October lows and market volatility pick-up should create buying opportunities for investors

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1 Market Perspective Technical Analysis October 2014 October lows and market volatility pick-up should create buying opportunities for investors Early signs suggest a wider market correction could follow the deterioration we have been seeing in the market breadth among small- and mid-size companies in the US and Europe. Europe s worsening economic picture secures its underweight, while the region is overshadowed by US economic and stock market growth which are structural drivers for the strengthening US dollar. China s stock market is showing signs of health despite malaise in the economy. And Japan needs support from domestic and overseas investors to deliver its anticipated next upward leg. Healthcare continues to outshine other sectors, and select technology stocks are attractive. The oil price has the potential to plunge further in the context of generally lower-priced commodities. CURRENT MARKET OUTLOOK Market correction could follow weaker SMIDs market breadth A short-term market correction might be imminent but it is unlikely to end the current cyclical uptrends in many markets. Having entered a new secular bull in 2009, the US market confirmed all-time highs in May A pause and a large trading range in 2014 to digest all the gains and confirm the breakout has been viewed as a likely outcome for much of this year. There are now signs that the deteriorating market breadth among small- and mid-size (SMID) companies in the US and Europe could predict a wider market correction. The market seems to be rejoining the simple Cycle Composite model I monitor closely this calls for investors to buy during a fourth quarter correction before heading higher into Such a shakeout will be positive for bull sentiment, which could be encouraged by the prospect of an S&P 500 target of 2350 in the next couple of years. Jeff Hochman is Director of Technical Analysis and a member of Fidelity s Asset Allocation Group. Before he joined Fidelity in 1996, Jeff spent five years with Deutsche Bank as an equity analyst and strategist, and worked for Chase Manhattan Bank prior to that. Jeff holds a Masters degree in International Management and a BA in Political Science and English Literature. Europe s position could soon worsen The outlook for Europe and the UK is overshadowed by US success and European market breadth is the weakest among the global regions. There are amplified concerns that growth-challenged Europe could be facing a cyclical top like the one we saw in The weak euro predicts underperformance for the region while weak exports and talk of recession in the German powerhouse of Europe add to the region s underweight position. Europe s banks have generally stabilised, but aside from healthcare, all other sectors paint a lacklustre picture for investors. China stocks are improving but USD strength weighs on EMs Despite concerns about China s wider economy, Chinese large-cap stocks and H- Shares have started to perform much better lately, breaking the five-year downtrend in August. Chinese market breadth at a three-year high is much more positive than the emerging markets composite market breadth. At the smaller end of the Chinese stock market, small and mid-caps are displaying a sustained uptrend. The current correction in Hong Kong following the recent pro-democracy street protests has created a buy opportunity. The Hang Seng China H Financials Index (H-Fin) looks very oversold. Small- and mid-cap fortunes are in the balance Small and mid-caps have been hit hard of late and are highly correlated with the high yield asset class yield movements which have also unwound recently. Although the valuation gap has narrowed versus large caps, analysts 20%-plus consensus EPS

