The Message of the CB Capital Global Overbought-Oversold Model

I hope all our clients are off to a great start this year. If we could summarize our long-term global outlook in one word, it’d be “transformation.” e.g. Most U.S. college students are being forced to re-evaluate their life options, as 1) a university degree is no longer a ticket to sure-and-life-time employment, and 2) rising tuition costs mean opportunity costs of attending college (versus entering a trade) have become cost-prohibitive for many Middle Class Americans. A constant debate at CB Capital has been whether the rise of the American Middle Class in the mid-20th century was an anomaly–or if, more likely (in my opinion)–we are seeing the rise in the Global Middle Class, and that the American Middle Class is meeting them half-way.

Another structural force that is putting pressure on the wages of the Global Middle Class is the rise of “Smart Machines.” A decade ago, it was still too expensive to automate most tasks–even repetitive tasks with the exception of auto manufacturing and semiconductor production. In many ways, increasing automation over the last decade was simply an extension of a trend in place since the dawn of the Industrial Revolution in the late 1700s, i.e. automate simple, repetitive tasks through more capital intensive processes. The rise of Smart Machines is now altering the fundamental fabric of working labor, especially among Emerging Market Countries. In the past, upstart EM countries were able to industrialize (e.g. China in the 1980s to 2000s) by taking advantage of their low-cost labor and a significant export market. The rise of lower-cost, Smart Machines will put an end to this, as we will discuss in our 2014 inaugural global macro issue.

“Transformation” and structural trends notwithstanding, we are also big believers in “reversion-to-the-mean” trades. At the same time, we believe in the increasing evolution of the global human condition, so we (for the most part) don’t believe in shorting overvalued markets as measured by traditional benchmarks such as P/E or P/B ratios. We do, however, like to go long in distressed or oversold opportunities, as long as the long-term economics make sense.

Our global macro commentaries have always been more tactical and granular. We have discussed individual commodities, as well as certain conditions in specific countries, such as China and India. For most of our clients, we realize it is very difficult to keep track of all country-specific market indices and new international ETF products. To that end, we have constructed a simple model designed to keep track of the overbought/oversold conditions in all Developed and EM investable countries and regions as tracked by the MSCI indices.

The inner workings of the CB Capital Global Overbought-Oversold Model are rather simplistic. For each country or region, we first compute the month-end percentage deviation from its 3-, 6-, 12-, 24-, and 36-month averages. Each of these percentage deviations are then ranked (on a percentile basis) against all their monthly deviations stretching back to December 1997 (May 2005 for the MSCI Frontier Market Index). This way, we are comparing apples to apples and can control for country- or region-specific volatility. Following is our Global Overbought-Oversold Model readings for the major indices and Developed Markets as of December 31, 2013.

Global Overbought Oversold Model Dec 2013 1

All the percentile rankings highlighted in red or green represent rankings: 1) in or below the 10th percentile, and 2) in or above the 90th percentile, respectively. That is, relative to the historical percentage deviations of the same country or region, a ranking highlighted in red is more oversold than 90% of its readings going back to December 1997; while a ranking highlighted in green is more overbought than 90% of its readings. For example, the world’s developed markets (MSCI World) is highly overbought on a two-year time frame, as its current price level’s deviation from the two-year average is higher than 94.2% of all historical deviations going back to December 1997. Similarly, the U.S. stock market is now highly overbought on a two- and three-year time frame. This is one reason why–as discussed in our 2014 U.S. Stock Market Outlook–we are more cautious on U.S. stocks this year, even though we do not foresee a peak in U.S. equity prices anytime soon.

Note that Emerging Markets is only mildly oversold on all time frames. Such readings do not guarantee above-average returns this year, especially with challenging fundamentals such as social conflicts and deteriorating trade deficits (e.g. India, Indonesia and Brazil). Following is our Global Overbought-Oversold Model readings for Emerging Markets as of December 31, 2013.

Global Overbought Oversold Model December 2013 2

Despite the recent selling in Thailand and Turkey, none of the readings for EM countries are sufficiently oversold to warrant even a speculative trade on the long side. When it comes to reversion-to-the-mean trades, investors better make sure the underlying story has not changed–or else, an oversold condition could turn into a market crash (e.g. purchasing Japanese stocks during WWII, Asian bank stocks in 1997, or money-losing U.S. tech stocks in 2001). At this point, Thailand is only oversold on a 3-month time frame; its longer term readings are not attractive enough to warrant a long position, given the country’s current societal conflicts and political uncertainty. A much better trade would have been going long on the MSCI Germany (could be readily purchased through the MSCI German ETF) in December 2011, when the index was highly oversold on both a 3- and 12-month time frame. A long position taken on the MSCI German ETF at the end of December 2011 would have returned 32.1% in the next 12 months–far outpacing a long position in Developed Markets (MSCI World: +16.5%) and the U.S. (MSCI U.S.: +16.1%).

Again, note that the above model is a price-only model and therefore doesn’t take into account valuations. As has been emphasized, it also does not work well for countries that are experiencing secular changes, or for timing peaks in the stock market (the quickest way to lose money is shorting a market or a stock that has high positive momentum and/or high valuations). One thing that comes in very handy, however, is the model’s ability to evaluate oversold countries/regions and to provide initial ideas on the long side. Going forward, we will update this as appropriate for our clients.

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