Market Commentary

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

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
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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.

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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.

Sustained periods of low volatility correlate well with steadily rising equity prices. Yet concern is mounting that the current low volatility is storing up future problems, because investors are doubling up on high share prices. By selling put options on shares and indices, thereby committing themselves to buy shares should the prices fall, these funds are exposed to an equity market sell-off through both their ownership of stock and the recently written put options.

It is perfectly rationale to sell puts if you believe that markets are rising. The concern however, is that funds are so starved of yield that they are writing puts for the short-term income benefit and relying on the world’s central banks to bail them out should stock markets take a dive. A parallel is drawn with the sub-prime mortgage debacle, when it was not the size of the market for poorly underwritten mortgage loans that triggered the financial crisis, but the vast number of derivatives layered on top that magnified risk throughout the financial system.

US Implied Volatility - 2 Years

Implied volatility for the top 500 US stocks has fallen sharply since the post-Brexit panic and even more significantly since the worries about global growth were at their height in February. Yet as the chart above shows, two year implied volatility remains in its average range and around 10% above the successive lows of 2015.

US Implied Volatility - Longer Term

On a longer timeframe the shock from the financial crisis and its echo in 2011 are clearly visible, but the current level of implied volatility is not unusual in the post-crisis period when central banks have been deliberately dampening volatility in order to encourage risk-taking. Implied volatility for US large caps is 6% above the low point of its average spread. In Europe the picture is similar and implied volatility is 18% above the bottom end of its normal range, which has repeatedly marked the low point for this indicator.

Europe Implied Volatility

The charts appear to support the strategy of the put sellers, because implied volatility still has room to fall to reach previous lows, during which time the options sold will expire worthless. The put writers are also doing central bankers’ bidding by taking more risk, so they will feel justified in expecting central banks to bail them out when necessary. Large, long-only funds find it difficult to react to sudden moves in markets, meaning that they miss their chance to scoop up large quantities of shares before prices rally back to where they were. A logical way to ensure that these funds benefit from temporary corrections is to write puts so that they are guaranteed stock immediately prior to a central bank induced bounce.

There is a near-term benefit in enhanced portfolio returns because of the income from writing puts, but the longer-term gains are based on the assumption that central banks will continue to do what they have been doing since 2009. Janet Yellen may lay out the path to higher interest rates in her speeches, but as long as the Fed is seen to be ready to ease monetary policy whenever markets are in stress, the put-writing investment strategy will work.

OTAS users may keep a close eye on the trends in implied volatility to see when the current normal moves become exceptional. They should also look for confirmation from other indicators presented in a similar fashion, such as the cost of credit for corporates derived from the CDS market.

 

The market often overlooks or neglects the potential signalling risk contained within company Insider Transactions. Investors are typically provided with basic trade details like who, how much and which direction but we’d argue there is simply not enough to infer positive or negative performance bias based on this information alone.

Using our prescient analysis, OTAS provides a unique star ranking which accompanies the Insider stamp telling you immediately whether the latest transaction by a company director or major shareholder has predicated the future price direction of the shares. From as little as a single well timed discretionary trade, OTAS can identify which insiders historically you should follow and those you shouldn’t….

The recent buying in retailer Metro AG is a prime example of one you should……

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3-Star rated Supervisory Board member Juergen Steinemann purchased €1m of stock on Friday. Singling out his own previous transaction history it is evident that he possesses particularly astute market timing, buying close to the trough after multiple periods of decline and prior to subsequent strong rallies in the share price.
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Of course an investment decision is not made on one factor alone. The Core Summary allows you to quickly draw conclusions on the state of a company by analysing a range of multi-asset observables to understand if and where additional risks(or opportunities) may lie.
In Metro’s case, the company is currently not displaying any undue signs of risk but conversely is supported by a continued contraction in credit spreads and short interest, whilst company sentiment remains positive with the sell-side in the TIM alpha capture platform, displaying a 9 score on the TIM indicator stamp.

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Don’t forget live Insider transactions are available via your intraday Alerts feed, so you’ll never miss a new, potentially price impacting trade….
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Today there will be a few Hong Kong large cap names releasing earning results and one of them is Ping An Insurance (2318 HK). It is worth noting that yesterday before the Hong Kong & Shenzhen Connect announcement, the northbound net buy was the highest in one year record and that Ping An Insurance was the top buy name among all the stocks.

Today Ping An Insurance is trading slightly lower ahead of its results, and it could just be a technical pull-back from profit taking from yesterday. It is interesting to see that Ping An Insurance’s implied volatility volume has risen significantly as seen from the yellow triangle displayed below. Note that when Ping An Insurance’s implied volatility volume spiked up last three times on January 12th, April 13th and July 15th this year, its share price always reacted strongly.

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Ping An Insurance – Implied Volatility Summary :

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Ping An’s implied volatility high volume signal on January 12th, April 13th and July 15th this year, and the current high volume signal:

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Ping An Insurance share price’s responses on the days where it had implied volatility volume spike:

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OTAS has fired a Bollinger Band (-) signal 4 days ago and on average the stock might generate 5.0% return over the following 20 trading days. Perhaps it could now be a good time to add positions before the results come out?

