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January 10 2013 Country equity allocation: methodology note Introduction The objective is to present an analytical framework to support the geographic allocation of the equity markets. Our goal is to present a dynamic, objective overview that captures the main driving forces of the markets so that we can ask the right questions. Our approach breaks down into two parts. The first mapping captures cyclical (short term) forces. The second puts so-called "secular" (long term) forces into perspective. The two approaches are independent and complementary. Main driving forces of the markets: momentum and valuation The behaviour of the equity markets may be stylised as follows (see graph): The idea is to capture the main driving forces of the equity markets: momentum and valuation. The first mapping captures cyclical forces: In this case, momentum is analysed from both a profit and a market perspective. Since the market anticipates profits, that suggests market rotation in our cyclical mapping. The mapping may be read dynamically, over several months, or depth-wise, by style or by region. i: Outflows and downward profit revisions become excessive and the market is undervalued ii: The market begins to anticipate an improvement in profits iii: Profits and flows recover and support a bull market iv: The market becomes overpriced, while inflows and upward profit revisions are excessive The second mapping refers to a longer term horizon, which erases the profit cycle with regard to both momentum and valuation. v: The market begins to anticipate a decline in profits vi: Profits and flows slow down and maintain a bear market. Stylised behaviour of the equity markets A version of this mapping is adapted to the developed markets and to the emerging markets. Without providing definitive answers, pairing the “cyclical” and “secular" dimensions helps to reinforce convictions in decision-making. Source: Amundi Strategy Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry January 10 2013 “CYCLICAL MAPPING” Source: Amundi Strategy 1 The cyclical approach, or how to integrate these factors to differentiate between markets Example of relative momentum: the German market in relation to the world index 9 In a cyclical approach, the notion of momentum should be separated into two pieces: profits and the market. Consequently, we use three dimensions that are represented in our first mapping (see above): market momentum, profit momentum and valuation. To highlight the trend, profit momentum is represented on the horizontal axis and market momentum appears on the vertical axis. “ 8 In a cyclical approach, there are two aspects of the momentum effect: profits and the market ” Since the markets anticipate profit trends, this suggests that the markets normally follow a rotation on the map, in the direction of the arrows. In addition, the size of the circles corresponds to valuation. Lastly, the colours differentiate among regions. Note that all the indices are shown relative to the MSCI World and are expressed in the same currency, in this case, in US dollars. How are the markets positioned on the map? 1. Relative market momentum (vertical axis of the map) We use two indicators: the index ratio (market index/MSCI World) compared to its 200-day average is the main indicator (first graph on the right). It aims to capture the relative market trend. The flow analysis (cumulative flows over 12 weeks, compared to their 10-year average) is complementary (second graph on the right). It aims to anticipate turnarounds. So, we are interested in extreme situations regarding flows and their potential to return to the average. In the end, the more bullish the relative market momentum, the higher the circle is positioned on the map. 2. Profit momentum (horizontal axis of the map) Here we also use two indicators: the relative profit index (source: IBES) compared to its 200-day average is the main indicator. It aims to capture the relative profit trend. The analysis of profit revisions by analysts is complementary. It aims to anticipate turnarounds. So, we are interested in extreme situations regarding profit revisions and their potential to return to the average. In the end, the more positive the profit momentum, the more the circle is positioned to the right on the map. 7 6 5 4 3 02 03 04 05 06 07 08 09 10 11 DAX Index/M SCI Wo rld M o ving average (200days) Source: Dat astream, Amundi Strategy Example of a flow analysis: the German market 4 3 2 1 0 -1 -2 -3 -4 -5 02 03 04 05 06 07 08 09 10 11 Flo ws M ean M ean + 1standard deviatio n M ean - 1standard deviatio n Source: EPFR, Amundi St rat egy 2 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry