This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Clayton Fresk, CFA, portfolio management analyst at Georgia-based Stadion Money Management.
For the first part of 2015, there were various markets that were trending strongly—both to the up and downside. However, over the past month, many of these trends have reversed course. Is this more of a temporary correction, or are we in the beginning of a new trend?
It’s always hard to tell, but it’s worth examining some of these shifting markets to get a better sense of what to expect. With that in mind, I’ll take a closer look at a few of these markets.
During the first months of the year, European equity markets were on fire. From the beginning of the year through April 10, the EURO STOXX 50 Index was up 21.9 percent. By comparison, Japan’s Nikkei rose 14.9 percent and the S&P 500 Index in the U.S. edged up just 1.6 percent.
This strength was accompanied by continuing weakness in the euro, which through April 10 was down another 12.4 percent against the dollar, even after its value deteriorated through the latter half of 2014. Without hedging, investors would have experienced only one-third of the local market returns during this time frame. For example, the unhedged SPDR EURO STOXX 50 ETF (FEZ | A-77) has returned just 7.6 this year, compared with almost 22 percent for the local index.
It is no wonder that the use of currency-hedged ETFs exploded during these moves. Shares outstanding in ETFs such as the iShares Currency Hedged MSCI EMU ETF (HEZU | D-43) have increased by 17 times this year.
However, over the past month, these different pieces of the European markets have each moved in opposite directions. The EURO STOXX is off 3.6 percent after trading 6.5 percent through May 5, while the euro has bounced off the $1.05 level and is trading about 5.6 percent higher. Thus, the net effect for an unhedged investor over the past month is a positive 2.2 percent.
Does this mean the hedged trade is no longer viable?
That does not necessarily seem to be the case, as situations such as the Greece exit and the quantitative easing program by the European Central Bank may still have pressuring effects on the euro. However, the smooth ride that these markets experienced early in the year could be running its course. Both euro volatility and the VSTOXX (the European equivalent of the VIX) remain elevated, and that indicates we could see some choppiness in both markets forthcoming.
This market has been on a very strong trend for longer than just the past few months. The short end of European yield curves resides in negative yield territory.
The benchmark German 10-year rate has been on a smooth ride lower since the end of 2013, where rates went from just shy of 2 percent all the way down to a measly 0.07 percent by April 17. The downward moves in Italian and Spanish yields have been even more impressive, trading from 4 percent to just shy of 1 percent over the same period.
While not listed in the U.S., the iShares Euro Government Bond 7-10 Year ETF (IBGM) was up 20 percent since the end of 2013 in local currency terms compared with a 12.4 percent gain in the iShares 7-10 Year US Treasury Bond ETF (IEF | A-51).
However, since mid-April, the bottom has fallen out of this market. The yield on the German 10-year note has spiked nearly 50 basis points since April 20, completely wiping out the year-to-date move lower. Similar moves have been felt in other European markets, leading the European-listed IBGM to trade 2.7 percent lower since April 20, compared with IEF’s decline of 1.7 percent.
So is the lower rate move in Europe now over?
Based on remarks from a popular market analyst, this move actually could have been expected. As he notes, the markets here in the U.S. saw similar rate spikes right after the start of quantitative easing injections, but rates leveled off thereafter. Therefore, as the ECB is going down a similar QE path, it could be expected that rates abroad follow a similar trajectory.
I interpret the outperformance of U.S. small-cap stocks as a bullish signal for the market. Relative strength in small-caps over the S&P 500 Index suggests investors are speculating rather than rotating to higher-quality large-cap names. During the first months of the year through April 15, the small-cap Russell 2000 Index was up 6.2 percent compared with the S&P 500 2.9 percent gain.
However, since mid-April, this trend has reversed, with the Russell 2000 down 3.1 percent versus a modest 0.6 percent gain for the S&P 500. While this underperformance does bring a bit of concern, a few factors could stem the bleeding. One of these factors is the small-cap-to-large-cap ratio, which looks to be at a resistance level.
The bottom half of the chart below shows the ratio over the trailing 12 months. The ratio is currently at 1.5. This is the same level we saw maintained for extended periods in summer 2014 and earlier this year. If we see this ratio level off, small-caps should at least keep par with their large-cap counterparts.
For a larger view, please click on the image above.
For a larger view, please click on the image above.
Another factor that was contributing to large-cap underperformance has been the quick strengthening we saw in the dollar, particularly in early March.
Since many large-cap constituents are multinational corporations deriving decent revenue from non-U.S. sources, the strong dollar was a drag on these companies. As a comparison, small-cap companies generally derive more revenue within the U.S., so they are not vulnerable to these currency-translation issues.
As we’ve seen the dollar weaken since mid-April, large-cap relative performance has improved. However, rather than being a stabilizer, this increased currency effect could add volatility to any relative performance going forward as currency markets decide which way to trade.
Some of the market trends we saw from early this year have reversed course. However, it is yet to be determined if these reversals are the start of a new trend or just a short-term correction.
The above constitutes the personal, professional opinion of Clayton Fresk, CFA, and does not reflect the views of Stadion Money Management LLC. At the time this article was written, Stadion held long positions in IEF. References to specific securities or market indexes are not intended as specific investment advice.
Founded in 1993, Stadion Money Management is a privately owned money management firm based near Athens, Georgia. Via its unique approach and suite of nontraditional strategies with a defensive bias, Stadion seeks to help investors—through advisors or retirement plans—protect and grow their “serious money.” Contact Stadion at 800-222-7636 or www.stadionmoney.com.