Which Way To Bet In This Market Environment?
Thong Nguyen | Sep 21, 2017 13:34
Originally published by BetaShares
Modern portfolio theory suggests there are two kinds of risks in stock returns:
- Systematic or market risk, which investors attempt to ‘diversify’ away by adding a variety of assets to their portfolios; and
- Unsystematic or stock specific risk, which represents a stocks return that is not correlated with general market movements
In recent times, global tensions have been rising particularly due to the resumption of North Korean missile and bomb tests, which have unnerved markets. In light of this, one may reasonably expect that a diversified basket of Australian large companies would outperform and be less risky than a diversified basket of smaller companies. One may well have this view as typically smaller companies tend to exhibit higher levels of volatility and are generally perceived as riskier investments.
However, in the current market environment, has this in fact been the case?
If we take a simple ratio of the S&P/ASX 100 Index (representing large caps) and the ASX Small Ordinaries Index (representing small caps) we can determine which segment of the market has out-performed recently.
Source: Bloomberg. Past performance is not an indicator of future performance
As you can see from the above chart, small caps have in fact been outperforming large caps since the middle of March 2017. You will also notice there has been an acceleration in this outperformance more recently, which coincides with the threat of nuclear war. So what may be causing this to occur?
There are two potential factors going on here.
The first is typical institutional investor behaviour. In the current environment, institutions and fund managers may be a bit nervous about the macro environment, and in particular events like war. History suggests such events may well have short-term effects on the markets but less so in the longer-term. Naturally the most efficient way to de-risk large institutional portfolios quickly with the least amount of market impact is to sell the most liquid assets, being larger companies. This selling behaviour will, in turn, put pressure on the pricing and performance of large cap stocks relative to small cap stocks, which generally receive less attention in these situations.
The second factor is the strong AUD/USD rate, which has been above 80 US cents recently. A strong Aussie dollar is good for importers, but not so good for exporters as it makes their products less competitive in the global markets. Typically, larger companies are more exposed to fluctuations in exchange rates, while smaller companies rely more heavily on local sales.
Get The App
If tensions were to increase, heightening the threat of nuclear war and the AUD/USD were to remain high, I would expect small caps to likely continue to outperform large caps in this environment, at least in the short term.
Trading in financial instruments and/or cryptocurrencies involves high risks including the risk of losing some, or all, of your investment amount, and may not be suitable for all investors. Prices of cryptocurrencies are extremely volatile and may be affected by external factors such as financial, regulatory or political events. Trading on margin increases the financial risks.
Before deciding to trade in financial instrument or cryptocurrencies you should be fully informed of the risks and costs associated with trading the financial markets, carefully consider your investment objectives, level of experience, and risk appetite, and seek professional advice where needed.
Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. The data and prices on the website are not necessarily provided by any market or exchange, but may be provided by market makers, and so prices may not be accurate and may differ from the actual price at any given market, meaning prices are indicative and not appropriate for trading purposes. Fusion Media and any provider of the data contained in this website will not accept liability for any loss or damage as a result of your trading, or your reliance on the information contained within this website.
It is prohibited to use, store, reproduce, display, modify, transmit or distribute the data contained in this website without the explicit prior written permission of Fusion Media and/or the data provider. All intellectual property rights are reserved by the providers and/or the exchange providing the data contained in this website.
Fusion Media may be compensated by the advertisers that appear on the website, based on your interaction with the advertisements or advertisers.