All posts for the month October, 2014

Ebola, oil and security are three priority operational issues that are confusing the outlook for airlines. Across Europe some earnings have crashed while others took off. Meanwhile shares have rallied over the last week, after a sustained slump.

Over the next three weeks we will hear from all of Europe’s listed airlines, but the real action is likely to be with those first on the runway, Air France-KLM and Deutsche Lufthansa. Both stocks are about as far below trend earnings as they ever get and implied volatility is plummeting even faster than it soared two weeks ago. One effective way to trade the recent market ups and downs was to identify that overall volatility had not exceeded its two year range ( and when it turned, to buy stocks where volatility had overshot. ( Airlines are clearly in this camp.

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Ebola is bad, but a lower oil price is good. Earnings expectations across Europe have turned positive over the past month, although this is a clear example of the old saw that head in the oven, feet in the freezer means on average you’re fine. EPS Momentum at SAS is over 50% positive and that at Air France-KLM 26% negative, with all the others grouped closely in single digits. After these changes, SAS trades bang in line with the trend in forward estimates, but AF does not, as shown below.

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Looking back over many years it is hard to find a period when the the stock price diverged more from the trend in forward earnings. This is also the case at Lufthansa.

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Cheung Kong Holdings [1], controlled by billionaire Li Ka-Shing, rose 13.9% over the last 12 months (red line on the chart). Sun Hung Kai Properties [16], the world’s biggest developer by market value, has increased similarly by 13.9% so far this year (yellow line).


However, this annualised performance masks the variations in the stocks over the period and it would be grim if you had invested in Cheung Kong Holdings in April 2014 instead of betting on Sun Hung Kai.


The outer reaches of the chart above represent when divergence between the two share prices has become statistically significant and have represented excellent opportunities to reverse the trade in favour of one property company over the other.

Cheung Kong has surrendered all the gains it made over Sun Hung Kai in the early part of the year. This has resulted in the relative valuation reaching a two year low and a significant degree of divergence.


The OTAS Divergence graph below shows the one month percentage change in share price and earnings, with the two white dots on the graph representing the two Chinese developers overlapping. EPS Momentum for both is stable in the past one month, while both prices are down 5%.


OTAS shows that the correlation coefficient of the two gigantic property stocks went has risen from 0.54 a year ago to 0.89 in the past 20 days, showing how closely they have moved together. This may be precursor to another shift in the performance of one versus another, to the benefit of Cheung Kong, to reflect its attractive relative valuation.

Not analysts, that’s for sure. EPS Momentum ticked negative in the month leading up to results, but forecasts were still for per share earnings this year of over $18. This is in line with the old guidance, but not the new and so heavy downgrades are being rushed through.

Short sellers were not active in the name either. Around 1.5% of the freefloat shares are on loan, which is well within the normal range over the last two years. The CDS market has been rising, but this is in keeping with the trend across the software industry and indeed the whole of the S&P and IBM’s cost of credit has held its typical discount to peers.

So once again we turn to the option market for the crystal ball. OTAS relative implied volatility for IBM spiked to extreme levels relative to the software industry immediately prior to results and a level last reached in mid May, after which the shares fell for the best part of six weeks.

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OTAS shows that put protection was the most likely cause of this jump in volatility and downside skew bucked a one month fall as the cost of puts rose more sharply than that of calls. Whether nervous or knowledgeable, option investors once more showed prescience above and beyond the broad consensus. Other investors are able to track positioning in the option market to help inform their own investment decisions, but the fact that IBM fell so sharply yesterday shows how few are able to read the runes.

Predictions of a $60 oil price are circulating; questions are being raised about the sustainability of global growth and the oil price is supposedly a weapon in the power struggle in the Middle East that transcends economic fundamentals. Against this backdrop, the SPDR for Oil and Gas Exploration and Production is down 29% since the beginning of the second quarter, having seemingly gone over the edge of a cliff at the end of August.

