Divergence Creates Opportunity

The best trading opportunities come when investors’ perception of an event, or market, diverges from the most probable outcome of that event or the most probable direction of that market.

The most attractive opportunities present themselves when there is a shift in the Fundamental Gravity of a market from one bias, bullish or bearish, to the opposite but investors are slow to react. These divergences get me salivating like Pavlov’s dogs. Right now, there is a divergence occurring in the Eurozone that is being ignored and providing a compelling short opportunity. The origin of this divergence is Germany.

 

Das Große Fundamentale

Germany’s Fundamental Gravity is shifting from one that provides a boost for equities to one that will prove to be a headwind in the months ahead.

In economic terms, Germany is the workhorse for the Eurozone economy like Barry Sanders carrying the ball 40 times against the Cowboys in ‘94. If you want to know the most likely trajectory for Eurozone growth, look no further.

With that said, every major German economic indicator, save industrial production, has been slowing for the last three months.

No part of the economy has been spared as both the manufacturing and service activity are waning. Everywhere one looks, there is slowing data: steel production, car production, factory orders, retail sales and labor productivity. The number of building permits, which are a valuable growth indicator, have fallen off a cliff since last year.

Finally, and most importantly, excess liquidity in the economy has been declining for well over a year and that downtrend regained momentum in January.

The reason this shift in Fundamental Gravity is a big deal is because an economic environment characterized by slowing growth, and less excess liquidity, is not friendly for equities.

The DAX, which is the German equivalent of the S&P 500 index, peaked at a brand new all-time high six weeks ago on June 20 and has since declined 7.2%. However, despite slowing economic data and a rollover in the DAX, we are seeing two interesting divergences across other Eurozone equity markets.  

 

Divergenz Eins

The first divergence is between Eurozone equity indices and their US ETF counterparts.

Despite the DAX peaking on June 20, its US exchange-traded fund equivalent, the iShares MSCI Germany ETF (EWG), continued higher for another five weeks before peaking. As of Friday’s close, it’s now just 2.3% below that high.

The CAC 40 index, which represents France’s equity market, peaked at a nine-year high back on May 8, and has since declined 7.0%. However, its US exchange-traded fund equivalent, the iShares MSCI France ETF (EWQ), continued higher for another three months before peaking last Tuesday. As of Friday’s close, it’s now just 2.7% below that high.

The IBEX 35 index, which represents Spain’s equity market, followed France’s lead by peaking at a two-year high back on May 8, and has since declined 8.0%. Here again, its US exchange-traded fund equivalent, the iShares MSCI Spain Capped ETF (EWP), didn’t peak for another three months. As of Friday’s close, it’s now trading just 4.3% below that high.

What’s the likelihood these US ETFs will continue to move in the opposite direction of the foreign markets they mirror?

 

Autos Verfolgen

If we look underneath the hood of these ETFs we see one reason why this divergence between ETFs and their foreign proxies is occurring.

Since France and Spain’s equity markets peaked on May 8, investors have poured $145MM into both the France (EWQ) and Spain (EWP) US equity ETFs.

What’s more, over $40MM of that $290MM has been added in just the last six weeks, since the DAX peaked on June 20.

The behavioral bottom line is that people are doing the investing equivalent of chasing cars. They’re chasing the performance of these US-based ETFs without any awareness of what’s happening with the foreign indices these particular ETFs take their cues from.

 

Divergenz Zwei

Given that Germany is the Eurozone locomotive, it makes sense that France, Spain and Italy would follow its lead. Although, French and Spanish equities are currently declining alongside German stocks, Italian equities apparently haven’t received the memo.

The Milan S&P/MIB index, which represents Italy’s equity market, peaked at a two-year high last Tuesday, and has since declined 3.2%.

However, unlike the other three countries the Milan index is moving lockstep with its US exchange-traded fund equivalent, the iShares MSCI Italy Capped ETF (EWI).

EWI peaked at a three-year high last Tuesday and is now trading just 2.8% below that high.

Riddle me this: how have Italian equities been able to buck the trend in Eurozone equities by continuing to grind higher for a full three months after France and Spain peaked, and over a month after German equities peaked? Opportunity anyone?

 

Die untere Zeile

The Fundamental Gravity, coupled with price and investor behavior is telling us we have two separate, exploitable, divergences occurring.

The first, US ETF proxies for these foreign markets are severely lagging the benchmarks they are supposed to represent. The US ETF for German equities peaked just two weeks ago, which was over a month after the DAX. What’s more, the US ETF representing both French and Spanish equities peaked last week, a whopping three months after their respective foreign indices!

The second huge divergence is Italy’s equity market versus the other key Eurozone players. I don’t know who Italy thinks they are but I can promise you there is no way Italian equities remain elevated at three-year highs when everyone around them is in a Fundamental Gravity-induced pullback.

With Germany economic data slowing, there is a good probability the US ETFs will “catch down” to their foreign index counterparts and an even better chance that Italian equities follow suit.

As always, stay data-dependent, process driven and risk conscious, my friends.