Archives

All posts for the month July, 2016

“Because as any coup-launcher or Fed-fighter or volatility-embracer knows, if you’re wrong on timing … you’re just wrong” – Ben Hunt, Epsilon Theory July 26, 2016

The number of short bets on sterling through the futures market is at a multi-year high ahead of next week’s expected cut in interest rates in the UK. While these may be the speculations of the same hedge funds that lost money on the UK referendum, there is a strong consensus that the pound is headed lower. As recent events have shown, this is putting UK companies in the shop window, but can OTAS provide a way of figuring out who is next to be taken over?

There have been strong suspicions and some academic research suggesting option market activity pre-empts M&A announcements. What the research cannot determine is whether trading was due to inside information or informed opinion. Typically it is out-of-the-money call option activity that is more informative than at-the-money or put options.

Before we look at the evidence from OTAS, will the Bank of England cut rates next week? This is a different discussion to whether it should. Jeremy Warner argues in the Telegraph that the sledgehammer-to-crack-a-nut response to a knee jerk, post Brexit survey of disappointed corporate Remainers is not the right way to run an economy. He points out that the acquisition of ARM Holdings funds the current account deficit for three months. Speculators may not be “fighting the Fed”, but they are battling investment flows.

The post referendum narrative is that the economically disadvantaged swung the result and new Prime Minister Theresa May has aimed her pitch squarely at where she believes this constituency lies. Politicians still fail to appreciate that many of those who feel left behind are middle class savers whose retirement plans are decimated by central bank group-think. Unfortunately, the prospects for this small-c conservative demographic are very poor, as explained by Ben Hunt in his latest Epsilon Theory.

If Ben is right and that nothing will stop the central banks from flooding markets with cash, as Brexit, data dependence and such-like are just excuses for more of the only thing the authorities want to do, then stocks should rise and the pound fall. Typically bull markets take place over longer periods than bear markets, and are associated with lower implied volatility as the direction of travel becomes more certain.

UK Large Cap Implied Volatility

UK Large Cap Implied Volatility

Implied volatility for UK large cap stocks is back in the average range of the past two years, but five points above the stable state of the first half of 2015 that saw UK stocks rising steadily. The two recent peaks reflect Brexit worries immediately before and after the referendum. The one before, which was a bigger shock regardless of what the media may tell you, was the global recession fears of February, now long forgotten in large part thanks to desperate/determined[1] action by the ECB.

The US market appears to be leading the UK, which is worth bearing in mind as the Brexit furore subsides and the Trump-panic-hype really takes off.

US Large Cap Implied Volatility

US Large Cap Implied Volatility

M&A activity may mean stock specific rises in implied volatility. OTAS shows that among UK large caps only BHP Billiton has seen such a rise over a month, while Anglo American and GlaxoSmithKline have risen over a week. This is based on at-the-money options, but OTAS users with desktop access may dig deeper to see at what level recent trading has taken place. The bulk of the activity for Anglo American, for example, has been out-of-the-money puts (no take-over expected here).

AAL 1-Week Exchange Traded Option Activity

AAL 1-Week Exchange Traded Option Activity

The chart for ARM Holdings shows that the take-over by Softbank was a surprise. The subsequent sharp fall in implied volatility reflects a done deal at a fixed price, while any continuing option activity is by arbitrage specialists using leverage to magnify small price movements.

ARM Holdings Implied Volatility

ARM Holdings Implied Volatility

There is much more to the option market than M&A. Specialist take-over investors will have lists of potential acquirers and targets and stay on top of many more factors than market signals. For the part-time speculator it is worth creating your own list of sectors and stocks that you believe could be vulnerable to approach were the pound to fall further. Putting these in a portfolio in OTAS will allow easy filtering for unusual activity, whether that is in the options market, dealings by directors, or idiosyncratic price performance.

For those interested in potential acquirers, checking the CDS of the companies may be a means of investigating which managements are planning leveraged take-overs. There are, however, other reasons why credit costs can jump, such as a shortage of cash from operations. For this reason, while OTAS provides an initial view on the world of potential M&A that goes further than press speculation, it is only suggesting stocks on which the user will need to do additional research.

Right now there is little unusual option market activity among UK large cap stocks. This may be because, as the quote at the top of the blog indicates, timing is everything. Or it may be because so few people seem to have been able to contemplate that the UK would have a corporate future outside the EU, any M&A activity comes as a complete surprise.

