Archives

All posts for the month September, 2016

Value is expensive. I am not sure that’s possible, etymologically speaking, although as it has happened it must be.

Investors are getting used to believing six impossible things before breakfast, as Lewis Carroll’s White Queen could. In a world of negative interest rates, this is the norm. Overnight I read another piece about Canada’s multiple investment bubbles and I am sure that one day they will all burst.

Timing, though, is everything. As a young man I worked in Malaysia during the frenzied stock market run of the 1990s. Each year more investors would come to visit (and shop), count the cranes building skyscrapers and return home bearish. One guy turned the taxi around within ten minutes of leaving the airport and took the next flight home. Eventually one of the visiting investors got their timing right. It would be nice to think it was the airport guy, but I can’t be sure.

Low value equates to low volatility. As this survey shows, low volatility is also low beta and financial strength. Yet over the long term, neither extremely low nor exceptionally high volatility delivers the best performance. That comes from stocks with middling risk.

This is logical. One test of any mathematical model is that it delivers intuitive results. Volatility is risk and if the lowest risk stocks always delivered the highest returns, then their price would be bid up to unsustainable levels. Equally, while risk and return are related, if constantly buying the riskiest stocks delivered the best performance, the word conservative would have fallen out of use.

How do we track this in OTAS? Median implied volatility for the largest stocks in the US is 24, which means that in three months’ time the average share is predicted to be up or down by 12%. The stocks with below average implied volatility have an average forward PE around 18x. This is a slight premium to the market.

PE Relative of Low Volatility Stocks

PE Relative of Low Volatility Stocks

Over time, the stocks that currently have below average risk trade at the same PE as the market. Not all of today’s low vol stocks will always have been less risky, but a lot of them will have been. The chart shows that when the PE premium in low risk stocks reaches 7%, the next move for the market is down.

There are arguments as to why low risk stocks might have the highest potential growth. Strong balance sheets leave scope for leverage and with all the free money sloshing around, buybacks can be used to raise EPS. But Q2 buybacks were the lowest for two years.

Alternatively, all the strongest stocks have the funds to invest in future growth, while the risky stocks have none and hence their earnings will fall. Also, low risk means low return, which equates to high current PE. And that is the point; when the PE of low risk stocks reaches a certain relative level, the low return element of the deal kicks in and stock prices fall.

This typically occurs when the market as a whole falls. When indices retreat from highs, the low risk stocks fall the furthest. Then a few more hedge funds close claiming the market to be irrational.

Canada’s still booming, there is tremendous demand for bonds that you pay to own and the least risky stocks have the highest expected growth. It’s not impossible that this continues, but history suggests that it is unlikely.

The mainstream media is all over the story of the demise of Deutsche Bank, which suggests we have entered the denouement. We use OTAS to assess what is currently factored into the share price as the consequence of any rescue deal for the bank.

Over the past ten years Deutsche has fared no worse than the average European bank, although of course it is supposed to be an above average player, both in terms of international investment banking and among the low return retail banks in Germany. Yet the combination of return on assets and return on equity is forecast to be the worst in the sector this year and next, meaning that for all its leverage, Deutsche’s core return is simply too low.

Deutsche Bank 10 Year Price Performance

Deutsche Bank 10 Year Price Performance

Over a decade, the share price is down 70%, as is the average European bank, while the European market as a whole managed a near 2% rise. By way of comparison, BNP Paribas is down just over 10% during the same period.

OTAS Technical analysis describes Deutsche as a falling knife; a stock trading below its significant moving averages and one that has yet to trigger signs of a turnaround. EPS Momentum is -9% over the past month, which unsurprisingly is in 95th percentile of the European diversified financials industry. There are, however, several banks and financial companies where short term momentum is worse.

Deutsche Bank EPE Momentum

Deutsche Bank EPS Momentum

Since the beginning of Q2 2012, forward estimates of Deutsche’s earnings have fallen 75%, while the share price is down around 70%. A further 15% fall in the share price is implied were it to match the change in EPS over this period. Once talk of bail outs goes mainstream, however, 12 month EPS forecasts move to the periphery of the investment debate.

The downgrades have pushed Deutsche’s forward P/E ratio to the highest on record and it recently touched a premium to the sector that surpassed the level reached in April 2009. Perhaps more significantly, the price to book ratio of 0.24x is below the low point reached during the financial crisis in 2008-9. At one third of the average rating of the sector, the prospects for recovery of Deutsche’s net asset value have never looked worse.