And yet implied volatility on the oil producers is falling from extreme levels as uncertainty around prospects declines. While the volatility still implies a move of +/- 19% before the end of January, this need not be downwards. The basket of producers is up 6% in a week since volatility peaked, outperforming the S&P 500 and has supportive technicals.

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Average implied volatility among the OTAS North American Energy complex is 38 and in line with the SPDR. Among the stocks of over $5bn market cap, implied volatility is significantly above normal relative to peers for pipeline company Energy Transfer Partners, its parent and Talisman Energy, while the greatest uncertainty exists over the share prices of Talisman, Weatherford International, Nabors Industries and Whiting Petroleum.

For those that do not have to concern themselves with market capitalisation, there is significant but declining uncertainty over the share price of Forest Oil, Harvest Natural Resources and Cobalt International. Over the past month the extreme outliers in the industry that have experienced falling share prices and declining volatility are Crestwood and Transcanada.

In the meantime, oil and gas exploration and production companies licking their wounds from the recent fall can thank their lucky stars that they are not gold miners. Since the beginning of 2008 the Market Vectors Gold Miners ETF has underperformed the Gold ETF by 95%. Over the same period the miners have underperformed oil producers by 71%. Uncertainty over the future price of the miners is almost as great as that of the oil producers, but with the S&P 500 seemingly on an inexorable path to recover all its under performance versus gold since the crisis, as detailed in our report of October 2 (“Gold and a New Era of Volatility”), the immediate prospects for the gold price and gold miners may offer less bounce back potential than for oil and its producers.

Fourteen, or 28% of the HSI stocks have more than 5 days to cover short interest, making them vulnerable to a positive shift in investor sentiment.


That shift in sentiment may be the move towards a reconciliation between protesters and the government, or simply the rebound in global markets.

Over the past month, most stocks have performed as expected, falling in price as short interest has risen. These stocks appear as white dots in the top left quadrant. The divergent shares are shown as yellow dots.


Want Want China Holdings (151 HK), one of the biggest food and beverages suppliers in Asia, has fallen 21% over the past six months, putting it among the three worst performing names in the index. Short interest on the name is 7.8%, with 29 days to cover. Short sellers are sitting on large profits that they may well want to realise.

Stocks with high days to cover where short interest has fallen in the past week include China Shenhua Energy (1088), CITIC (267) and Hang Seng Bank (11).

According to the FT, hedge funds are on course to have their worst year since 2011. Unexpected interest rate falls and failed M&A deals are just two of the stumbling blocks that money managers have had to deal with in recent months, and with markets currently in free fall, the immediate future offers little respite. Over the past month, the S&P 500 is down 7%, while the STOXX 600 has fallen 8.5%….it would appear the bulls have officially left the building.

Despite the mass sell off, there are some beacons of light within the melee of world stock markets. Interestingly, the stocks that have gone against the grain are those that have more recently had to endure exceptional levels of short interest. Why is this? There are two likely explanations. The first is that hedge funds have been forced to cover shorts aggressively for risk management purposes. In selling large chunks of the long book, they must also reduce the size of short holdings and hence cover large amounts of stock. Consequently, the most shorted names have seen the largest short term increases in their share prices – especially in the US.

Below we highlight names in the Russell 1000 that have more than 30% of their free float shares on loan. Note how the majority saw positive performance yesterday, despite the nation wide sell off.

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The other, more contrarian explanation why these stocks have performed particularly well in such adverse conditions is that some hedge funds may believe the worst is over in these names and have covered aggressively as the market sold off. If we consider the 3 month performance of this same list of stocks, the results are clear – most have underperformed the market significantly. Walter Energy for example has seen a 67% drop in its share price, while the wider market rose by 6%. Yesterday the stock was up 11%.