January 10 2013 3. Relative valuation (three circle sizes) We use two very traditional criteria: PER and P/BV estimated over the next 12 months (source: IBES). These ratios are read relative to the market (e.g.: PER of the market/PER of the MSCI World) in relation to their average over the last 10 years (see first graph on the right). The more overpriced the market, the larger the circle on the map. Example of a valuation criterion: relative PER of the German market 1,00 0,95 0,90 How to read our cyclical map To make our mapping easier to read, we have named its four parts: “Star”, “Doubt”, “Repair" and "Challenger". At first glance, there is a favourable bias for “Challengers” capable of rallying in terms of profits and “Stars” that are not too overpriced. We avoid the “Doubts”. There is a somewhat unfavourable bias for “Repairs” as long as the market is not “really underpriced”. 0,85 0,80 0,75 0,70 02 03 04 05 06 07 08 09 10 11 Comments on the map example from the preceding page (from 16 October 2012): STAR: The US market (S&P 500) outperforms the MSCI World both with regard to the market index and the profit index. This market is a “Star”. But, it is expensive compared to the rest of the world. The market would therefore be vulnerable if profit momentum should weaken. P ER 10 Y mean 10 Y mean + 1standard deviatio n 10 y mean - 1standard deviatio n Source : Dat ast ream, Amundi St rat eg y DOUBT: The Japanese market underperforms the MSCI World, but its relative profit trend is neutral. The market is not expensive. It is still in the “Doubt” period, but is about to enter the “Repair” zone. If the market is right, profits will end by weakening and the market will actually re-enter the "Repair" zone. Or, profits will hold firm and the market will emerge a “Star”. Trajectory of the German market on the cyclical mapping REPAIR: The UK market underperforms the MSCI World. Likewise, its relative profit trend is negative. Its relative valuation is neutral. It is in “Repair” mode but is not a good enough deal to anticipate a rebound. CHALLENGER: The Australian market is beginning to outperform the MSCI World, but the profit trend is not yet sustaining this upward movement. Its valuation is neutral. This market is a “Challenger”. Profits need to accelerate in order to sustain its trend and become a “Star”. The mapping may be read dynamically, over time, or depth-wise, by style and by region: “ It is wise to analyse the trajectory of a market in order to better understand its dynamics by The consistency of the reviewing its position on the map, for example, whole allows convictions for six months (second graph). We can also to emerge analyse a market by investment style (third graph) and zoom in on a region such as Europe (first graph on the following page) or the emerging countries (second graph on the following page). The consistency of the whole allows convictions to emerge. ” Source: Amundi Strategy Reading of the markets by style Relative Market Trend (vs World) 2 Europe Mid USA Large 1 Europe Small Europe Large USA Mid USA Small 0 -2 -1 0 1 2 -1 Japan Small Japan Mid Japan Large -2 Relative EPS Momentum (vs World) Source: Amundi Strategy 3 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry January 10 2013 2 A complement to the cyclical reading: the “secular” approach Focus on cyclical mapping for Europe 2 Relative Market technical Trend (vs World) Considering markets with another time horizon further improves our understanding of them. With the “secular" approach, we refer to a long-term horizon that erases the profit cycle. So, now we use only two dimensions for our second mapping: market momentum (vertical axis) and valuation (horizontal axis). For market momentum, we use two criteria: - The absolute return of the market compared to its 10-year, 4-year and 1-year averages. - Flows, but this time accumulated over 3 years (in order to capture positions more than movements) compared to the history over the last 10 years. The markets are graded 0, 50 or 100 depending on whether they are bear, neutral or bull markets. The indicator on flows is centred and reduced on a scale from 0 to 100. The position on the vertical axis corresponds to the average of the two. In order to appear in the upper portion, for example, the market must be on secular bullish trend. Then, the more the market is bought, the higher it is positioned on the vertical axis. Germany Belgium Switzerland 1 Norway Denmark UK Spain Austria Sweden 0 France Portugal Greece -2 -1 0 1 2 Italy Netherlands -1 Ireland -2 Relative EPS Momentum (vs World) For the valuation, we use four non-cyclical criteria which inform the models with regard to long-term trends: Source: Amundi Strategy Focus on