2 forecasts for European SMIDs in particular look overly optimistic. In the near term, US small caps could remain under pressure especially if the perception persists that HY yields have hit a floor around the mid-6% yield level. If HY yields break the 7% level this would create an attractive buy opportunity for high yield bonds, and we could expect US small caps fortunes to follow in the same vein. Global earnings growth remains a key risk through 2015 Developed markets have already rerated considerably and Europe, the UK and the US continue to trade on forward and trailing PEs that are generally viewed as fair value to expensive. The sell-side analysts have been moderating their 2014 EPS forecasts as we would expect, but 2015 EPS forecasts are still 10% higher and SMIDs have attracted as much as 20% forecasts. While the regional pace of downgrades has moderated, earnings results support a very stock-specific market where individual company performance is rewarded accordingly. US dollar continues to show signs of strength The structural outlook for a stronger US dollar continues to be confirmed by positive data, and on a trade-weighted basis the currency continues to make solid gains this year, moving closer to sterling s leading position. Consensus long calls for the US dollar fuelled by diverging central bank policies, as well as associated weaknesses in emerging markets and commodities, will likely continue during the fourth quarter, but this is now a very one-sided poistion, so short counter swings can happen at any time. Healthcare and select technology stocks enjoy sector leadership Sector leadership remains unequivocally with healthcare and select technology stocks. Energy stocks are performing poorly. Utilities stocks are maintaining their expected defensive characteristics as the market corrects, but these will reverse when the market rallies and if and when yields rise again. The search for yield is particularly pronounced in Europe. Capital goods & materials and cyclicals (like consumer and industrial) all remain under pressure, rightly deserving their underweighting. Global financials are still proving fairly resilient overall, although this remains a very stockspecific sector with very low intra-sector correlations. Commodities (dark blue line) are very long-term and short-term losers among global asset classes Chart 1 and 2. Source: Datastream Measured over the last 14 years (left-hand chart) and since early 2013 (right-hand chart), commodities have performed poorly relative to other global asset classes. The sharp decline in the oil price this year has compounded the appeal of commodities, which remain out of fashion for investors. While the global equities asset class has maintained a clear lead over asset classes since early 2013, the right-hand chart clearly shows the market fluctuations have impacted the asset class in recent months. Global property has experienced a similar outcome. US high yield has performed relatively well over this time period but continues to suffers from yield compression.

3 Seasonality suggests a positive outcome from the US mid-term elections Chart 3. Source: IDC. The chart above shows how the US equity market performs in the months either side of the US mid-term elections they will be held on November 4 this year. Usually there is a decline leading into the mid-term elections and after the market performs extremely well, on a relative basis. The red line shows the current set-up leading into this year s elections. The green dotted line depicts the Dow Jones Industrial Average around midterm elections in a rate-rising cycle, made up of seven such periods since the 1940s. The blue line is the average of all pre- and post-election periods. We are seeing a continuous series of lower highs of volatility Chart 4. Source: Bloomberg. Each of the preceding mini-spikes in volatility we have witnessed over the last couple of years has led to a distinct buy-the-dip mentality among investors. However, the prevailing market conditions are generally defined as a trend of ongoing series of volatility typified with lower highs. The bottom section of the chart illustrates different volatility measures these have remained with a relatively constant range for most of this year. The outlook suggests that the low-volatility environment will continue for some time to come.

4 Tactical sentiment indicators are oversold again Chart 5. Source: S&P Dow Jones Indices. The sentiment combo model is now at the low end of neutral. This could signal a time to buy during the month of October. The S&P 500 was tested twice in recent years as the blue line in the chart shows. The key near-term support zone for the S&P is 1900 but under this level could be more challenging. The 1954 level was recorded in early October. US relative EPS continues to dominate the global market Charts 6 and 7. Source: Goldman Sachs, IBES, Datastream. The two charts above clearly represent the contrasting market conditions in Europe and the US, showing why US relative EPS continues to dominate the global market. The grey lines show the performance of both the US (left-hand chart) and Europe (right-hand chart) relative the world. Whereas the US shows a healthy earnings outlook the blue line shows relative 12-month forward EPS there is an inverse expectation for European relative EPS. While EPS contribution has been lacking in Europe completely since September 2012, the US market has seen about one-third earnings contribution and twothirds rerating during this period. The market breadth indices, regional Advancers less Decliners, indicate much more strength in the US than in Europe.

5 Eurozone equities have been unable to break higher than the 2008 level Chart 8. Source: Bloomberg. Eurozone equities tumbled below the key resistance zone (see red dotted line) in 2008 and have been unable to recover beyond that level since then. With the region on the brink of deflation, its currency weakening and even the usually impervious German economy showing some signs of faltering following recent weaker export data, investors should keep a keen eye on key economic developments. Although the probability remains low, Europe s recent stock market performance resembles some of the characteristics of 2011 which led to that unforgettable 20% drop, taking the bank stocks down to their lowest level in years (the black line in the top section of the chart shows). A major upward leg is still expected in Japan but timing remains very uncertain Chart 9. Source: Bloomberg. The big picture looks favourable for a further major upleg in the Japanese market, with the potential of breaking into a range of (in Japanese yen terms). The timing for this outcome remains uncertain though and depends on some important conditions. These include the market also rising further in US dollar terms following more conviction in the market from overseas investors. Also, the Japanese market needs to appreciate more than the yen depreciates.

