Developed Countries

​​​​​​​Underweight (High-Conviction) The last two weeks have seen earnings reports from the S&P interactive media & services index’s heavyweights Alphabet (the parent of Google) and Facebook and the prints were varied. Facebook reported revenue ahead of estimates and falling, but still solid, margins and the stock price soared. However, Alphabet reported slowing growth that drove the worst single-day share performance in seven years. A theme in both quarterly results were regulatory fines; privacy violations saw Facebook set aside $3 billion for an expected fine from the Federal Trade Commission while Alphabet’s earnings were lowered by the $1.7 billion fine over advertising violations from the EU. As a reminder, increasing regulation is core to our high-conviction underweight thesis. With respect to fundamentals, the S&P interactive media & services index’s forward earnings growth has fallen below that of the broad market (second panel) while above-market share price performance so far in 2019 has driven the valuation premium to extreme levels (bottom panel). This is a mismatch that we expect to be resolved via significant relative underperformance in the year to come. We reiterate our high-conviction underweight recommendation. The ticker symbols in the stocks in this index are: S5INMS – GOOGL, GOOG, FB, TWTR and TRIP.

Overweight The S&P tech hardware, storage & peripherals (THSP) index was cheering yesterday as index heavyweight Apple reported results that, while not strong, were better than the market had feared after the terrible Q4 print. Importantly, management commented that the rate of decline in China had eased significantly over the course of the quarter while services revenues hit a new record. Perhaps more important to equity investors was the $27 billion the company returned to shareholders in Q1, the authorization of another $75 billion for share repurchases and a 5% increase in the dividend. In the context of the still-pristine sector balance sheets (bottom panel), further shareholder friendly actions seem likely. Nevertheless, while sector valuations have bounced off the recent relative lows, the S&P THSP index continues to trade at a wide (though shrinking) discount to the broad market (second panel). We continue to find this discount excessive in anticipation of a sector rerating. Bottom Line: Troughing results in China, progress in services and a surge in return of capital to shareholders all point to more gains for the S&P THSP index; stay overweight. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP.

