All animals are equal but some are more equal than others
- George Orwell (Animal Farm)
Orwell was clearly a fan of the stock markets...
Let's get straight into it...
Are all stock markets created equal?
No: They have individual characteristics and variations in the same way that people (or animals) do.
Do stock markets share some similarities?
Yes: Although overall there tend to be more differences than similarities.
The most obvious similarity is that they are all markets for the creation and trading of equities.
So... What are the causes of these variations?
The composition of the domestic markets feeds into the indices and the nature of the stocks contained within them.
For example, developed markets will have a very different profile to emerging market indices, and relative sizes evolve over time...
There are other differentiators beyond the economic profile in which the market is based, caused by the quirky nature of stocks...
Persistent differences and traits exist within, and between, individual stocks and sector groupings - collectively these traits are called factors.
Sounds far more complicated than it is. Some examples of factors:
Variations between markets are partially explained by this type of equity factor analysis, but in a circular and somewhat nested way, factor analysis also helps to justify the idea that stock markets are and can be differentiated from each other...
The table above shows us the performance of a selection of these equity factors by decade between 1930 and 2010 compared to the overall market return in each decade.
This data is for the US but equity factors exist in ALL markets and the degree to which high performing and low performing categories are present in an index or market will clearly have a significant influence on the overall performance of that market or index.
The perfect example 👇
Long-term changes in the composition of UK and US stock markets (by sector)...
Can you spot the tech sector in the FTSE?
Wonder why it's been lagging the rest of the world...
We wrote more about this here:
Even if we were not aware of the existence of equity factors their existence could probably be inferred from other data such as the correlation to and with other assets.
The chart above is a correlation matrix showing the degree to which the prices of financial assets are linked (or likely to move together).
Correlation is a statistical measure that comes in three flavours: positive, negative and non-correlated.
In this matrix, we have highlighted the correlation between the broad-based S&P 500 sectors and the price of the US 10-year treasury bond.
XAE (the energy sector) is negatively correlated to the T-bond price whilst XAK (the technology sector) has a stronger positive correlation.
This suggests that as T-bond prices fall (and their yields rise) energy stock should rise in value whilst tech shares should fall in value which to a large extent has been borne out by recent market moves.
Tim recently shared an interesting snippet with me, which to some extent shows what’s happening in the markets right now but which also highlights the differences between the US and Europe and the differences between their stock markets.
My thoughts were that the divergence between the US and Europe could be laid at the door of the market’s expectations over inflation and future interest rates and the differences therein.
The chart above shows the market's expectation of European inflation 5 years from now and five years into the future from that point (RHS) and compares that to the price of Brent crude and a potential driver of inflation (LHS).
However, as we can see even though inflation expectations have increased in Europe over the last 18 month or so they haven't exactly exploded out of the box and are still sitting around 1.30%
As we can see below 10-year bond yields in Europe’s biggest economy, Germany, remain firmly in negative territory partly as a consequence of this lack of inflationary pressure...
Our final two charts tie the thread together.
Let's take a look at the relative sensitivity of the German Dax to the price of US 10- year bonds
The chart below shows the performance of the Nasdaq100 against the US bond over the same period
The Dax is far less sensitive to implied changes in US interest rates than the Nasdaq 100, but perhaps that’s to be expected because the Dax has very little exposure to technology and growth stocks whereas the Nasdaq 100 is chocked full of them.
One of the best places to discover more about the composition of specific indices and stock markets are index fact sheets (or facts sheets for ETFs that track the index in question)
Clicking on this link takes us to a very informative page that highlights sector and individual company weightings in the Dax
The Dax has just a 10.51% exposure to technology/software and much of that comes from one stock (SAP SE) whilst industrials, autos and chemicals account for more than a third of the benchmark.
Many of these companies are exporters that benefit from lower exchange rates.
Higher US interest rates (or interest rate expectations) tends to strengthen the US currency at the expense of rivals such as the Euro.
As traders, we should of course be aware of these types of differences and how we can use them to our advantage.
On that basis, the Dax might be something to focus on as and when US bond yields are rising, U.S tech stocks are under pressure, and the dollar is strengthening accordingly.