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Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors.
Before trading, please ensure that you fully understand the risks involved
Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors. Before trading, please ensure that you fully understand the risks involved

Monday, January 31, 2022

Europe 600 v/s Netherlands 25

By Century Financial in Investment Insights

Europe 600 v/s Netherlands 25
Europe 600 v/s Netherlands 25

* Trading in financial market carries risk and can result in loss of capital.
* This performance is only observed with historical backtests and not traded by the company.

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The product and investment ideas do not consider the risk profile and financial position of the recipient and may not be suitable for everyone. Trading in financial markets and use of margin involves a significant risk of loss, which can exceed deposits. Please read the complete disclaimer carefully.

Risks & Assumptions

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Past performance is not indicative of and does not guarantee future results. Please read the complete disclaimer carefully.
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Holding cost is subject to change impacting the trade either negatively or positively.
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Trading pairs is not a risk-free strategy. The difficulty comes when prices of the two securities move contrary to the positions taken resulting in losses. Thus, it is important to adhere to strict risk management rules when dealing with such adverse situations.
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Individual stocks in the index are subject to both weightage recalculation & recomposition risk. As a result, certain stocks may be added or removed from the index upon index recalculation. Consequently, the performance of the relative index may deviate.

Change in Central Bank Stance

Global markets experienced a havoc since the start of 2022 on the notion that Federal Reserve policy makers are poised to signal plans for their first interest rate hike since 2018 and discuss shrinking their bloated balance sheet as they seek to restrain the hottest inflation in nearly 40 years.

Markets are now pricing in five Fed hikes this year, while a week ago, the odds of five Fed hikes this year was 0%. Though European Central bank have maintained a dovish stance, major central banks like Federal Reserve and Bank of England have adopted a hawkish stance that has led to rising global yields.

Effect on Valuations

It’s been a turbulent January for equity markets around the globe. But for Europe’s defensive value stocks, the best may be yet to come while for growth plays the trough might not have been reached.

An interest rate hike by major central banks has taken global yields to pre-pandemic highs resulting in sector rotation globally, having an effect on the eurozone too. In a high interest rate environment, the opportunity cost to hold high-flying stocks rises making investors shun such high valuations stocks such as technology. While value stocks are more sensitive to the strength of demand in the economy and thanks to the less severe omicron variant, economies worldwide are reopening swiftly making stocks that are true to their valuations regain limelight.

Trade Rationale

The strategy involves going long on the Europe 600 index and simultaneously taking a short position on the Netherlands 25 index.

The chart below illustrates the ratio between Europe 600 and Netherlands 25:

Graph

Source: Bloomberg (weekly 10-year chart)
Date: January 31st, 2022

Sector Composition

Europe 600 Sector Constituents
Top Sector Name Market Capitalization (in € Billions) Percentage by market capitalization
Industrials 5690 21.23%
Financials 4540 16.94%
Health Care 3800 14.18%
Consumer Discretionary 2940 10.97%
Consumer Staples 2300 8.58%
Materials 1760 6.57%
Information Technology 1680 6.27%
Energy 1410 5.26%
Communication Services 1130 4.22%
Utilities 881.74 3.29%
Real Estate 664.69 2.48%
Total 26796.43 100%

Source: Bloomberg
Date: 31st January 202

Netherlands 25 Sector Constituents
Top Sector Name Market Capitalization (in € Billions) Percentage by market capitalization
Information Technology 303.32 30.6%
Consumer Staples 201.56 20.3%
Consumer Discretionary 155.15 15.6%
Industrials 100.03 10.1%
Financials 77.32 7.8%
Materials 69.13 7.0%
Communication Services 51.55 5.2%
Healthcare 25.63 2.58%
Real Estate 9.17 0.92%
Total 992.86 100%

Source: Bloomberg
Date: 31st January 202

The Europe 600 is majorly formulated of the Industrial, Energy and the Financials sector. Consumer and business confidence are high and the rapid economic recovery from the lingering effects of the pandemic indicates that the demand for basic material should be high, benefiting this sector. The banking sector will benefit in rising interest rate environment as banks' profit margins could expand substantially due to the wider spread between the money they earn on loans and the interest they pay out to depositors.

Whereas, Netherlands 25 has a significant allocation to technology sector that is severely affected during rising interest rate environment since higher discount rates now imply lower present value of their future cashflows which doesn’t seem justifiable for their high prices.

Thus, in a rising interest rate environment, a more value focused index that is Europe 600 is expected to outperform the tech heavy index-Netherlands 25.

Risks and Assumptions for Back-tested trading strategies
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The risks and assumptions listed here are not intended to be an exhaustive summary of all the risks and assumptions involved.
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The strategy might suffer from look-ahead bias which occurs due to the use of information or data in a study or simulation that would not have been known or available during the period being analyzed. This can lead to inaccurate results in the study or simulation.
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Future price movements may not be exactly the same as the historical price movements and this could lead to variation in performance.
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Testing can sometimes lead to over-optimization. This is a condition where performance results are tuned so high to the past they are no longer as accurate in the future.
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The model assumes no slippages in trading. Slippage refers to the difference between the expected price of a trade and the price at which the trade is actually executed.
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Drawdowns in actual trading can be higher than the tested system and losses could be significant in the event of leverage.
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Unforeseen events can lead to variation in performance from the tested trading strategy.
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The tested result has been computed with price feeds available from Bloomberg.
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The testing environment has not considered transaction or any other costs.
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Trading indicators used for the purpose of testing has been provided by Bloomberg.
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The strategy might suffer from data mining fallacy, selection bias and backfill bias.

Data Source: Bloomberg
Data & Prices as of: 31/01/2022

Arun Leslie John
Chief Market Analyst

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