[1] Delete as per your preferred narrative

The supermarket sector in Australia has been quite competitive, Coles has recently took over Woolworths as the leader in market share in the region, while Aldi is gradually gaining more and more market share and taking business from Woolworths and Coles. For the past three weeks, we have seen that Woolworths has been having a good run. The stock has rallied from the low $A20.5 to last Friday’s high at A$24.48, with huge volume of 13.5m shares happened just last Friday after the Company released the FY16 EBIT guidance. The CEO announced that there are clear signs of progress in terms of positive customer scores, team engagement scores and continued transaction growth. Despite this giant retailer seemingly standing strong, OTAS has picked up a few signs that this rally is perhaps triggered only by short covering, and that it may not be sustainable because of the stock’s high valuation, falling EPS momentum and descending dividend trend.

The % of free float shares on loan and the stock price of WOW AT has recently narrowed and crossed, as shown in the short interest graph below. The data is up to July 25th 2016 and it has taken into account the big volume day from last Friday:

1

The stock is highly expensive among the retailing space and its Asia ex Japan peers.

2

The OTAS Divergence graph shows that Woolworths is an outlier in the EPS vs. Price Graph below. Its price has been up 14.3% while EPS momentum is down by -3.56%. Analyst consensus is showing that the mean target price is at the A$22.58 level which is 4.2% lower than the current share price.

3

4

Forward dividend yield graphs is trending lower, another implication that the risk of falling profits could be taking place.

5

BP is struggling today, current down 3% after missing quarterly profit expectations and cutting its investment budget.

OTAS is often used to look at positioning risk ahead of quarterly results and in BP’s case, the stock was screening poorly ahead of today’s results. OTAS shows;

  1. BP is unusually expensive vs the Sector
  2. 20% outperformance vs the Sector since beginning of June
  3. Negative technical screening. RSI Sell signal which has an 82% success rate looking back 10 years
  4. Unusually low Sector–relative implied volatility which is arguably a sign of complacency. Previous extreme low levels in Sector relative implied volatility has preceded sell-offs.

 

  1. Unusually expensive vs sector. Trading on 1.3x Sector multiple which is approximately 2 Standard Deviations expensive on a 2 year view
    BP 1
  2. Strong post Brexit rally. 20% outperformance vs the Sector since beginning of June
    BP 2
  3. RSI Sell signal which has an 82% success rate looking back 10 years. This is the most statistically reliable Technical Signal on BP
    BP 3
  4. Unusually low Sector–relative implied volatility which is arguably a sign of complacency. Previous extreme low levels in Sector relative implied volatility has preceded sell-offs
    BP 4

 

A follow up to last week’s note, the hype of Pokemon Go continues to spread across the globe. Yesterday, the well-known Hong Kong listed technology stock Lenovo rose up by 7.6% to a two-months high, thanks to the company plans to launch Smartphone Tango with Augmented Reality features in September this year.

1

OTAS has effortlessly captured the positive sides of this stock in a glance. Particularly, if you take a closer look at the Insider Transaction of Lenovo for the past one year, OTAS shows that the Chairman of the Board & CEO, Yang, Yuan Qing, has increased stake by five times. The last period of time when Yang increased his stake was in August 2015 (three times) with average price of $7.18, subsequently the stock rose up to $8.76, a decent rally of 22% within three months. This current month, Yang has increased stake by 20,000,000 shares, a much larger number of shares than his previous stake increase. In fact, Yang has increased stake to a much more significant position of 8.12% from 6.79% (as shown in the table from Hong Kong Stock Exchange below), revealing his confidence about the company’s future share price.

2

HKEx filings – Yang Yuan Qing  % of issued share capital from 6.79% to 8.12% as of July 8th 2016.

3

Moreover, the valuation of the name is at a very cheap level with P/E lower than most of its technology peers in Asia. And according to IDC, Lenovo has the highest market share in PC shipment and the overall global PC shipment in Q2 2016 has exceeded expectation. Combined with all the other positive flags from OTAS, we can expect a stronger demand of Lenovo’s sales in the second half of the year.

4

5

The OTAS Divergence chart shows that the price has been up +11.92% in a month, with short interest just up slightly by +0.82%. We do not see significant new shorts on back of the rally.