Throughout this time, the short interest in the shares has been surprisingly benign, although the exceptional trading volume of late points to the action being in the cash market. The current level of free float shares on loan is in the middle of its normal range and seems unlikely to be a useful indicator of where the share price goes from here.

The question now becomes what a recapitalisation of Deutsche Bank looks like, assuming it is correct to assume that for all its hard-line rhetoric, the German government cannot let its largest bank go under. With the equity currently expected to return 25% of its value, what about the debt? The CDS trades at 232 basis points, an extreme level over the last decade, but not the highest point reached in that time. Interest rates have fallen over this period however, so it is worth noting that at 1.9x the level of the average European financial, Deutsche’s debt is consider more risky than it has ever been.

Deutsche Bank CDS Relative to the Sector

Deutsche Bank CDS Relative to the Sector

For those who are prepared to bottom fish, there are a number of indicators in OTAS that might point to a turnaround in fortunes at some stage. One would be a stabilisation and then improvement in EPS Momentum, although history teaches that the share price will have moved before the analysts are ready to risk reputations on calling a buy. Thus OTAS technical signals, which focus on mean reversion, may provide an earlier indication of a bounce, especially if combined with another signal. This may be from the CDS market, because if debt investors start to relax about how many cents in the euro will be returned, then Deutsche’s shares should rally.

Stay tuned to OTAS, for it hasn’t happened yet.

Following on from our recently written blog on the uncharacteristic contraction in short interest for UK retailers Morrison’s and Sainsbury’s, it is with interest that one of their European peers Ahold Delhaize is actually seeing the polar opposite this week according to OTAS.

The Core Summary indicates however that the expansion in short interest is not the only risk indicator flagging on the stock currently, it is also noted that an eminent Executive Board member has recently sold a large cash holding in the company whilst income investors may be concerned of the low sector relative dividend yield Ahold currently offers.

Having significantly outperformed the broader Retail sector YTD, Ahold Delhaize has subsequently struggled to make further headway post merger and listing at the end of July.
Those analysing the current market observables in OTAS may conclude that the risk landscape is becoming more uncertain for the company.
ad

Performance: – Having outperformed the sector by 26% YTD, Ahold has started to underperform the sector(and market) over the last week and month.
ad1

Insiders:- Level A Exec. Board member James McCann recently sold €2m worth of Ahold Delhaize stock. Having only made a handful of previous transactions our chart and star ranking suggest his market timing/knowledge is self-evident.
ad2

Short Interest:- Having been practically zero, AD’s percentage of free float shares on loan has increased to 1.3% over the last week. This 5 day move is highly unusual when compared to recent history and suggests negative positioning by Long/Short funds.
ad3

Dividend:- The rally in the share price has left the 12m forward yield of 3% looking particularly low for AD when compared to sector peers. It should be noted however that the divi is over 2x covered for FY1 & 2
ad4

This week the Federal Reserve is expected to keep interest rates unchanged. Generally speaking, lower interest rates are considered a drag on the profitability of banks and a boon to leveraged investors such as utilities. This is because the two industries may be seen as opposites, as banks’ traditional role was to supply the debt that utilities used to fund power projects. Both institutions are highly geared, but one to rising rates and the other to lower.

The implied volatility of banks tends to rise relative to utilities at times of market panic. Not only is bank leverage higher than that of utilities, or any other sector, and hence the business model more risky, but the response of the Fed to market panics is to lower rates, which hurts bank profitability. This is a highly simplistic view of investing, but it is not hard to see how it has become a dominant one in a world of repeated accommodation by the Fed.

Bank risk relative to utilities

Bank risk relative to utilities

The chart shows the median implied volatility of banks in North America against that of utilities. In other words, it is a measure of how risky banks are relative to power companies. Typically banks are greater risk because the value of the index is over one, although in periods of high complacency such as Spring 2015, this was not the case. While the spikes in the chart show when selloffs in the market occurred, it is the periods prior to the spikes that we might contemplate.