Highlights Open an equity market relative overweight to Europe versus China. Upgrade Denmark to neutral. Downgrade the Netherlands to underweight. Maintain Switzerland at overweight. With the Euro Stoxx 50 now up almost 20 percent from its January 3 low, the majority of this year’s absolute gains have already been made. Core euro area bond yields will edge modestly higher… …and EUR/USD will appreciate, as the backward-looking data on which the ECB depends catches up with the more perky real-time economic data.   Feature Vertical charts scare us, as we contemplate falling over the edge. But they also excite us, as we contemplate a lucrative investment opportunity. Right now, the vertical chart that is causing us palpitations is technology versus healthcare (Chart of the Week).  Chart of the WeekTechnology Versus Healthcare Has Gone Vertical! The technology versus healthcare sector pair is critical, because it looms large in several stock markets’ ‘fingerprint’ sector skews. Meaning that the technology versus healthcare relative performance has unavoidable consequences for regional and country stock market allocation (Chart I-2 and Chart I-3). The technology versus healthcare sector pair is critical, because it looms large in several stock markets’ ‘fingerprint’ sector skews. Chart I-2When Technology Underperforms Healthcare, Netherlands Underperforms Switzerland Chart I-3When Technology Underperforms Healthcare, China Underperforms Switzerland Specifically, from a European stock market perspective, the Netherlands is overweight technology while Switzerland and Denmark are both overweight healthcare. Further afield, the U.S. is overweight technology while China is both overweight technology and underweight healthcare. Explaining Verticality And The Subsequent Fall What creates vertical charts? To answer the question, let’s turn it on its head: what prevents vertical charts? The answer is: the presence of value investors. In a healthy market, a cohort of value investors will sit on the side lines and only transact with the marginal seller when the price falls to a semblance of value. In other words, the value sensitive investors help to set the price, preventing verticality. But if the value sensitive cohort switches out of character to join a strong uptrend, the cohort will suddenly become value insensitive. In this case, the marginal seller will set the price higher and the formerly uninterested value sensitive buyer will now buy at the higher price. The market has morphed into a trend-following market. As more of the value cohort switch sides, the process adds rocket fuel to the rally. Driven by the ‘fear of missing out’ the marginal buyer will buy at larger and larger price increments, and the chart becomes vertical. What triggers the subsequent fall? When all of the value cohort have joined the uptrend, the fuel has run out: the marginal seller will no longer find a willing marginal buyer at the elevated price. At this critical point, one of two things will happen. Either: a completely new cohort of even deeper value investors will switch out of character and provide new fuel to the trend, allowing it to continue. Or: the deep value investors will stay true to character and will only deal with the marginal seller when the price falls, perhaps sharply, to a semblance of deep value. Technology versus healthcare is now at this critical technical point at which the probability of trend-reversal has significantly increased. Both the theoretical and empirical evidence suggests that at this critical point, the probability of trend-continuation decreases to about a third and the probability of a trend-reversal increases to about two-thirds. Technology versus healthcare is now at this critical technical point at which the probability of trend-reversal has significantly increased (Chart I-4). Chart I-4Technology Versus Healthcare: The Probability Of A Trend-Reversal Is High Therefore, on a tactical horizon, it is now appropriate to underweight technology versus healthcare – which, to reiterate, carries unavoidable consequences for country and regional stock market allocation: Open an overweight to Europe versus China. Upgrade Denmark to neutral. Downgrade the Netherlands to underweight. Maintain Switzerland at overweight. Distinguishing Between Valuation And Growth Is Extremely Difficult There is another problem for value investors. Over short periods – meaning less than a year – it is very difficult, if not impossible, to decompose a price return into its two components: the component coming from the change in valuation and the component coming from the change in earnings growth expectations. A stock market’s actual earnings are highly sensitive to small changes in economic growth. This is universally the case but is especially true in Europe, because the European stock market’s skew towards growth-sensitive cyclicals gives it a very high operational leverage to GDP growth: a seemingly minor 0.5 percent change in economic growth translates into a major 25 percent change in stock market earnings growth (Chart I-5). The slightest improvement in economic growth expectations causes the market to upgrade its forecasts for earnings very sharply. Chart I-5A Minor Upgrade To Economic Growth = A Major Upgrade To Profits Growth Given this very high operational leverage, the slightest improvement in economic growth expectations causes the market to upgrade its forecasts for earnings very sharply. Which of course lifts the market’s price, P, very sharply. In contrast, equity analysts’ forecasts for earnings, which drive the market’s ‘official’ forward earnings, E, adjust much more slowly. As my colleague, Chris Bowes explains: “analysts get married to a view and usually require overwhelming evidence to materially change it.” The upshot is that the P rises very sharply but the official forward E does not, meaning that the official forward P/E also rises very sharply. This gives the impression that the move is mostly valuation driven, but the truth is that the move is mostly earnings growth driven. In a similar vein, when central banks guide interest rates lower, how much of the equity market’s move is due to a higher valuation, and how much is due to improved prospects for economic growth resulting from the central bank policy change? Over relatively short periods of time, it is extremely difficult to tell. All of which provides an important lesson: over short periods, do not focus on separately forecasting the valuation change and earnings growth change of a stock market. Much better to forecast the stock market price directly, by focussing on the two main things which will drive it: changes to central bank policy, and changes to short-term real-time economic growth. Focus On Central Banks And Short-Term Economic Growth Central bank policy now ‘depends’ on relatively longer-term changes (say, year-on-year) in backward-looking data, most notably the consumer price index. Whereas the stock market’s earnings growth expectations take their cue from shorter-term changes in real-time economic indicators (Chart I-6). Chart I-6Quarter-On-Quarter Growth Is Rebounding Hence, the ‘sweet spot’ for equity markets is when, in simple terms, year-on-year CPI inflation is decelerating, implying central banks will become more dovish, while quarter-on-quarter economic growth is accelerating, implying the market will upgrade earnings growth (Chart I-7). The stock market’s earnings growth expectations take their cue from shorter-term changes in real-time economic indicators. The ‘weak spot’ for equity markets is the exact opposite, when year-on-year CPI inflation is accelerating, implying central banks will become less dovish, while quarter-on-quarter economic growth is decelerating, implying the market will downgrade earnings growth. As 2019 progresses, our high-conviction prediction is that equity markets will move from a sweet spot to a weak spot. With the Euro Stoxx 50 now up almost 20 percent from its January 3 low, it implies that the majority of 2019’s gains have already been made in the first four months of the year – and the market is unlikely to be significantly higher at the end of the year. Compared to the equity market, the bond, interest rate, and currency markets are – almost by definition – much more dependent on central banks’ lagging reaction functions than on real-time growth. Which solves the mystery as to why bond yields are close to new lows while equity markets are close to new highs. It also solves the mystery as to why EUR/USD has lagged the very clear recovery in euro area real-time growth and in euro area stock markets (Chart I-8). Central banks are following lagging indicators. Chart I-7Stock Markets Take Their Cue from Real-Time Indicators Chart I-8Central Banks Are Following Lagging Indicators, Stock Markets Are Following Real-Time Indicators But as the backward-looking data, on which the ECB depends, catches up with the more perky real-time data, core euro area bond yields will edge modestly higher, and EUR/USD will gently appreciate. Next week, in lieu of the usual weekly report, I will be giving this quarter’s webcast titled ‘From Sweet Spot to Weak Spot?’ live on Wednesday May 8 at 10.00 AM EDT (3.00 PM BST, 4.00 PM CEST, 10.00 PM HKT). Through a series of key charts, the webcast will reveal the prospects and opportunities for all asset-classes through the remainder of 2019. At the end of the webcast, I will also unveil a brand new investment recommendation. So don’t miss it! Fractal Trading System* Supporting the arguments in the main body of this report, fractal analysis suggests that the recent rally in China’s stock market is at a technical point that has reliably signaled previous major reversals. Accordingly, this week’s recommended trade is a stock market pair trade, short China versus Japan. Set the profit target at 2.5 percent with a symmetrical stop-loss. We now have six open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9Short China Vs. Japan   The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.   * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.     Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations