The End of America First? Stock Index Relative Value Analysis: US vs EU/UK/Japan

No, I am not talking about US administration policy before Biden’s, I am talking about stock index trend between US market vs other 3 major markets (EU, UK, Japan), which has been there since the great recession of 2008 for more than 12 years. I noticed it the first time around 2 years ago, but with latest Coronacrisis and turmoil in bond market lately, this trend might be about to change.

Motivation

In my previous article explaining the relationship between bond market and stock market by comparing 10-year treasury bond yield (risk-free rate) and dividend yield, to reflect investor’s need for equity risk premium in stocks investment, I partially compared the distance of both yields between S&P 500 and DAX 30 indices. The comparison was surprising. While DAX 30 is yielding at least over 200bps above German’s 10-year bund yield, the situation is much different for US market, where 10-year treasury bond yield right now (ca. 1.66%) is already above S&P 500 dividend yield (1.53% as of February 2021 reading). This is despite FOMC meeting announcement last week, where Fed’s commitment to further buy bonds to reduce pressure on yield was mentioned.

I also did mention in my previous article about Tesla’s P/E ratio that was around 1000 with no dividend yield, which is in contrast to Volkswagen and BMW stocks, both having P/E ratio below 15 and dividend yield at least 2%. Just to give idea to readers who are not aware about EU’s automotive market right now, VW Golf has been going electric for at least a year now, also BMW with their I-series. This means, after 18 years since its foundation, Tesla is not the only EV player around anymore, yet still not able (or commit?) paying dividend to its investors.

In this case, I noticed that the Tesla phenomenon of astronomical high P/E ratio (1000!) with no dividend yield for stocks despite significantly large market cap is just taking place in US market. Especially, when considering the equity risk premium on stock market, I have more reasons to believe that the relative value trend in stock market between US and EU/UK/Japan markets may change relatively soon.

Analysis

The analysis is using combination of return correlation, pair trading (relative value) analysis, and technical analysis, on the following major indices:

• S&P 500 (US)
• Nasdaq 100 (US)
• Eurostoxx 50 (EU)
• DAX 30 (Germany)
• FTSE 100 (UK)
• Nikkei 225 (Japan)

While it is possible to prepare the analysis for all possible indices combination between US vs EU/UK/Japan market, for sake of simplicity, I focus only on the following combinations and readers later can perform similar analysis in TradingView:

• Eurostoxx 50 vs S&P 500 (Graph 1, EUR/USD rate adjusted)
• DAX 30 vs Nasdaq 100 (Graph 2, EUR/USD rate adjusted)
• FTSE 100 vs Nasdaq 100 (Graph 3, GBP/USD rate adjusted)
• Nikkei 225 vs S&P 500 (Graph 4, USD/JPY rate adjusted)

When performing return analysis, we can immediately notice the strong correlation between these major economy stock indices. However, when performing technical analysis on relative value between these indices with currency exchange rate taken into account, the result is even more interesting. Taking the top trend line from candle wicks since 2008, we can see on Graph 1 to Graph 4 below that EU/UK/Japan indices are at the start of breaking through this 12 years long trend of US dominance in the stock market. While this reversal is still not fully confirmed yet, the timing is really close altogether for indices in these 4 markets, in which reader can also experiment themselves by comparing with other stock market indices.

While various commentaries currently taking place in the market (e.g. Tesla going 3000, TINA “There Is No Alternative” for stocks is ending), I think it is important for investors to remember that stock market is still a risky investment, which is the main reason why equity risk premium exist. Under bankruptcy, equity investors will very likely lose all of their investments, unlike bond investors where they may still cover part of their investments, depending on the seniority of bonds that they hold. Therefore, negative equity risk premium, as what we are currently witnessing in the US market, but not on the other major stock markets (EU/UK/Japan), signals a broken market mechanism is currently taking place.

What Now?

At this time, my portfolios consists of stocks from all the 4 regions (US/UK/EU/Japan), with mix of value and growth stocks from various industries. Though my main focus indeed is on stocks with low P/E ratios and high dividend yield, I still have some allocations on high-tech start-ups. However, as I mentioned to my fellow network in a WhatsApp chat this morning, when having focus on capital gain (not dividends), one should remember that there are more considerations to take in owning stocks, such as: management team, products, market share/growth, capital expenditure, and patents (intellectual properties).

Finally, while we need to monitor the possibility of this massive trend change in the stock market relative values between markets, I am afraid that there is another trend change potential that we also need to monitor: the reversal of the USD index. While I do expect this to happen from EUR/USD movement, the reversal pattern that I am seeing right now is 2–3 months too early. Since USD index is sort of “investors are holding cash” indicator, the bullish reversal of this index at the same time as the stock market relative values reversal is not good sign.

Stay safe in this Corona period and Godspeed!

Graphs

Graph 1: Eurostoxx 50 vs S&P 500 indices relative value, with EUR/USD exchange rate adjustment (Source: TradingView)

Graph 2: German’s DAX 30 vs Nasdaq 100 indices relative value, with EUR/USD exchange rate adjustment (Source: TradingView)

Graph 3: UK’s FTSE 100 vs Nasdaq 100 indices relative value, with GBP/USD exchange rate adjustment (Source: TradingView)

Graph 4: Japan’s Nikkei 225 vs S&P 500 indices relative value, with USD/JPY exchange rate adjustment (Source: TradingView)

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Gior Simarmata is a risk/finance professional located in The Netherlands. He has worked as a senior risk advisor with ING Bank N.V. in the Risk Management Department, responsible for the risk reporting and analysis over the XVA portfolio of the bank’s global derivative positions. He started his career in The Netherlands banking sector with Rabobank as Product Controller in the Finance and Risk Center Department, with trading desks reporting and control responsibilities covering Equity Derivatives, Commodity Derivatives, and Group Treasury’s Structured Notes portfolios.

Email: giorevinus.simarmata {at} finrisk.eu

This article along with my other articles are also available in LinkedIn and Medium