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(1) Pricing anomalies
Global equity markets have become increasingly correlated
As conditions normalise, correlation should fall, presenting
opportunities for investors to dig out mispriced securities
We suggest some areas where these can be found
High correlations offer opportunities
The past decade – and the past three years in
particular – have seen a big increase in
correlations across equity markets. When markets,
sectors and countries move together, irrespective
of their different fundamentals, this should leave
some dramatically mispriced securities, throwing
up opportunities for investors.
A decade ago, the three-month correlation of weekly
returns between the 47 countries in the MSCI All
Country World Index (ACWI) and the overall index
was about 40%; this year it has averaged 74%, and
has been as high as 80%
The same is true at the sector level. In 2010 to date,
none of the 24 sectors has had less than an 83%
correlation with the index (the lowest is autos); the
average sector correlation is 92%. Even sectors that
10 years ago moved to their own beat, such as food
& beverage or energy, now move largely in line
with the overall index
Correlation has risen sharply even among
individual stocks. The options contract on S&P500
implied correlation (traded on the Chicago Board
Options Exchange) shows that in late September
this year correlation reached 80%, exceeding even
the level at the time of Lehman Brothers’
bankruptcy (Chart 3). Although it has fallen back
slightly since to around 70%, it is still well above
the 40% or so in the more normal times of early
2007 (when the contract was launched).
The heightened correlation has produced a much
smaller range for sector valuations too. Currently
the range between the cheapest industry group by
12-month forward PE in the MSCI ACWI index
(diversified financials on 10.0x) and the most
expensive (real estate, 19.6x) is about the narrowest
it has been for 15 years. The dispersion of
valuations has fallen steadily (except for a hiatus in
the crisis of 1999) since the TMT bubble in 1999-
2000 and is now the lowest since 1995
What seems to have happened is that growth
sectors (software, tech, media, pharma, personal
products) which traditionally traded at a
significant premium to the market, often with
forward PEs of 20-30x, have lost their premium.
Traditionally cheap sectors such as banks, energy
and materials remain cheap. We think, therefore,
that some growth sectors now look undervalued.
What has caused markets to move together in this
way? Partly it is a reflection of growing
globalisation. Economic fundamentals, such as
economic growth, have become more correlated
since the 1990s too. Not only have capital flows
become more globalised, but the growth of
indexation and ETFs means that the components of
an index tend to move more closely together. Over
the past four years, for example, almost USD400bn
has flowed in equity ETFs globally
What are the implications?
As the economic situation continues to normalise
over the coming few quarters, with markets being
driven less by momentous macro shifts, in our
view correlation will begin to decline. To an
extent, this has already started to happen over the
past couple of months, as Charts 1 and 3 above
suggest. As correlation declines, investors should
be rewarded for digging out under- (or over-)
valued securities. Below we suggest some areas
where we think these can be found.
In Europe, our analysts see such opportunities in
sectors as varied as resources, real estate,
construction and media. In the clean energy sector,
our analyst argues that share prices of Iberian wind
companies have been dragged down excessively
because of sovereign risk concerns. In oil services,
high correlation between stocks has thrown up
opportunities particularly in dividend stocks.
In Asia, analysts find the largest number of
underpriced stocks in Korea. Automakers such as
Hyundai Motor (005380 KS, OW, KRW172,500,
TP KRW240,000) have traditionally traded at a
discount to global peers due to earnings volatility
and high leverage, which is no longer justified.
Korean insurance companies are usually priced on
PB; on more sophisticated measures such as price
to embedded value, they look cheap.
Technology companies generally look cheap
relative to history. In Taiwan, for example, most
of the companies under our coverage have 2011e
dividend yields of around 5%.
Unloved stocks. One way to spot mispricings is
to look at which sectors and stocks are most out of
favour with investors and analysts. For example,
Table 7 shows the country/sector pairs in the
MSCI ACWI with the lowest average analyst
ratings (where 1=Buy, 3=Hold and 5=Sell).
Unsurprisingly, this throws up the financials
sector in a number of countries; also materials, IT
and healthcare
Analysts’ average rating (higher score, the more bearish)
Current rating 10-year average
Spain Financials 3.33 2.93
Sweden Financials 2.82 2.54
Australia Consumer Staples 2.77 2.57
South Africa Materials 2.74 2.63
Italy Financials 2.73 2.63
France Materials 2.73 2.56
South Africa Financials 2.70 2.45
Taiwan IT 2.64 2.33
Germany Financials 2.62 2.54
Australia Financials 2.62 2.60
Japan Health Care 2.61 2.55
Source: HSBC, Thomson Reuters Datastream (Limited to country/sector pairs with at least 5
stocks and a market cap of 0.2% or more of the MSCI ACWI. We excluded sectors which
have a more bullish rating now than the 10-year average)
Many of these examples illustrate a broader theme
in which, in a low interest rate environment,
stocks with dividend yields well above risk-free
rates should attract attention. We discuss this in
more detail in the next section.
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