6

U.S quarterly reporting gets into full swing this week with 91 companies in the US Top 500 releasing Sales or Earnings updates to the market. A timely reminder then, that our Earnings Positioning screen allows you to identify those potential ‘risk’ stocks by analysing a range of multi asset factors and highlighting those exhibiting extreme market characteristics or displaying specific sentiment bias.

Lets look at a couple of example screens:-

ep1

  • 11 stocks are currently technically Overbought(>70) on an RSI measure heading into numbers.
  • 7 of these companies are considered ‘expensive’ versus their respective sectors in terms of valuation.
  • A further 4 of these offer a poor sector relative yield (Johnson & Johnson, Intel, Union Pacific & Stryker).
  • The only company to see sector beating earnings upgrades in the last month is D R Horton possibly supporting its overbought status whilst Stryker retains a comparatively high degree of short squeeze risk with nearly 9 days to cover

Perhaps the most interesting name from the screen above is Lockheed Martin. Not only is it technically overbought with a low relative yield, it has also seen an extremely unusual 5 day move in the % of free float on loan(short interest) increasing by 211% over the week, possibly indicating downside risk expectations by Hedge Funds. Interestingly other market observable’s and sentiment indicators in the Core Summary such as EPS momentum(flat) and Estimize(@$2.93 vs Wall St $2.92) suggest the broader market is expecting an inline report.

ep6

Positive risk indicators are also highlighted in the Earnings Positioning screen. For example, conversely to Lockeed, both Southwestern Energy and WW Grainger have seen a significant contraction in the short interest over the last week, with the latter displaying large short squeeze potential with nearly 15 days to cover. Additionally, Southwestern has seen analysts adjust their EPS estimates up by 42% in the last month putting in the top 10% of its sector for upgrades.

ep3

Only one stock has greater short squeeze risk than Grainger and that is Visa with over 30 days to cover.

ep4

The single stock Core Summary for Visa indicates a number of concurring factors such as strong positive technicals and EPS momentum, low sector relative valuation alongside expectations of a ‘beat’ within the Estimize comunity and the highest sell-side TIM Indicator score of 10.

ep5

Don’t be caught out over Earnings season, let OTAS bring together the most important factors and performance drivers so you never need miss a potentially stock moving trigger.

Last Friday the stock Nintendo rose 11% after one of its smartphone game Pokemon Go was ranked no.1 of the apps download chart in the US, Australia and New Zealand. Furthermore, this morning the stock has rallied another 25% and hit daily limit up in Japan. In a nutshell, Pokemon Go is an augmented reality smartphone game and players would ‘capture monsters’ using their smartphone cameras in the real world locations. When investors might be thinking that the Nintendo share price has been in a rally due to short squeeze, OTAS has pointed out that there are some real investors buying the company as the short sell levels of the stock is only 1 day to cover. And in fact we also see that all the Japanese gaming names have a low short interest ratio.

Investors were worried about the results and shorted the stock ahead of the results in April 2016. However with the successful launch of their first mobile app Miitomo in March, the % of FFS on loan of Nintendo has remained to be on low level.

1

Generally, the short interest of the Japanese gaming industry is relatively low compare to the stocks in Japan Top 225:

Stocks in the Japanese entertainment field

2

Japan Top 225 stocks:

3

Volume of Nintendo has spiked up last Friday and today with close to no short covering as shown above. Investors are not hesitant despite Yen coming strong (around 100.6) and been chasing the stock.

4

The Nintendo stock performance has been positive so far this year, as well as being the out-performer compare to its region and industry.  With the success of Pokemon Go, plus a strong pipeline with lots of other popular characters, the company see a promising outlook in the near term.

6

As UK stocks refuse to collapse, some Remain supporters highlight the drop in bank shares as evidence of the self-inflicted wounds of the referendum. A quick look at OTAS shows that the reality is different.

RBS

RBS Share Price and 12 Months’ Forward EPS Estimate

Earnings expectations for RBS, in blue above, have fallen 7% in the past week, but have also reduced steadily since November 2014. The rate of decline accelerated from November 2015 and the recent drop is not the steepest downgrade of the past year. What did happen, however, was that the stock price diverged from trend earnings from early May and it is the reversal of this move causing the recent, sharp fall in the share price.

