moved above their respective 10-days, suggesting broad participation in U.S. stocks since Wednesday. However, if we look at the number of global markets above their respective 10-day moving averages, you’ll find that this number has dropped from just over 55% to its current level of 43.5% over the same time frame (below). Clearly, the U.S. has delivered a broader-based uptrend.
If we look at broader measures of participation using simple moving averages, you’ll find that only 43.5% of MSCI ACWI markets are above their 50-day moving averages and 53% above their 200-day moving averages (below). As shown in the performance box in the lower clip, historically, global markets do better when more markets are participating or in bullish trends. While the U.S. markets are reacting better and more optimistically about the change in the U.S. administration, global financial markets, overall, are not.
The most glaring example is the devastation occurring in Mexican financial markets. The Mexican peso has declined nearly 12% in the past few days, and in dollar terms, EWW, the iShares Mexico Capped ETF, has lost over 17% of its value. Economic growth prospects for Mexico, which rely on trade with the U.S., are now being questioned. While we think this move is overdone to the downside, we are not yet prepared to enter a direct long position in Mexico. We are watching this closely.
While we don’t have direct exposure to the Mexican market and the peso, we do have some exposure to those markets through our holding in VWO, the Vanguard FTSE Emerging Markets ETF. Mexican securities represent just over 4% of this fund (and less than 0.5% exposure in our Tactical ETF strategy). The largest country exposure in the VWO is China at 26%. Like other emerging markets, China’s stock market has also weakened over the past several days, in addition to their currency, the yuan. For U.S.-based investors in domestic ETFs that track international markets, currency exposure is an important factor in determining your returns. In fact, the impact of currency trends is much higher for international allocations than our U.S. exposure. In other words, while the yuan will ebb and flow, the impact will be much higher for Chinese ETFs priced in dollars than U.S. equity ETFs priced in dollars.
As shown below, the correlation between the currency exposure indicator and VWO has increased. This illustrates the impact of currency moves on the ETF’s performance. Over the past week, VWO has declined 2.81% and 123 basis points of that decline can be attributed to underlying currency weakness. This is a good illustration of the impact of dollar strength versus emerging market currencies.
In addition to emerging markets, we have some exposure to Asia and Europe, areas where we feel growth prospects and attractive valuations warrant portfolio allocation. Like EM currencies, the Euro has weakened versus the dollar, putting pressure on the dollar-based European funds, as has weakness in the Yen.
LOOKING FOR GROWTH
U.S. dollar strength has been a function of higher relative rates in the U.S. The old saying has always been that ”money goes where it is treated best.” Nevertheless, at this time, it is our view that dollar strength has gone too far too fast. In other words, we are looking for, at the least, a short-term reversal. We point to the fact that on a purchasing power parity basis, the U.S. dollar is overvalued versus most of its major trading partners’ currencies. Therefore, we are not ready to move our international exposure into ETFs that hedge the currency exposure.
Our allocation to foreign markets is fairly minimal at this time (<20%), but we would look to add to those international markets that are exhibiting good growth prospects. Below is a chart of the year-over-year PMI (purchasing managers’ index) for international economies. While growth does not always translate into equity market performance, it is a supporting factor. As shown, many emerging markets have improving and growing PMIs, in addition to developed European and Asian markets, highlighted by darker green areas on the map below.
We will continue to look to increase exposure on further pullbacks, though at this time we are not prepared to increase our overall market exposure substantially until we see broader global participation. We will continue to make small tactical adjustments. Additionally, we will vigilantly continue to monitor foreign exchange trends as they pertain to our foreign holdings. Right now the stronger U.S. dollar is helping our U.S. equity exposure (which we are overweight), but hurting our international exposure. Our view is this may be short-lived and international exchange rates will likely stabilize and possibly move in our favor over the intermediate to longer term. So while America will move forward and adjust to a new political administration, we will wait for our foreign counterparts to adjust as well.
Have a wonderful week,
Day Hagan Investment Committee Consultant
Day Hagan Asset Management
— Written 11.10.2016
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