banks

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Let’s quickly dismiss the view that investors learnt from Brexit how to react to the election of Trump. US options are the world’s most liquid and the three month market that we track has consistently shown that President-elect Trump would be a sanguine outcome for stocks. Commentators are falling over themselves after the event to explain why this is, but OTAS has portrayed a consistent message of financial calm.

US Large Cap. Implied Volatility

US Large Cap. Implied Volatility

There have been three notable spikes in implied volatility over the past 16 months. Two of those, which we have labelled China and Recession, took this measure to exceptional levels, as fears mounted that a slowdown in Asia would cause the world economy to crater. The third spike, in the aftermath of the vote for Brexit, saw risk rise to unusual, but not exceptional levels. Politics may have rediscovered Paul Graham’s mantra that “It’s charisma, stupid” to explain which candidate wins a two-horse race, but the market remains firmly fixated on the economy.

By now we all have the received wisdom that Trump is good for certain regulated industries, such as banks and pharmaceuticals and his fiscal policies will mean more inflation and higher interest rates. The perceived riskiness of utilities relative to financials has jumped to unusual levels, last seen just before everyone remembered that Greece was about to default. With a while to wait to find out what Trump really stands for, big banks could be less risky than energy distributors for a while.

Implied Volatilty of Utilities Relative to Diversified Financials

Implied Volatilty of Utilities Relative to Diversified Financials

Central banks may have come to realise that forever easier money does not generate growth, but now they have the perfect foil to allow them to reverse course. Governors around the world have been beseeching politicians to do more to generate growth and the public has responded by electing those who promise to do something rather than nothing. There are incumbents who need to wise up fast. If Renzi’s reform bid fails then he may be gone, and if it succeeds and leads to a German imposed bail-in of bank depositors, then he’ll likely be gone a little later. The French also have an activist alternative to hamstrung mainstream politicians. Keep track daily of the implied volatility of the relevant markets and sectors with OTAS.

The chart of PE for the US top stocks suggests that the post-election move has room to run further and it would take a 7% re-rating to lift the valuation back to the highs of May 2015, when forward PE was last in touching distance of exceptional levels.

US Lage Cap. PE Valuation

US Large Cap. PE Valuation

One piece of received wisdom that is not playing out is that Trump will be unreservedly bad for trade and hence China and Emerging Markets. Mexico has taken a kicking, but perceived risk among China Enterprise stocks is almost unchanged. Once again it is fears of economic slowdown that floats this boat and clearly investors are not worried about a slowdown at present. Perhaps they believe that China wins relative to Mexico.

China Enterpise Implied Volatility

China Enterpise Implied Volatility

UK media is fretful the economy will suffer from trade restrictions. It is not obvious why Trump would single out the UK for harsh treatment when everything he has said points the other way and the immediate stock market weakness is likely to be currency related. The financial community in the UK is too savvy to confuse its own post-Brexit well-being with the health of the economy, when the opposite may be true. Keep an eye on implied volatility in the UK and be prepared to buy when threshold levels are reached. Threshold low PE ratios are also approaching.

One more thought going back to our blog of October 17, in which we argued that insurance stocks would be back in business once interest rate rises were on the cards. It may take a while for recalcitrant European central banks to get it, but the valuation of US insurance stocks in the last couple of days reinforces the conclusions we drew about what happens when they do.

US Insurance Sector PE Valuation

US Insurance Sector PE Valuation

After years of impasse, when the conclusion of culture wars rather than the economy occupied politicians, there are signs that activism is bringing markets to life. People worry that cultural change will be reversed, but let us hope that politicians and central bankers focus on the most important task of restoring growth for the benefit of all.

“It’s the devil’s way now, There is no way out

You can scream and you can shout

It is too late now, Because you have not been

Payin’ attention”

Radiohead 2+2=5

This week our Blog pulls together the themes and indicators from OTAS that we have been talking about for a while. We have been looking for clues that investors are losing faith in central bank omnipotence, which will expose those who do not adjust their portfolios from following the axiom of the past few years to a significant drawdown. There is a fierce debate among those who believe that judgement is coming and those who expect more of the same.

We tackled this issue in early September in what was probably my favourite blog, because the charts used to illustrate the points were the default charts that can be pulled up from OTAS with virtually no effort. For example, this chart of the average cost of credit for US large caps illustrates how credit risk has flat-lined this year, indicating a collective ambiguity about the direction of interest rates. Perhaps this is why the fiercest online investor arguments are about rates; because no one can be sure of where they are heading.

