Secular bull market to continue after mid-year correction

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1 This is for investment professionals only and should not be relied upon by private investors APRIL 2014 TECHNICAL ANALYSIS Secular bull market to continue after mid-year correction Jeff Hochman says we are likely to see a modest market consolidation or correction in the short term to absorb gains made in 2013, before the secular bull market accelerates again later this year or early next. As global equities are made up of 85% European and US constituents, they are supported by the strengthening US economy, excess liquidity in the form of quantitative easing, and to a lesser extent increasing optimism about European recovery. Very close attention should be paid to just how effective policy support will be in Japan. In general, investors are keen to see earnings coming through this year in developed markets to support the higher valuations as these markets rerated higher in CURRENT MARKET OUTLOOK The US leads the ongoing secular bull in global equities Despite an increase in sector rotation, the S&P 500 achieved new highs in April. This break to new highs started just under a year ago when the S&P 500 confirmed the transition from a secular bear to a secular bull market. But while developed market equities have recovered to pre-financial crisis levels, the outlook will remain uncertain in the short term. The technical situation in Japan has deteriorated more than was expected in the first quarter as foreign investors nervously pulled out money from the country. Investors are concerned about the level of Japanese policy support and the impact of this month s consumer tax hike from 5% to 8%. If the outlook weakens, we could see a further 5-10% drop in the Japanese market. After five very strong years of the current secular bull, a pause, followed by a large trading range in 2014 to digest all the gains and confirm the breakout, is therefore possible. In history there have been correction periods of one-three years in the mid- 1940s and early 1980s following exits from long-lasting secular bears. Jeff Hochman is Director of Technical Analysis and a member of Fidelity s Asset Allocation Group. Before he joined Fidelity in 1996, Jeff spent five years with Deutsche Bank as an equity analyst and strategist, and worked for Chase Manhattan Bank prior to that. Jeff holds a Masters degree in International Management and a BA in Political Science and English Literature. The search for yield continues and sentiment is strengthening The lack of apparent earnings and in many cases revenue growth continues to be a key risk in equity markets in Developed markets have already rerated with higher PEs and now have valuations which are considered to range from fair value to expensive, depending on an investor s individual viewpoint. The recent tactical moves and sector rotations continue to offer investors opportunities. Stock picking has become more challenging as valuation dispersions decrease The risk-on/risk-off dominance faded dramatically in 2013, allowing stock pickers to enjoy a tailwind as volatility and intra-sector performance dispersions fell. That said, valuation dispersions have also decreased from 2012 levels, so not as many stocks stand out as clear anomalies, creating a more challenging environment for investors. Healthcare maintains market leadership The healthcare sector and to some extent the technology sector are clear-cut favourites in terms of market leadership, but these are well-known stories. Yet with intra-sector dispersion low, there are still ample stock-picking opportunities in sectors such as consumer discretionary and financials, and the consensus sells of consumer staples, materials and energy. Dividends are key to boosting long-term total returns Dividends are crucial to the total returns that investors enjoy over time. The magic of compounding is the single most important determinant of long-term equity gains and nothing else even comes close to boosting returns like dividends do as they compound over time. Especially in years like in 2014 when price action might correct/consolidate, owning dividend-growing stocks will likely be a winning combination.

2 Japan: can policy support help lift the equity market again? The central question about the Japanese equity market is: what has happened to the momentum behind the fifth wave of expansionary breakout in the Japanese stock market? How quickly perception changes it now appears that Japanese equities are resting on key policy support. So, there will be close scrutiny of how the market performs in 2014 to ascertain whether the impact of Abenomics is delivering positive effects. Emerging markets: small caps still offer some favourable opportunities So far in 2014, there are few technical signs that emerging markets will reverse their underperformance versus developed markets, but currently they are staging a small recovery rally as many investors have capitulated and sold all their holdings. In absolute terms, emerging markets have only fallen about 6% in US dollar terms since the asset class hit its relative peak versus the US equity market in September In relative terms, however, emerging markets continue on a steady downward path. It is evident though that this trend is dominated by the fate of large-cap companies, while many smaller companies continue to perform quite well. Importantly, there are very strong country and sector variations within the broad theme of emerging markets. Short-term interest rates to remain low this year Short-term interest rates are likely to remain low in 2014, but it will be important to maintain a watchful outlook as the year progresses for any early signs of rates increasing. Similarly, although long rates will eventually rise towards 4% in the US, it might take longer to reach this level than we have previously thought, with the lower end of the 12-month ranges currently being tested in both the US and the eurozone. Confirming the 2013 secular breakout in 2014? Chart 1. Source: 2014 Ned Davis Research The Cycle Model Composite has been a very effective measure of predicting the general market trends since the 1920s, and extremely well during the past five years. The four-year and 10-year cycles should dominate in 2014, which predict a flat or downward-moving Q2-Q3, followed by a strong Q4. The Cycle Composite (see chart above) suggests a soft patch now followed by more upside later this is illustrated in the red line at the far top-right of the chart. If a correction/pullback unfolds in 2014, it should start within the next few months. While there are of course signs of sentiment froth now, such as IPOs, and biotech and technology PEs, the market is not the same as it was in 1987 or A slowdown in G7 growth lead indicators provides the macro backdrop to justify a scenario of consolidation. Despite a possible pause in the uptrend over the next 15 months or so, the US and European equity markets are poised to continue their new secular adventure, most likely at the expense of commodities, which are expected to move sideways to downwards over the next few years.