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We can use the OTAS dashboard to examine which stocks have seen increasingly negative sentiment, despite the market’s already prominent readjustment over the past week. Here, we can see that AKS US, CLF US and AZO US have all underperformed the market significantly over the past 3 months but despite this, hedge funds continue to short these names implying the worst may be yet to come . BYI US and MCY US, two stocks that have performed strongly over the past 3 months, have also seen sizeable increases in their short interest over the past 5 days and could offer a suitable short replacement for hedge funds looking to rotate out of other names.

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Alternatively, we can also isolate those stocks that have seen significant covering over the past 5 days, despite the market continuing to fall. All three stocks were up yesterday, with EDMC up 31% off the back of earnings. Notice how CIEN US and EDMC US have significant Price/Short Interest divergence – could hedgefunds be a leading indicator to the medium term performance of these name or are they merely taking risk off their books?

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JP Morgan has released results showing adjusted EPS marginally below expectation, but with return on assets and equity within the range set by the last four quarters. Given Q3 was the quarter that saw volatility return to markets, the group’s financial statements are a model of stability. Coming into the numbers, implied volatility on JP Morgan was 96% of that of the diversified financials industry and was anticipating the shares to be +/- 11% by the New Year.

Volatility across the bank sector however, had spiked up to levels last seen on February 3; the exact date that the KBW Bank Index touched its year-to-date lows. Then yesterday, implied volatility rolled over.

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On a two year view, the recent move in implied volatility across North American banks has been sudden, but it has not been exceptional. And using OTAS to stretch the chart out further, we see current bank implied volatility is within its average range over the past six and a half years. There are plenty of voices shouting that this time is different and that you have seen the peak in equities, but until volatility breaks a fair bit higher, the truth is that we do not know. To the machines and algorithms that trade the markets, conditions look to be conforming to a predictable recent pattern.

JP Morgan’s numbers were released early, which will have raised a few eyebrows. Citibank, Wells Fargo, Bank of America, Goldman Sachs and Morgan Stanley are among the financial groups that will report numbers before the week is out. If they can do that while we establish a downtrend in volatility after last night’s turn, then equity prices are liable to rally.

The share price fortunes of Switzerland’s two largest Banks have seen notable divergence in the last 5 months, with Credit Suisse outperforming peer UBS by +19%(+12% adjusted for dividends) from the relative year low spread seen in May. The price move has been exacerbated by, amongst other things, the ongoing speculation of a multi-billion Euro fine for UBS in its French Tax evasion case and heightened market expectations of a positive earnings report from Credit Suisse ahead of its Q3 release in 10 days. Such market anticipation has not always been delivered on.
Credit Suisse’ shares are rapidly approaching multi-year highs again vs UBS, historically, levels which previously offered meaningful resistance. Its all about timing….

Whilst sentiment continues to drive contrasting share price performance between the two, historic trends indicate that this relative performance may start to mean revert.
OTAS Pair View allows analytical comparisons across a range of different metrics between two stocks and highlights relative extremes in both Valuation and Price(Spread.)

The price Spread graph between Credit Suisse and UBS shows the former has historically traded at a discount to UBS over the last 2 years, -27% at its widest in September 2013. From the relative YTD lows seen in May of this year, Credit Suisse has clawed back +19% over UBS and is now within a few percentage points of trading at parity with its closest rival. As is observable from the Spread chart, parity(the yellow line) has historically offered significant upside resistance for Credit Suisse shares in relative terms, indeed the three previous occasions have seen a retracement of at least 10%.
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When comparing the relative Price to Earnings ratio, the gradual re-rating of Credit Suisse over UBS since the start of 2014 sees it now trade at its narrowest level in just under 2 years, a 2 standard deviation event. Whilst on a Price to Book multiple UBS is now at lows last seen in April 2013.

 Relative P/E Ratio                                                                           Relative P/B Ratio                             
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Moreover, on an absolute Forward Price to Book multiple UBS is trading at 1 year extreme lows, a level which was seen in August this year and correlated well with a positive inflection point in the shares.