cyclical mapping for emerging countries - The adjusted PER of the cycle, often called the Shiller PE ratio - An average of more traditional indicators (PER, PBV, DY) 2 Relative Market technical Trend (vs World) - The risk premium (1/PE - real long-term yields) - The level of real long-term yields (to take into account the fact that the lower the real yields, the higher the equilibrium risk premium) The current levels are compared to very long historical levels (1970s) then centred and reduced. Their average is finally reported on a scale of 0 to 100 on the horizontal axis. The more the market is positioned to the right, the more expensive it is. Below is the “secular" mapping for the developed countries. The same is available for the emerging countries. We see four key problems emerging over the long term: - Are investors too optimistic? - Some markets are “fallen angels”. We will avoid them. - Others may be "value traps”. India Philippines 1 Indonesia -2 STRONG Thailand Korea 0 Colombia Peru Chile Russia -1 Brazil China 1 2 Malaysia Argentina -2 Relative EPS Momentum (vs World) Source: Amundi Strategy “SECULAR” MAPPING 100 OPPORTUNITIES ? 90 POTENTIAL EXCESSIVE OPTIMISM ? USA ositive Bias 80 LONG TERM MOMENTUM Hungary Taiwan Czech 0 Republic -1 - Others are still opportunities. This is clearly where we want to look for buy ideas. Germany Canada 70 Norway 60 UK Sweden Hong Kong Ireland Denmark Singapore 50 40 Australia Belgium Austria 30 20 POTENTIAL VALUE TRAPS ? 10 WEAK Mexico Poland Italy To be avoided Switzerland France Japan Greece Spain FALLING Portugal Netherlands ANGELS ? Finland 0 0 CHEAP 10 20 30 40 50 VALUATION 60 70 80 90 EXPENSIVE 100 Source: Amundi Strategy 4 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry January 10 2013 Conclusion Without providing definitive answers, pairing the “cyclical” and “secular" dimensions helps to reinforce convictions in decision-making. The table below illustrates a few examples. United States Star The S&P 500 is outperforming, which is evidenced by a profit index that is also outperforming. But the market is overpriced relative to the last 10 years. Be cautious. Excessive optimism? The S&P 500 is on a positive secular trend, but it is also overbought. In addition, the valuation suggests low er long-term returns than the average in other markets. Germany Star The DAX is outperforming, which is evidenced by a profit index that is also outperforming. In addition, the market is neither overpriced nor underpriced relative to the last 10 years. Favourable. Opportunity? The DAX is on a positive secular trend. It is clearly somewhat overbought, but its valuation suggests higher long-term returns than the average in other markets. Japan Doubt / Repair The Nikkei is underperforming, as evidenced by profits that are only just able to compete with the global average. But, the market is not overpriced. Should w e revisit Japan? Potential “value trap” The Nikkei’s valuation suggests higher long-term returns than the average in other markets. But, its secular trend is negative. And the market may not be underbought by accident. United Kingdom Repair The FTSE 100 is underperforming, which is evidenced by a profit index that is also underperforming. In addition, the FTSE 100 is not underpriced, but it is not overpriced either. Not attractive enough yet. Excessive optimism? The FTSE 100 is on a positive secular trend and is slightly overbought. The valuation suggests long-term returns close to the average in other markets. Positive Neutral Negative 5 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry Valuation (LT) Secular Map Momentum (LT) EPS Index Cyclical Map Valuation (10Y) A FEW EXAMPLES January 10 2013 Contributor Editor Philippe Ithurbide - Head of Research, Analysis and Strategy - Paris +33 1 76 33 46 57 Contributors Eric Mijot – Deputy Head of Strategy and Economic Research – Paris DISCLAIMER Chief editor: Pascal Blanqué Editor: Philippe Ithurbide In the European Union, this document is only for the attention of “Professional” investor as defined in Directive 2004/39/EC dated 21 April 2004 on markets in financial instruments (“MIFID”), to investment services providers and any other professional of the financial industry, and as the case may be in each local regulations and, as far as the offering in Switzerland is concerned, a “Qualified Investor” within the meaning of the provisions of the Swiss Collective Investment Schemes Act of 23 June 2006 (CISA), the Swiss Collective Investment Schemes Ordinance of 22 November 2006 (CISO) and the FINMA’s Circular 08/8 on Public Advertising under the Collective Investment Schemes legislation of 20 November 2008. 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