3 Waiting for EPS support to shine through this year Chart 2. Source: Datastream. Generally, the consensus analyst forecast of double-digit EPS growth in 2014 remains very optimistic and is starkly contrasted with the bottom-up analysts that are still downgrading the average stock in all regions ex-japan. Europe s rally has been almost exclusively achieved through rerating rather than growth in EPS, while in the US EPS growth has been modest at best. The chart above shows the contribution of both EPS and PE rerating and derating since March It is still difficult to conceive of much more multiple expansion coming through as a contributor to further gains without seeing earnings actually increase. Low inflation may be the kicker to keep PEs higher for longer before a valuation-induced correction, which will only be apparent in hindsight. Real money continues to flow into the HY space, less in Europe and Japan, and less out of emerging markets Charts 3 and 4. Source: Deutsche Bank, EPFR Real money continues to flow into the high yield space with strong daily inflows into European high yield. The volume of equity now flowing into European and Japanese equities has reduced somewhat, while outflows continue in emerging markets, but at a much slower pace than in recent quarters. However, there are some concerns about the level of inflows into passive funds. Approximately 85% of the flows into the US have been via ETFs over the past 12 months. Over the same period, the level of ETF inflows has been more or less half in Europe compared with the level we are seeing in the US. In addition, ETF volumes in Europe are starting to follow the US example and pick up market share.

4 Social Network Analysis shows continued growth in global sector correlations Charts 5 and 6. Source: ASR Research, London Social Network Analysis shows continuing growth in global sector correlations. In the second half of 2013, the global sector map is loosely grouped. There are four clusters with an average 2.5 members and 14 sectors are not in any group. There are only six positive correlations and 10 negative correlations on the map (threshold > 0.4). In the first quarter of this year, this sector map remains loosely grouped, but the cluster size is larger. There are four clusters with an average 3.25 members and 11 sectors are not in any group. There are 12 positive correlations and 16 negative correlations on the map. Various sectors are offering very attractive stock-picking opportunities Charts 7. Source: Deutsche Bank Equity Quant Strategy Group With healthcare maintaining market leadership, investors can still enjoy stock-picking opportunities in other sectors, even the consensus sells of staples, materials and energy. In the first quarter of this year, the utilities sector became more appealing, and the outlook for European utilities has stabilised somewhat, especially as bond yields and inflation remain subdued. The consumer discretionary theme is still alive, yet if rates and petrol prices rise too fast this sector is usually the first to be sold, especially if housingrelated stocks come under pressure. The current market environment is much more about individual stock-picking opportunities rather than sector rotation, which is important for the market to remember. With a 25% sector weighting in the broad index, picking the correct financial stocks is very critical at this stage of the game as there are clear winners and losers.

5 Japanese equities are now resting on key Bank of Japan support Near term key support Charts 8. Source: Bloomberg After January s failed breakout, price action has taken a notable turn for the worse and as the Japanese yen strengthened there is hope that the recent setback will stop at February s lows. That said, we could see another 10% drop in the Japanese market. So, the focus going forward will be on how the Bank of Japan will act to support the decline and help boost the next breakout. Few technical signs that EMG will reverse underperformance vs developed EMG Index Charts 9. Source: Bloomberg Outflows from the emerging market funds, particularly ETFs, has been indiscriminate when it comes to large- and small-cap holdings as well as good- and poor-quality companies. The net result is that there are now many oversold stock-picking opportunities available, especially in the consumer and financials sectors. For example, it is clear that the large-versus-small divide is still alive and well, particularly in China. While the composite index and large caps are not doing so well, small and mid caps and small and micro caps are doing very well. The current emerging market correction is nothing new it has happened many times before and each time has led to fantastic buying opportunities for selective securities as the markets mature.

6 US (top) UK (bottom) long and short rates are likely to stay lower for longer Charts 10. Source: Datastream, FIL If UK rates look like US rates, it is because they are tracking each other very closely. Short-term interest rates are likely to remain low in In essence, we will need to see a clean break above 3% in both US 10-year Treasuries and Gilts to confirm any strong conviction in a rising rates environment. The markets are speculating that the US Federal Reserve and the Bank of England will raise short rates much sooner than they say they will, and 10-year rates will rise towards 4% end of Inflation seems to under control in most markets, with the exception of rising food prices in emerging markets.

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