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For those seeking Income opportunities, the relative yield attractiveness of UBS versus Credit Suisse may also be considered. OTAS Pair View highlights the current 12m Fwd Dividend Yield of both stocks compared history vs the sector over the last 2 years.
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The VIX is up over 20 testing YTD highs, the Fed is ending QE and Draghi’s asset plan brings a peashooter to a Howitzer convention. There are more reasons than those not to be cheerful, but these are serious enough, headline grabbing statements to show that the world, or the stock markets at least, have entered a period of sustained uncertainty.

Median implied volatility across European stocks is also up sharply since mid September, and the STOXX 600 index in Europe is down 7.5% over the same period. However, this measure of implied volatility is rapidly approaching the levels that coincided with previous market bottoms. Stop press; there may be a major buying opportunity right around the corner.

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The STOXX 600 has climbed in a jagged saw formation, with plenty of peaks and troughs along the way and frequent opportunities to buy-the-dips. The chart of the progress in the index mirrors that of the median implied volatility of stocks, which peaks when the news is at its worst and declines as share prices recover. We have marked a few recent market bottoms on the chart, but each mini peak in volatility represents a previous buying opportunity, back to the big one on June 24, 2013 and beyond.

We wrote about rising volatility in our blog “The stocks that are about to fly (or crash)” towards the end of September and our very next post “Before earnings season, its downgrade season” gave the fundamental justification for falling share prices, if one is ever needed. Since that latter post average implied volatity across the European index has gone from below normal to near exceptional levels. Decision time for investors is fast approaching; are they about to be handed one more significant buying opportunity?

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We have 21 Australian ‘materials’ stocks in OTAS that have market caps of > $1bn USD. Companies range from chemical manufacturers to raw commodity miners however it is the miners that we are more concerned with in this instance.

It has been well documented that stagnating growth in both China and Europe has forced the prices of raw commodities to drop substantially in recent months. Iron ore and crude oil, two proxies for growth forecasts, have seen their prices fall by 40% and 18% respectively since the start of the year and consequently margins have collapsed, which in turn has lowered the CAPEX of Asian miners. Australian listed miners such as Fortesque and BHP Billiton have seen their share prices fall sharply over the past 6 months, and if it wasn’t for recent M&A revelations, Rio Tinto would be trading around 2 year lows.

For all three stocks, OTAS paints a risky picture, with implied volatility well above average ranges when looking back over the past year for both BHP and FMG and RIO experiencing a 5% increase in perceived price risk over the past week.

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Note here how in all three stocks, the upside skew is <1 and the downside skew is >1 – suggesting that the options market continues to position itself for downward price moves over the next 3 months. This shift in risk sentiment is not unique to the three aforementioned names. Since September, option market investors have become more wary of the sector as a whole and as negativity increases implied volatility should also rise.

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The S&P/ASX 200 Materials Index has fallen by 11.56% over the past 3 months, its sharpest fall over this period since the start of 2013. What we can gauge from the options market is that, in all probability, investors are positioning themselves for a further 14.3% fall in share prices over the next 3 months, inferring the worst is yet to come.


Looking at the valuation chart, it’s clear that Australian names were due a correction back in September.

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Now however, it seems that many mining stocks have normalized, with analysts downgrading their EPS estimates heavily over the past 3 months.

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One indicator that is lagging behind both implied volatility and EPS momentum is short interest. Granted, the average level has increased by 55% over the past week, however the current level is still well below the highs seen in September last year.

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Perhaps hedgefunds have taken the option to short oil or iron ore outright, however there is certainly an opportunity to take advantage of the existing volatility within this sector. Could a sudden bout of short selling put more downward pressure on stocks in the near term?

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Dividend yields across the sector are now at 2 year highs, which could prompt entry from income fund investors once the macro economic news flow has stabilised. Dividend cover rates look stable, however if firms cannot afford to increase their CAPEX what hope is there for income investors to receive as healthier a yield as is presently available?

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