Wednesday, April 04, 2007
The market’s risky asset love-in has seemingly reached fever pitch, as the travails of late February and early March appear to be little more than a distant memory. China famously regained new highs a couple of weeks ago, and the DAX has followed suit this morning. (We won’t mention the SENSEX, which is closer to its recent lows than it is the February high.) While the equity explosion has hurt Macro Man’s alpha portfolio hedges, the impact has clearly not all been bad. Not only is the beta plus portfolio off to a nice start to the month, but a Japanese asset allocation shift out of JGBs and into equities last night has helped the fixed income portion of the alpha portfolio.
A poster made an interesting point the other day about regional equity differentiation, suggesting that European equities are generating excess returns to the upside (compared to the SPX) while participating only partially on the downside. If true, this has implications for Macro Man’s portfolio, given that he has a short exposure to the DAX through his long put position.
In the very recent past, this has clearly been the case, otherwise the SPX would be at its highs just like the DAX. But from a longer term (last few years) perspective, is it the case that the returns from European equities are positively skewed vis-à-vis the US? Macro Man looked at the question in two different ways: examining the daily return profile of the SPX and DAX, to see if it has changed over time, as well as looking at longer term return-to-risk ratios, updating an earlier study.
The findings were quite interesting. Macro Man looked at the absolute value of daily movements in the SPX and DAX, splitting the results between up and down days, and then examining 2000-2003 and 2004-2007 as separate periods. In the former period, the SPX outperformed the DAX by about 18%; in the latter period, the DAX has outperformed by 44%. All told, the DAX has outperformed by 3% since the end of 1999 (these are nominal returns not including dividends.)
The data suggests two explanations for the reversal of (relative) fortunes between the SPX and DAX. The first one was surprising. In 2000-2003, the average up-day in the SPX was slightly larger than the average down-day. This was surprising, as the return profile of equities is famously skewed to the downside, and this period included a bum-clenching bear market. In fact, the data suggests that the SPX went down simply because there were more down days than up-days. The DAX, meanwhile, underperformed despite having a slightly higher “hit ratio”, simply because the average up-day made less than the average down-day lost.
In the more recent period, the DAX has maintained a skewed return profile. The average down-day still loses more than the average up-day makes. However, the hit ratio has improved from 49% to 57.2%, which explains the stellar performance of the index. The SPX has also seen its hit ratio improve; however, the lag versus the DAX has widened from 0.4% in the early period to 1.6% in the later period. This goes a long way to explaining DAX outperformance. Crucially, however, the SPX now loses more on down-days than it makes on up-days, just like the DAX. The S&P 500, therefore, has lost its “special” return profile and now looks like a normal market (that wins less often than the DAX.) So rather than Europe enjoying a put option that the US doesn’t have, the data suggests that the US has lost a put option that Europe never had. You don’t need Macro Man to suggest where that lost put may have come from!
On a total portfolio basis, meanwhile, the returns on European assets have almost never looked better. The 3 year return to risk ratio on a typical balanced European portfolio is now 2.26, just shy of the 25-year high set in the mid 1980’s. The equivalent ratios in the US and Japan are also high, but neither is close to its previous best, and both have started to lag Europe. If the trend continues, perhaps the euro won’t need the help of Voldemort and friends to set new record highs against the dollar and the yen!