There was no reason based on the likely result of the referendum for the RBS share price to rally while its earnings fell. At the very best the status quo was on offer, which suggests that there was a degree of irrational exuberance ahead of the vote. Equally, if the share price was to fall far below the trend of earnings, this would imply that the EU was a source of strong growth for RBS, which we have not heard even the heartiest Remainer claim.

The situation is very similar for Barclays, although the negative EPS Momentum and share price moves are not as marked. To put the referendum reaction in context, the long-term chart of Barclays’ share price and 12 months’ forward earnings expectations is shown below. NAD refers to New Annual Data and marks the date of publication of the annual accounts.

Barclays Share Price & 12 Months' Forward EPS Estimate

Barclays Share Price & 12 Months’ Forward EPS Estimate

Earnings expectations for Barclays have fallen sharply from the beginning of the year and it is hard to discern any meaningful Brexit impact. Over the long-term the share price tracks earnings momentum rather well. (If you want to know the discount for government ownership of a bank, check out the same chart for RBS using OTAS.)

Uncertainty is the bug-bear of market participants and implied volatility for UK banks has jumped to exceptional levels, on a two-year view. The uncertainty is a result of the referendum vote, but one read of the Bank of England’s Financial Stability Report is that Brexit has exposed significant fault lines through the UK economy that were already there. Further interest rate cuts and monetary measures to suppress volatility are the only game in town as far as the Bank is concerned, but this will continue to damage commercial banks’ earnings prospects as has been the case for many months.

One unknown for UK banking is whether non-EU banks will retain passport rights to operate on the mainland. If not, then some very senior US bankers will be looking for a new home on the continent, which is not a prospect that particularly appeals. Expect passporting to be the post referendum hot topic, much to the bemusement of the majority of voters.

Goldman Sachs has an important passport bank that is currently based in the UK. This, however, is not the primary determinant of the group’s earnings outlook. The chart below shows that exuberance for Goldman Sachs shares occurred about a month before the rally in UK banks, but that share price and EPS estimates were converging from early May. Once again, earnings momentum is the best indicator of long-term share price.

Goldman Sachs Share Price & 12 Months' Forward EPS Estimates

Goldman Sachs Share Price & 12 Months’ Forward EPS Estimate

Brexit is a great excuse for managements who need to impart bad news about earnings. Banks in particular sense rare media support for their plight, even though earnings have been falling for months and share prices were out-of-kilter with forecasts before the referendum. Whether Brexit, or over-leverage and a clampdown on tax inversion has slain the M&A golden goose, the best game in town for investment banks has ended. Throw into the mix that senior bankers may be leaving London and you have a number of upset people.

We are not singling out Goldman Sachs, other than in our title, which will most likely be one of the industry winners whatever the outcome. For all passport banks there is talk that Paris is not a likely destination because of the Establishment’s dim view of banking, Frankfurt a little dull and Dublin lacking infrastructure. All of a sudden Madrid emerges as one of the most liveable EU cities for jet-set financiers. There remain only the minor issues of where to buy a latte prior to market open and getting an answer for the East Coast before tomorrow.

The rapid rebound in stock markets since the UK’s vote for Brexit is witness to two things. The option market, which is easily and effectively tracked using OTAS, expected little disruption through the vote and this is what has happened. Equally, investors anticipate another injection of liquidity from central banks to prop up asset prices, as the likely reaction to further shocks and as we discussed in April.

The debate about the efficacy of further central bank support was well underway before the UK referendum, as the protagonists knew the result was unlikely to change their opinions. A summary of the arguments is provided here, courtesy of Evergreen Gavekal’s weekly newsletter. At a time when the machinations of party politics are dominating the UK headlines and there is great gnashing of teeth at the absence of leadership, it is well to remember that central banks and not politicians have determined economic outcomes for many years, and it is their policies on which we must focus.

The optimistic case is put by Niall Ferguson, distinguished economic historian, who argues that the world’s central banks have coordinated their actions to stymie the rise in the dollar and end the currency wars that some believe will be the trigger for the next global downturn. If so, then the Bank of England Governor Mark Carney may have helped trigger a final competitive devaluation for the pound through his otherwise unseemly haste to declare his Brexit warnings as fact.  Sterling could be argued to have been held up by fumes, Brexit or no Brexit, given the UK’s gaping trade deficit and short-term financing requirements and the economy may benefit from the recent depreciation.

