(MS) European Equity Strat. : Going Overweight Defensives

We upgrade Defensives to Overweight post weaker performance over the last few months, and with our MTI moving out of buy territory. We upgrade Consumer Staples to Neutral. In Cyclicals we downgrade Industrials to Neutral and Materials to Underweight.

We upgrade Defensives to Overweight for three reasons:
i) Our market timing indicator (MTI) has moved out of buy territory and median stock PE valuations are at a level consistent with poor subsequent returns.
ii) Breadth of defensive outperformance has fallen from 70% at the start of the year to 35% today. Historically, low breadth readings such as this have signaled subsequent outperformance.
iii) The recent price underperformance of Defensives has occurred despite continued EPS outperformance from the group.

Stay Overweight Pharmaceuticals and Telecoms
Telecoms is the most oversold sector in the market, with just 20% of stocks having outperformed the market over the L3M, the lowest level since Jan- 2013. Telecoms' relative underperformance to Utilities is now at -2SD. Pharmaceuticals is the only defensive sector in Europe to trade below its longrun relative valuation average, and hedge fund net exposure is at a 5-year low.

Upgrade Consumer Staples to Neutral
Recent price underperformance has occurred against a backdrop of its strongest relative earnings revisions in five years. Our analyst Eileen Khoo argues that European Food Producers have seen a meaningful de-rating in recent months and she thinks consensus EPS forecasts are too low post the rally in EM FX.

Industrials most overbought area of market – downgrade to Neutral
Industrials is the most overbought area of the market, with each sub-sector (Capital Goods, Commercial & Professional Services and Transport) trading 2SD above their 12MA. Industrials also looks particularly extended versus Consumer Discretionary, trading 2.5SD above its relative 12MA and at the highest relative N12M PE since 1992.

Breadth of commodity outperformance at 5Y high - downgrade Materials to Underweight
The breadth of commodity stock outperformance over the L3M is close to a 5Y high at over 80%. Post strong performance we think the space is vulnerable if there is either a move up in the US dollar or a deterioration in sentiment toward China (on the back of a moderation in stimulus plans).

>>> US Early premarket gappers

Early premarket gappers

Gapping up: ANAC +54%, TPUB +22.1%, GSAT +18.4%, IAG +5.5%, CHK +3.9%, HMY +3.6%, SDRL +3.3%, FCX +3.3%, PBR +3.2%, AG +2.8%, BBL +2.6%, RIG +2.5%, RIO +2.5%, ASML +2.5%, BHP +2.4%, YHOO +2.4%, GFI +2.4%, JCP +2.2%, ABX +2.1%, GDX +1.6%, X +1.6%, RDS.A +1.4%, AA +1.4%, BP +1%

Gapping down: BBEP -58.5%, ESLT -3.8%, YY -2.2%, WB -1.3%, ING -1%, VRX -1%, SHAK -0.9%

>>> European Mkt Midday Update

**Equities**
Indices [Stoxx50 +0.7% at 2,955, FTSE -0.3% at 6,122, DAX closed, CAC-40 -0.9% at 4,281, IBEX-35 -1.3% at 8,607, FTSE MIB -0.8% at 17,581, SMI closed, S&P 500 Futures +0.1%]

Market focal points/key themes: European stock open down slightly and trade depressed with low volumes; markets closed in Germany, Scandinavia, Switzerland and Austria for holiday; materials stocks supported following analyst action, commodity prices; Konecranes best performer following acquisition of unit from Terex, and desisting on merger

**Sectors
- Consumer discretionary [Hennes & Mauritz HMB SS -0.6% (April sales)]
- Energy [Hunting HTG LN +3.5% (analyst action)]
- Financials [British Land BLND LN +1.5% (trading update), Crest Nicholson CRST LN +5.0% (trading update)]
- Industrials [Konecranes KCR1V FH +19.1% (Acquires Terex unit), Anglo American AAL LN +5.7% (analyst action)]
- Materials [Lonmin LMI LN +14.4% (results)]
- Telecom [Telecom Italia TIT IM+3.2% TITR IM +3.2% (results)]