There are two primary reasons why anchoring your investing decisions to a market’s Fundamental Gravity gives you an advantage over other market participants, writes Landon Whaley of Whaley Global Research writing in his Gravitational Edge Wednesday.
First, most investors have very little insight into what’s truly happening from a fundamental perspective. It’s not easy to distill economic and central bank policy developments as they occur, judge how those developments will impact asset prices and then turn that distillation into an investing playbook.
Second, any Fundamental Gravity-based knowledge investors could use to drive their decisions is often obscured by their emotions, or what we call their “humanness.” Human beings are hardwired to do exactly the wrong thing at exactly the wrong time, especially as it pertains to financial matters.
Even those investors who do pay attention to fundamentals are often very slow to change their opinion. They often dismiss economic data that is contrary to their current perspective, until the data becomes so pervasively overwhelming that it forces them to change their viewpoint.
Right now, investors have anchored their current perspective on eurozone equities to the fact that eurozone growth has been accelerating for the better part of the last four years.
However, the eurozone’s Fundamental Gravity is beginning to shift, starting with Germany. This FG shift, which investors will be slow to acknowledge, is providing a nice opportunity to book gains in existing long eurozone equity positions. For those of us who like to go both ways, it’s also providing an opportunity to get positioned on the short side of German equities.
Fundamental Gravity says what?
There are two critical components to any economic equation: growth and inflation. After busting a move to the upside in both growth and inflation for the better part of two years, Germany is beginning to experience the flipside of that coin.
Germany’s growth-related data to start 2018 has slowed across the board. Both service and manufacturing sector PMIs are declining, as is the all-important German ZEW Economic Sentiment Index.
Just last week, we received further confirmation of the growing grip of this new Fundamental Gravity. German industrial production slowed in January, pushed lower by a deceleration in energy production, but it was also negatively impacted by a decline in construction output. Nasty weather to start the year has put a hitch in Germany’s construction giddy-up.
On the other side of the economic equation, inflation has been slowing in Germany since it peaked last November. Last week’s reading for February showed that German inflation slowed for the third consecutive month, falling to its lowest level since November 2016. This slowing inflation parallels what we are seeing in the broader eurozone economy: the lowest inflation readings in the last two years.
I regale you with this data deluge not to put you to sleep, but because this “growth down, inflation down” Fundamental Gravity has a profound impact on German equities.
Since the Financial Crisis, Germany has been through two regimes when growth and inflation slowed at the same time: March 2011–March 2013 and June 2014–December 2015.
During those two regimes, the iShares MSCI Germany ETF (EWG) returned −0.3% and −11.8%, respectively. While the returns are clearly bearish, it’s the downside risk for German equities in this type of Fundamental Gravity that should grab your attention. During these two regimes, EWG’s maximum drawdowns registered at −37.8% and −26.6%, respectively.
The bottom line is that when the German economic equation is growth slowing plus inflation slowing, it equals a crash in German equities. Boo-yah!
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Quantitative Gravity says what?
As a quick reminder, the Quantitative Gravity component of our Gravitational Framework is not technical analysis, which is ineffective and misleading. Rather, we use quantitative measures that are based on the reality that financial markets are a nonlinear, chaotic system.
We’ve identified four primary quantitative dimensions of financial markets that affect price movement: energy (trend), force (momentum), rate of force (buying pressure), and a market’s irregularity.
Social is our measure of a market’s current energy, or trend. Like many other equity markets around the world, EWG started 2018 in full party mode. However, while many of those markets have rebounded after February’s market meltdown, EWG entered a hangover and currently remains there.
Momo is our measure of the amount of force behind the market’s current state. EWG’s Momo peaked on January 22, two days before its price peak, and turned outright negative on February 6. This negative reading is a critical development because prior to February 6, EWG’s Momo had been positive for an impressive 294 consecutive trading days! We’re talking about a Cal Ripken-type streak.
Barometric is our measure of the rate of force behind the current Momo. EWG’s Barometric switched from a balance of buying and selling pressure to all selling pressure on February 27. Since that date three weeks ago, Barometric has registered zero buying pressure. This measure gives us immensely more information about investors’ degree of conviction than a simple measure of volume alone, and it’s telling me that even though EWG’s price has flatlined for several weeks, selling pressure is building.
Finally, Topo is our measure of a market’s irregularity. I’ll keep this one simple: when a market is rallying, then a declining Topo confirms the upswing. On the flipside, if a market is falling, a rising Topo is the confirmation signal that the downtrend is more than just a pullback. EWG’s Topo remains at the highest level of irregularity we’ve seen since July 2016, which is decidedly bearish.
Most investors are hyper-focused on price action. Unfortunately, price is nothing more than the current point where there are equal parts of disagreement on value and agreement on price.
If you’re new to our Quantitative Gravity framework, it’s important to note that the four quantitative dimensions of a market that we monitor typically move ahead of price. Said another way, price is the last aspect of a financial market to move, quantitatively speaking.
However, price is an important factor, and my bearish thesis for German equities will remain intact as long as EWG trades below $34.17. If EWG closes above this price for three consecutive days, then it means one of two things is occurring.
One possibility is that the Fundamental Gravity is shifting back to a bullish posture for German equities.
The other is that EWG’s price action is diverging from its bearish Fundamental Gravity. While such divergences often occur, they typically don’t last longer than a few weeks.
On the flipside, if EWG begins to bear the weight of its bearish Fundamental Gravity and closes below $31.49 (approximately 3% below Friday’s closing price), then I’ll put the women and children to bed and go huntin’ for wabbit.
Behavioral Gravity says what?
Our Behavioral Gravity lets us evaluate investors’ perception of this market and how that perception is changing as we move through time.
Retail investors have added approximately $1B to the five largest eurozone equity ETFs (including EWG) so far in 2018, and nearly $9B in the last twelve months alone. Clearly, these folks don’t know what we know; they are blissfully unaware of what’s going on from a Fundamental Gravity perspective.
The fact that investors are continuing to pile money into eurozone equity ETFs is a bearish Behavioral Gravity for EWG. Anytime people are throwing money at a market when the Fundamental Gravity is shifting bearishly, it’s usually a great shorting opportunity.
The bottom line
Most U.S.-centric investors follow every tick of the S&P 500 and Trump tweet to determine how to position their portfolios. But it’s a big world out there, and it’s ripe with opportunity if you embrace the Gravitational Framework to better align your portfolio with the critical developments in global financial markets.
A quick perusal of media headlines will confirm that we are one of the few firms talking about slowing eurozone growth, and specifically about what’s happening in Germany. Remember, Germany is the locomotive of the eurozone, which means that as Germany’s economy goes, so goes the rest of the eurozone.
There is no better opportunity than when the public’s perception of a market diverges from the Fundamental Gravity of that market, which is exactly what we are seeing in German equities right now.
As always, stay data dependent, process driven and risk conscious, my friends.
