Thursday, March 13, 2014

It’s time to move from US stocks to Europe

Everybody understands, that US stock market is overbought. As a result, future returns on a time frame of next 2-3 years should be low. Long-term investors should consider reallocating from US stocks to somewhere decent.

Europe is a good choice. Let’s take a look at volatility-adjusted market-neutral pair of two ETFs: SPY for US stocks and IEV for European stocks:

You can clearly see how European bubble inflated during the time when money where cheap and risks where underestimated before 2008 crisis. And how it deflated during hard times after the crisis on fears about eurozone future.

But as I see it, the bottom of this process has already been reached.

So now we have overbought US market against Europe, where outflows have already ended, but inflows are still moderate. It is a good idea to build a pair portfolio with Europe stocks in long position and US stocks in short position.

But with such a market-neutral portfolio we lose an exposure to long-term uptrend in “stocks in general”. We’d like to keep a contact with this uptrend.

That’s why it is better to set coefficients in our pair portfolio as +1.5 for Europe and -0.5 for US. This way we keep an exposure to the common stock uptrend and we still bet on Europe vs. US flows. Here’s how it looks:

Since US is in short, a bonus applies: we have an opportunity to short US using super-liquid ES futures. We have some benefits here:
- Margin requirements for ES futures are very modest.
- Backwardation gives us some profit.
- We can sell some far out-of-money puts (they are almost always overbought) without additional margin requirements and have some more profit.

We have a software to manage volatility-adjusted portfolios: Cognitum Rebalancer.

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