We have written a lot about using implied volatility as the measure of how equity markets will react to supposedly high risk political events, including Brexit and the US Presidential Election. This week, Institutional Investor has been good enough to publish our article making precisely this point. Today, however, I want to focus on corporate credit and its importance in determining the success of central bank policy.

Once again I am grateful for outside help, in this instance EvergreenGK for pointing out when and why “Don’t fight the Fed” works. The crux of the argument is that our mantra should really be “Don’t fight the Spread“.

The message from implied volatility in equity markets is that stocks and shares are set fair for the next three months at least, which takes us to the eve of the Presidential election, supposedly the most polarising event in living memory. Equity investors are relying on volatility-crushing central bank interventions to maintain an upward trajectory to equity markets.

Evergreen notes that the early 1930s, the start of the 2000s and mid-2008 to early 2009, were all periods of expansionary monetary policy and terrible stock market performance. If you hadn’t fought the Fed on those occasions, your portfolio would have come-a-cropper. The signal to break from orthodoxy was the rise in corporate credit spreads, because investors considered the risk of companies defaulting to be so great that no authority could do anything about it. This proved to be the case for periods of time that we now call the Great Depression, the bursting of the Dot-Com Bubble and the Global Financial Crisis.

So to today and the five-year credit default swap for the average large cap US company as an indicator of risk for equities. The low point of the median CDS was June 2014 and there has been a steady rise since April 2015. This coincides with total global trade by volume (not value) starting its decline; hard evidence that the trend towards globalisation ended well before protectionists were the only choice for the White House.

Average 5Y CDS for US Large Caps

Average 5Y CDS for US Large Caps

I have shown the chart over a five year period. What this highlights is that corporate credit risk is now very close to the average level over that period and below levels seen in 2011 (thus well below extremes three years earlier). The high point of central bank potency has passed, because the links between money and trade, a primary conduit of long-term global growth, are just too tenuous. What central banks appear to have done however, thanks to the ECB’s intervention in February, is cap the level of risk for now.

EUR CDS

Average 5Y CDS for European Large Caps

The trends for large European corporate credit are similar to those in the US. Average credit costs are 13% higher in Europe, despite US policy rates being above those in Europe. This means that the risk of companies defaulting is greater than in the US, even though the ECB has been buying corporate debt directly since June.

This week the Bank of England announced that it would purchase up to £10bn of corporate debt. The rationale for this is that it will do more to make investors buy other corporate securities (i.e. equities) than if the Bank simply purchased more gilts. Also, with the cost of debt reduced, companies should issue more debt. It remains to be seen whether this has any impact on corporate investment, but recent history suggests that it will boost share buybacks and M&A.

UK CDS

Average 5Y CDS for UK Large Caps

Credit risk in the UK is higher than both the US and Europe. The highest risk is for mining companies, followed by supermarkets and then financial companies. The issues with each of these industries pre-dates Brexit by some way, although as we argue in the Institutional Investor article, the rapid response to Brexit by the Bank of England will only exacerbate the woes of banks and insurers. The UK economy is peculiarly dependent on financial industries.

The success of central banks in holding down corporate credit costs may well determine whether you should be “fighting the Fed” or going with the flow. OTAS presentation of corporate credit is relevant because of the deep statistical analysis that sits behind every chart and table and in the flags that alert you, stock-by-stock, to significant credit events. You can stare at other screens for hours if your firm buys the data feeds, but without the statistical significance, it’s all just noise.

Overnight the crude oil price settled below $40, meaning the price has pulled back 20% from $50 to below $40 within two months. China’s largest offshore Oil and Gas producer CNOOC (883 HK) issued a profit warning six days ago, citing that it is likely to make a greater than expected first-half loss of $1.2bn. Behind the headlines however, there are concealed opportunities highlighted by OTAS this morning, where a few positive signals have flagged with the stock down 10% from the recent high.

The implied volatility of CNOOC relative to the industry has decreased to 0.90 from 0.93 last month, and remains below the industry average. Month-on-month implied volatility is down 7%. In general, declining implied volatility means greater certainty and may lead to a firmer share price.

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While the share price has dropped 3.7% in the past month, EPS momentum has increased by 9.25% despite the recent profit warning. In fact, CNOOC’s EPS momentum has picked up from a negative three months ago into a positive in the last two months.

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EPS Momentum Chart (past 1 year)

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EPS Momentum Chart (past 6 months)

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The 12 months forward dividend of 3.38% remains relatively high within the sector. Peers such as Petrochina ‘H’ and China Oilfield Services ‘H’ yield only 1.92% and 0.84% respectively on a 12 months’ forward basis. CNOOC’s dividend payout is far greater than that of Petrochina and it is a signal that management is relaxed about a period of temporary earnings weakness, which in any case appears to be over.

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“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