MMC5.16

Call #1: Overweight Germany

The news in Europe continues to be mixed. On the plus side, the core countries in Europe continue to post strong economic growth. We had more evidence of that this week with solid GDP results from both Germany and France. The problem of course remains the periphery, particularly Greece. Greek debt was downgraded again and markets are now convinced that Greece will need to restructure – the lingering question is when and how. The when refers to the fact that originally Greece was expected to return to the bond market in 2012. That now looks highly unlikely, so Greece will need another 25-30 billion Euros from the European Union to fund their deficit next year. The how refers to the fact that a restructuring by Greece could take many forms, the most benign of which would be a “re-profiling”, or extension of the maturity of the existing debt. This may not be enough, so Greece may need to ultimately have a managed restructuring of its debt, with bondholders taking at least a 25% haircut on their holdings.

The upshot of all this is while we believe the euro zone will continue to recover along with the global economy, European stocks – particularly the banks – are likely to trade at a discount given the lingering concerns over sovereign debt. The exception to this remains the northern European countries, particularly Germany, whose economic strength is compensating for the risks at the periphery. Despite the troubles in Greece, we still favor Germany.

Call #2: Overweight Healthcare, Underweight Small Caps

Our basic view is that while the US market can continue higher, the gains are likely to be accompanied by more volatility than we witnessed during the first 4 months of 2011. With the exception of the spike around the time of the Japanese earthquake, US market volatility has been its lowest since 2007, with the VIX Index – which measures implied volatility on S&P 500 options – hitting a four year low of below 15 in April.

We believe this is too low. Over the past 20 years volatility on US large cap stocks has averaged around 20% a year. Given the current environment, which is characterized by the continuing unrest in the Middle East, the lingering US sovereign debt issues, and the lingering European sovereign debt issues, it is hard to justify below average volatility. On a more quantitative basis – we can model the volatility based on a number of factors including market momentum, credit conditions, and changes in leading economic indicators. When we compare the current level of volatility to these indicators, market volatility looks around 25% too cheap. In other words, we believe that market volatility should be in the low 20’s not the mid teens.

Bottom line: volatility looks set to rise further this summer. We favor the following: (1) lower portfolio beta through more defensive sectors like Healthcare and (2) lower exposure to small caps, which tend to be more volatile.

Potential iShares solutions

Overweight Germany EWG – iShares MSCI Germany Index Fund (click here for fund details)
Overweight Healthcare IYH – iShares Dow Jones US Healthcare Sector Index Fund (click here for fund details)
Underweight Small Caps IJR – iShares S&P SmallCap 600 Index Fund (click here for fund details)

Disclosure: Author is long EWG.

Bloomberg:

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Securities focusing on a single country, investments in smaller companies and narrowly focused investments may be subject to higher volatility.

The iShares Funds are not sponsored, endorsed, issued, sold or promoted by Dow Jones Trademark Holdings, LLC, MSCI Inc. or Standard & Poor’s. None of these companies make any representation regarding the advisability of investing in the Funds. Neither SEI, nor BlackRock Institutional Trust Company, N.A., nor any of their affiliates, are affiliated with the companies listed above.