The chart runs from the beginning of the second quarter of 2010 to date. There is no compelling rationale for this time period, but it illustrates neatly the periods of extreme weakness in markets and that the two most recent sell offs, in February and June, were mild compared with the late 2011 and mid 2012 events. Investors are pretty benign about the risks to banks relative to utilities at this point and, using this as a gauge of market sentiment, pretty pleased with how the market should behave through the next three months.

This may be surprising given the impending US elections and an Italian referendum that could become a vote on the EU and membership of the Euro. It does, however, show how reliant investors are on central banks keeping asset prices high.

Thus it is worth considering Ben Hunt’s latest missive, in which he puts the odds of Fed hike at three times those implied by consensus. Why should we pay attention to a lone voice when so many are of a different opinion? Because if the consensus consists of a majority that all thinks the same thing for the same reason, then it is dogma rather than the wisdom of crowds.

The other reason for contemplating what might happen should the Fed raise rates is another look at our alternative fear gauge. While bank risk relative to utilities rose last week, it remains at a low level, creating an asymmetric risk-return payoff. A few basis point on, rather than off interest rates, will not be sufficient to restore bank profitability, but it would probably be enough to cause a major rethink among portfolio managers.

There is a debate in the UK about how David Cameron will be remembered. Further from the mainstream, the New Statesman attempts to define the legacy of New Labour’s “Golden Generation”, whose political careers appear to be over. A common theme of the conclusions is that no matter how intelligent you may be; an inability to connect with the electorate will be your undoing.

The aura of technology is painted by Apple, Google and Facebook; companies that tell consumers what their hearts desire before they know it themselves. The reality of much of the tech world is more mundane, and an inability to provide customers with what they want will kill off innovation.

At OTAS, our quest is to simplify efficient equity trading to the point where all that you need to know is encapsulated in a single chart. To arrive at that point however, is a journey of a thousand marginal improvements, more in keeping with the mantra of an Olympic coach than a Silicon Valley visionary. At each point we test our innovations with the heavy users of our software, collect their feedback and adapt the service to be of incremental use.

The barrier to our one-chart-world is the plurality of use cases for the software; differences that are largely unknown outside of equity trading desks, but which create a number of competing demands. One trader may focus only on the liquidity of orders, while another wants to see unusual price patterns. Some desks desire an automated dealing solution that sends regulation trades for low touch execution, while others require frequent updating on delivery versus benchmark. The quest for one-chartism continues.

To this end we are launching the Intraday Screener. This may be connected to an order book, portfolio, sector or market index and will show you at a glance the outliers in real-time trading.

OTAS Intraday Screener

OTAS Intraday Screener

The example above is of the UK non-life insurance sector. The size of the bubble represents the value of shares traded, while its position shows the deviation from normal in terms of both volume and return. In this snapshot, seven of the eight shares are trading up, a couple of which to an unusual degree (to the right of the chart). Four of the shares are trading with exceptional volume, the most extreme of which is down on the day. By hovering over this bubble we reveal real-time performance data for this outlier, Jardine Lloyd Thompson.

In truth, Intraday Screener is not a single chart. You may change the axes to show whichever combination of performance metrics you desire, be that absolute or relative to normal, relative to a basket of similar shares, liquidity, spread or predicted volume. You may also change the variables defined in the size and colour of the bubble, as well as alter the chart to show a map format. Yet we believe the screener represents meaningful progress towards the one chart to rule them all.

The chart above makes an important point about efficient trading, which is that it is not the biggest order or most liquid name that should automatically command your attention. Trading in such names is most likely to be within the normal range, so that steady execution using a risk-adjusted schedule is the optimum way to complete an order. Often the exceptional action is in other order book names, where close attention is required to avoid losing precious performance. The Intraday Screener shows you immediately the names that require your trading skill.

There are users who trade too few names a day to be concerned about relative dispersion. There are others who trade too many for a single chart to capture effectively. There is even a third category that has to be finished before the portfolio manager makes another tour of the floor. Yet we hope that Intraday Screener proves to be a most useful tool for our customers and one that effectively combines machine learning with their human intelligence.

The European Food & Staples Retailing sector has seen particularly unusual activity in short interest for two of its UK listed constituents. OTAS has identified both Morrison’s and Sainsbury’s have seen an extreme* contraction in the percentage of free float on loan in the last week suggesting Hedge Funds are aggressively re-thinking short bets against both companies. Moreover, both companies are due to report financials imminently.

