Divergence is a state of market behaviour where factors do not agree.
In the case of the post-Brexit world, the U.S. market is on the cusp of making all-time highs (last week the NYSE's new 52-week high list was 12.7 per cent of the index, the highest reading since March, 2015). However, the biggest safe haven of all, U.S. Treasuries, are at all-time highs and gold has some mojo not seen in years.
That does not add up. One thing we have learned over 30 years of investing is that bond investors understand the economy far better than equity investors most of the time. Overseas, the European banking index made multiyear lows this week and Italy is on the edge of a major banking crisis with non-performing loans at about 20 per cent of gross domestic product (the U.S. figure is about 1.7 per cent, by comparison).
If one simply looks at price behaviour, these divergences are everywhere. In Britain following Brexit, the large capitalization FTSE 100 has made new highs while the more domestic mid– and small-capitalization companies in the FTSE 250 are still 8 per cent below their pre-Brexit levels. The main reason for this divergence is that the large companies have about 22 per cent of revenue in British pounds while the smaller companies have closer to 80 per cent of revenue in British pounds. The now-weaker British pound makes the large companies more profitable. Keep in mind before considering chasing this trend: They are not growing market share, they are not better companies because of Brexit. They simply benefit from a weaker currency, something management is not responsible for, and not really a good reason to buy them – but we leave that missive for a future column.
One of my favourite exchange-traded funds (ETFs) to follow and compare performance against is the Vanguard Total World ETF (VT-N). It trades in the U.S. market and represents the entire world of equities all in one place; large, mid, and small cap companies in every country in the world that has a bourse. Nearly 7,500 stocks in one place – talk about diversification! If your goal is to grow your portfolio at a rate that is better than the world equity market, you want to buy assets that are performing better on trend versus the world index or sufficiently discounted to the world index and offer compelling value.
For the foreseeable future, Europe looks to be the centre of global stress (followed closely by China) and likely will continue to underperform. The U.S. market remains the best dirty shirt in the laundry, but it is not clean or pressed. Some have opined that the global markets can decouple and that Brexit should not affect the U.S. markets – we don't agree.
Late in the bull market cycle we tend to see lots of divergences as the rising tide no longer lifts all the boats, and money tends to chase what is working. We saw this in a meaningful way in late 2007 and mid-2008 prior to the markets coming unglued in the wake of the U.S. housing collapse. An alarming statistic is the number of non-performing loans in the U.S. auto sector. Zero interest rates can mask a ton of bad lending – much like it did in the housing crisis. While the size of the auto loan market is $1-trillion (U.S.) versus the $10-trillion we saw in housing; the inevitable defaults will likely be hard on the bank sector and the U.S. economy.
As an example of money chasing performance, we have seen massive flows into interest-rate-sensitive sectors like utilities as bond yields tumble. The best performing sectors of the S&P 500 this year are telecom and utilities: up 20 per cent each with virtually no earnings growth. Both sectors are 30 to 40 per cent above long-term valuation averages. Flight-to-safety you might say? They may be among the last to fall, but they will fall, too. The biggest weights in the S&P 500 index are technology and financials, which are the only two sectors that are down this year.
The boat has a leak in it and the coming earnings season will likely show that top line revenue growth is marginal at best and earnings per share growth is largely being fuelled by share buybacks. I've been positioning my portfolios in a defensive way. For some that means lots of U.S. cash (iShares Short Treasury Bond ETF, SHV-N; Horizons U.S. Dollar Currency ETF, DLR-T; Purpose U.S. Cash ETF, PSU.U-T), for others we are net short the overvalued Russell 2000 (RWM-N).
I expect that the markets will offer some very good buying opportunities in the coming months, and into 2017, where Brexit contagion could take hold in Dutch and French elections. One of the biggest risks to Italy and the next leg of "Euroskepticism" is the constitutional referendum in October. If it does not pass, the Renzi government will likely fall and the anti-EU Five Star party, now the most popular in Italy, would hold a Uscita (Italian for exit). The wake of Brexit is not over by a long shot. Those minimizing its importance probably are naive about global systemic risks. Don't run out and sell everything you own, but do consider some of my divergent observations and remember we are very late in the market cycle (seven years of a U.S. bull market), where history reminds us that having a little cash on hand is prudent.
Larry Berman is co-founder of ETF Capital Management. He is a Chartered Market Technician, a Chartered Financial Analyst charterholder, and is a U.S.-registered Commodity Trading Advisor.