6 China a clear switch in fortunes for small caps versus large caps Chart 10. Source: Bloomberg. China s stock market continues to favour small & micro caps (pink line) and small & mid caps (dark blue line) over large caps (see bottom lines). These improvements in the stock market are seen as positive despite concerns in the wider economy. However, there has been a reversal of fortunes for internet stocks (cyan line) since the summer reversing what was looking like a market-leading trend. US long rates continue to fall although the consensus view expected rises Chart 11. Source: Datastream, GS, FIL. A break below the 2.5% yield in 10-year US Treasuries would suggest risk of another drop in the region of basis points. This appears to be underscoring a trend of lower yields for longer not just being confined to the short end.

7 US dollar strengthening, sterling remains strong and other currencies are weak Chart 12. Source: Datastream, GS, FIL. Note: All currencies are rebased to Taper Day (22 February 2013) While sterling (red line) strength is showing signs of slowing, it still remains the strongest of the major currencies, but at the bottom of the range, it could end up at $1.50 in the next few months. The US dollar (black line) has been bucking the global trend by appreciating rapidly on a trade-weighted basis over the last few months. It would be surprising to see the euro break through the 1.30/1.31 level against the US dollar. If the yen breaks the 110 level against the US dollar, it could quickly move to 115. Crude oil hits four-year low will the price stabilise or drop much further? Chart 11. Source: Bloomberg.

8 The price of a barrel of Brent crude oil has dropped by almost 20% in 2014 (like it did in 2012) marking out its $88-$115 a barrel trading range. A clear break below $88 (denoted by the black dotted line in the top section of the chart above) could even target $60 a barrel. The causes for the price drop are complex: slower economic activity in China; the strengthening US dollar; and ample supply of shale oil from the US and crude from the Middle East. Some of the 12 country members of the Organization of the Petroleum Exporting Countries (OPEC), which produce 40% of the world s oil, are motivated to see high oil prices in the region of $130 to support their public finances. Others, including Saudi Arabia, can manage their output around today s price per barrel and even lower. It s unclear whether OPEC will announce a cutback in production at its next meeting in November in order to boost the price. IMPORTANT INFORMATION This document is for Investment Professionals only, and should not be relied upon by private investors. Fidelity Worldwide Investment refers to the group of companies which form the global investment management organisation that provides information on products and services in designated jurisdictions outside of North America. Fidelity Worldwide Investment does not offer investment advice based on individual circumstances. Any service, security, investment, fund or product mentioned or outlined in this document may not be suitable for you and may not be available in your jurisdiction. It is your responsibility to ensure that any service, security, investment, fund or product outlined is available in your jurisdiction before any approach is made to Fidelity Worldwide Investment. This document may not be reproduced or circulated without prior permission. Past performance is not a reliable indicator of future results. Unless otherwise stated all products are provided by Fidelity Worldwide Investment, and all views expressed are those of Fidelity Worldwide Investment. Issued by FIL Investments International (FCA registered number ) a firm authorised and regulated by the Financial Conduct Authority. FIL Investments International is a member of the Fidelity Worldwide Investment group of companies and is registered in England and Wales under the company number The registered office of the company is Oakhill House, 130 Tonbridge Road, Hildenborough, Tonbridge, Kent TN11 9DZ, United Kingdom. Fidelity Worldwide Investment s VAT identification number is Issuer in Germany: Issued in Germany by FIL Investments International - Niederlassung Frankfurt on behalf of FIL Pension Management, Oakhill House, 130 Tonbridge Road, Hildenborough, Tonbridge, Kent TN11 9DZ. Issuer for Austria, Hungary, Slovakia and Czech Republic: FIL (Luxembourg) S.A., 2a rue Borschette, 1021 Luxembourg Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and currency F symbol are trademarks of FIL Limited. The availability of the investment discipline(s) and portfolio manager(s) proposed in this document is based on the situation at the time of submission and may be subject to change. Reference in this document to specific securities should not be construed as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity Worldwide Investment. ITL14-32