OTAS applications Top Stocks and Lingo both alerted you to these moves(and other outlying factors)

Top StocksPositive Screen – Sainsburys & Morrisons ranked #1 & 2
mrw

A further deep dive across multiple OTAS observables can be conducted via the single stock Core Summary providing a complete assessment of potential directional triggers.

For example Morrison’s screens positively due to the contraction in short interest but has a number of other potential risk factors to consider:-

  • Shares up 32% YTD and have outperformed the European Retail sector by 43%
  • EPS momentum vs Price diverged from long term trend suggesting the market is already pricing in a better outlook for Morrison’s.
  • Shares currently trading at a 13% premium to analyst ave. price target.
  • Small pull back in price has prompted higher degree of short covering into earnings, with short interest still at around 14% of free float.
  • ‘Experts’ still remain negative on the stock as identified by the TIM Alpha Capture indicator.

mrw1

Particularly powerful around financial reporting, OTAS’s award winning analytics provides you with multi-asset intelligence and risk outliers in one ‘go-to’ place, allowing you to make more informed investment decisions and provide a better understanding of factors which could impact on share prices.

 

*statistically higher than average 5 day moves over the last 2 years

Two articles published overnight indicate that the period of central bank omnipotence has ended. The Daily Telegraph carries this commentary on the ECB exhausting its ability to improve the Eurozone economy and this piece about the need for central banks to continue to project omnipotence, whatever the reality. One of our favourite analysts, Ben Hunt, has already declared  that central banking influence is on the wane.

Our recent blog on the logic of investors doubling up equity positions through the option market concluded that this strategy was rational when central banks are the primary influence over stock markets. It stands to reason that if this influence is on the wane, then the risks to equity exposure are mounting.

At OTAS we spend a lot of time looking at the indicators that may inform investors about a change in trend. One popular indicator is the level of credit default swaps, shown here for the median US large cap.

US Large Cap Median CDS

US Large Cap Median CDS

The lowest level of risk for US companies on this measure was June 2014. We have noted that this corresponded to the approximate peak in global export volumes and that economic momentum has deteriorated subsequently. The Fed indicated its taper strategy in December 2013 and officially ended bond buying in October 2014, but it was not until April 2015 that the cost of credit for US corporates began a meaningful rise. Credit risk has returned to its average level and stalled. This may indicate a reluctance to believe that the Fed can raise interest rates meaningfully.

US Large Cap Median Implied Volatility

US Large Cap Median Implied Volatility

Implied volatility is another favoured measure of risk. This also reached a trough in the summer of 2014 and showed a more meaningful pick up from Q2 2015. The reduction in implied volatility since February however, is at odds with the CDS risk indicator. This may suggest that the actions of investors are supressing volatility without the same degree of support from central banks as in the past. This is either because corporate earnings are on a growth trajectory, or because a bubble is forming based on past behaviour by central banks.

US Large Cap Median PE

US Large Cap Median PE

The PE valuation of US large caps is above its average range and on the verge of completing four weeks of decline from close to record highs this cycle. PE can fall due to rising earnings or falling prices and there is nothing to stop the two occurring simultaneously.

The situation in Europe sees the PE valuation of large caps at the very top of the average range. Relative to US stocks the valuation is mid-range, as shown below. The relative valuation has been rising since early July, which may be currency related. It does not, however, bear out relative rates of growth and is not factoring in that further ECB action may be detrimental to the economy, as suggested in the first article referred to above.

European Large Cap Median PE relative to US Large Cap

European Large Cap Median PE relative to US Large Cap

Our final chart shows the valuation of large cap UK stocks. This looks a lot like the US chart, albeit at slightly lower levels of PE. Short term positive EPS revisions are dominated by the Materials sector; much as Energy stocks dominate the list of most recently upgraded US shares. In Europe, ex the UK, without such a prominent resources sector, upgrades show no obvious sector bias.

UK Large Cap Median PE

UK Large Cap Median PE

The last month suggests that cracks are beginning to form in the equity bull market thesis. One rationale for this is that the power of central banks to influence stock prices is diminishing, perhaps at an accelerating rate. The bigger point is that monetary policy alone has been insufficient to drive an economic recovery that translates into corporate earnings rising as quickly as stock prices. One has to doubt that investors will afford politicians and fiscal policy the same perceived omnipotence as they have allowed central banks and monetary policy in recent years.