The pessimistic case, put by successful fund manager John Burbank, does not doubt that central banks desire to pour more fuel on the fire of monetary easing, but sees the policy as self-defeating. Where optimists cite Reinhart and Rogoff’s study of recoveries and the average eight years from financial peak to eventual recovery, the pessimists assume that the dollar will resume its rise and draw liquidity from much of the rest of the world in the process. Time will tell, but both camps appear sanguine short-term, which brings us to the three month predictions of the option market as deciphered through OTAS.

UK IV

UK large stock implied volatility, a measure of risk or uncertainty, is at the top of its normal two year range. The post Brexit peak was lower than previous highs, including when Brexit first headed the polls and well below the February level, when global economic slowdown was the issue. While it is tempting to conclude that Brexit is no big economic deal, it is just as likely that investors expect evermore intervention by central banks. Thus the correct investment strategy remains to buy-the-dips, as it has been throughout the post-crisis years.

It is worth noting the frequency with which volatility tops out close to the two standard deviation level, marked by the upper solid blue line on the chart. While risk is not a normal distribution, the two standard deviation level remains highly instructive and statistical analysis provides a superior guide to upcoming investor behaviour than market commentary. The turning point normally comes when the noise level advising otherwise is at its zenith.

UK Stoxx IV

The recent disruption to the blanket volatility suppression undertaken by central banks does have a British flavour.  A week before the referendum, the relative volatility in the UK compared with the STOXX 600 matched the February peak and, again, was at a two standard deviation level measured over the previous two years. The post plebiscite peak did not reach this high, as it becomes increasingly apparent that uncertainty remains greater in Italy and Spain than in the UK (OTAS will show you this). Overall, UK large caps are barely more risky than Europe’s largest stocks and current relative risk is only a couple of percentage points above the average level.

STOXX IV

Turning to Europe and a longer timeframe, implied volatility in the STOXX 600 remains safely mid-range over the past ten years, a result of continuing central bank activity and the insignificance of the likely long-term economic effects of Brexit on the UK or Europe. There is uncertainty, as many are determined to repeat, but the range of expected outcomes appears to be narrow. Note from the chart above how over this time period the one standard deviation levels, marked by the dotted lines, prove to be the normal resistance and hold in all but the most extreme trading environments.

STOXX S&P IV

The final chart compares current volatility in Europe to that in the US. Risk reduction is a global policy, but the biggest Brexit shock, which came before the vote, was enough to cause a spike in this measure from which markets have not fully recovered. By keeping a careful eye on the relative positioning of option investors in different markets around the world, OTAS users have a ready-made guide to what is most likely to unfold in equity markets. This should be of use as the news flow shifts to the potential for political uncertainty in the US later in the year.

Arguably against the odds and the Brexit doomsayers, the FTSE 350 has managed to record a stellar +11% return from the market lows seen in the opening minutes of last Fridays trade post vote, and is in fact now c+2% higher than the pre-referendum Thursday close.

Whilst it is evident that not every sector has embraced the rally(read housebuilders, retailers, financials,) it is possible through OTAS, to analyse and interpret how different investor types in the market are reacting to the move and identify stocks which are attracting their concerns/confidence.

For example, thinking specifically about the Hedge Fund community, we note that there has been a sharp increase in the median value of short interest across the top 350 UK companies, suggesting a conscious move by ‘fast money’ accounts to generally re-position negatively into the ensuing rally. The level has surpassed February’s highs and you would have to go back to mid 2012 to see similarly elevated short interest levels…
si1

OTAS actually takes you a number of steps further than just this top down view.
Firstly, it identifies which stocks have seen a highly irregular 5 day move in Short Interest compared to what is normally expected over a similar five day period. Six stocks have seen a extreme increase in free float shares on loan, whilst just one, Ashmore has seen a decrease. These names are clearly attracting more attention than normal but are investors & shareholders aware of what these risks are….Brexit related or other ?
si2

Alternatively, it is possible to screen for stocks exhibiting the highest absolute change in free float shares on loan to understand which names are seeing a general change in market positioning.

Here are the Top 5 ranked FTSE 350 stocks ranked by absolute increase over the last week….
si3

Whilst there has also been some stocks who have seen a contraction in free float on loan over the same period.
si4

In summary, the increase in median short interest value suggests an uptrend in negative bets being placed currently and OTAS will help you identify those shares contributing most to the change in sentiment.

 

Follow us on Twitter at @otastech