Friday, November 14, 2014

A Possible Set Up For Ex-US Markets To Outperform

While the US economy continues to repair, albeit slowly, the situation in the rest of the world looks more dire. As a result, the performance of SPX relative to ex-US stock markets has gone parabolic over the last two months.

Zoom out, moreover, and this pattern looks like its reaching the same peak it reached in 1999, right before a dramatic fall.

It looks like a blow off top. Is this a danger signal for the US stock market?

There are a host of issues facing global equities. Perhaps this really is the cataclysmic end. But, in the past, this pattern has signaled the start of a period of outperformance by ex-US markets. US markets don't fall; they rise less quickly.

The next chart looks at the current bull market; the top half is the same as in the charts above, the bottom half shows SPX (black) and the ex-US index (red). You can see that whenever the US starts to underperform (yellow shading) its because ex-US markets have bottomed and are starting to rise again. The US also rises, just more slowly.

In fact, these periods corresponded to important bottoms in ex-US markets in 2010, 2012 and 2013.

The same was true in 1999: it wasn't the top of the bull market (that was more than a year later), it was the start of ex-US markets catching up to US performance after lagging behind.

US equity markets are frequently viewed as a safe haven. Money runs into the US when there is trouble abroad. The spike in US market outperformance, like we have seen in the past two months, is evidence of that.

You can also see that in the chart above. US markets fell hard from 2000 to 2002, but ex-US markets fell harder. As a result, the US outperformed (green arrows).

We know that sentiment toward US equities is running hot (e.g., equity fund inflows; surveys). So is the sentiment towards the dollar (here). At the same time, ex-US markets and foreign currencies are largely feared; expectations are very low (chart). That also means their equities are relatively inexpensive: European CAPE is half the US and price to book is 40% lower (here). For contrarians, this supports a hypothesis that a period of underperformance by US markets may be next.

Maybe the fall in oil prices will destabilize world markets. It seems to be a serious risk (more here). But in that case, if past is prelude, that implies that US markets will likely continue their parabolic rise higher relative to ex-US markets.

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