US Large Cap Average Cost of Credit

US Large Cap Average Cost of Credit

From here we developed the theory of Wall Street’s alternative fear gauge, where we used the relative volatility of banks and utilities to assess how relaxed investors were feeling about stock prices. In less than three weeks since then, the riskiness of banks, where low levels indicate an absence of fear, has fallen below that of utilities. This can hold true for several months, but it is not normal.

Relative Volatility of US Banks vs Utilities

Relative Volatility of US Banks vs Utilities

An obvious reason for the low relative riskiness of banks is that the odds of a US rate rise have increased, resulting in the dollar index breaking out of its recent trading range to the upside this week. Higher rates would raise banks’ margins, while hurting heavily borrowed utilities and diminishing the relative appeal of their dividend yields. This is a simple, but erstwhile effective investment conclusion.

Utility stocks are a stalwart of the low volatility portfolios that have been underperforming of late. This has led some to argue that the size of the unwind of the consensus trade in favour of low volatility and high yield will be the cause of the coming equity market fall. Last week we addressed the trigger point for index corrections in terms of the relative valuation of lower risk stocks. The sell-off in these names has pushed the riskiness of utility shares to extreme levels, which historically have not held for very long.

Relative Volatility of US Utilities

Relative Volatility of US Utilities

The mean reversion mechanism for this indicator is either that utilities lead and the rest follow in a coordinated meltdown in share prices, or the active few who trade relative volatility exit the stage, leaving the majority who passively expect the Fed to keep bailing them out to buy the dips.

The Radiohead song 2+2=5 references George Orwell’s 1984 and specifically Doublethink, whereby the state can compel citizens to believe something that is not true. For many investors it is axiomatic that stock prices will continue to rise, supported by easy monetary policy, because there is nowhere else for anyone to invest. The exchange rate related crushing that gold has taken this week reinforces this belief.

Radiohead subtitled their song The Lukewarm. This is a reference to those on the edge of Dante’s Inferno, who cannot figure out why they are there, because they didn’t do anything. For Dante, and the politically charged members of Radiohead, inactivity is precisely the crime for which these people are condemned. When you have an environmental activist in the family as I do, which makes Christmas colourful, you come to understand the charge sheet against the silent majority.

So who is more right; those who expect a major correction or those who believe that debt, deflation and an ageing population will result in years more pump priming by central banks. The reality is that both may be correct. A sell off in markets may be triggered by a rise in US interest rates, which could happen at the low point for our alternative fear gauge, which is now just a few points away. The resulting tumble could then trigger recognition of a policy error, leading central banks to resume the path of easy money.

In the first Blog referenced above we warned that CDS and implied volatility were sending conflicting signals. So far it is a correction in volatility that has addressed this discrepancy. US large cap CDS and implied volatility are two of the easiest charts to find and follow in OTAS. As Radiohead knew, there is no excuse for not payin’ attention.

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.

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.

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.

Within OTAS we use many metrics to keep an eye on risks for equities. Credit default swap (CDS) spreads have been a coincident and occasionally leading indicator of trouble, especially for the bank sector. And when the bank sector is in trouble, the rest of the market tends to follow.

The median CDS of European banks spiked of late. A rise in value happens when debt investors become concerned that their bonds will not be honoured in full, while a fall back indicates that those concerns have eased. The latest reassurance was rapidly forthcoming.

Banks CDS 2 yr view

A quick round-trip for bank risk

It is worth pointing out that risk remains elevated relative to the average level over the past two years. A couple of years ago 100 bps of risk was the point at which we might start worrying about corporate credit, but in a world of zero and negative interest rates, 100 bps seems pretty high (I’d like it on my savings account please, Mr. Banker). The risk however, remains well below the peak of nearly 350 bps reached in 2011 and was put back in the box pretty quickly over the past two weeks.

Once again the ECB rode to the rescue, with another promise of saving the financial system (read the Euro and the politicians whose entire careers depend on it), with what once was quaintly referred to as unconventional monetary policy. Of course, for prices of CDS to fall as they have done in the last couple of weeks, someone has to become much less risk averse. That someone is anticipating unloading all unwanted bonds onto the ECB at sometime between now and expiry.

The consequence of a central bank buying corporate debt is that corporate debt no longer carries the same signalling quality for equity investors. It may be that we need to pay much more attention to far smaller moves in the median CDS, for it is by pushing up the price that investors signal they need another intervention from the ECB. These investors are hungry offspring, nuzzling mother, until she rolls over to uncover her teat.

There remain other measures of risk. Short interest is one that has had mixed benefits, because the authorities are prone to interfere in this market pretty rapidly. The steady rise in short interest on the average European bank year-to-date however, would appear to be sending a message.

Banks SI 2 yr view

Short sellers home in on banks

It is noteworthy that Nordic banks are among the most shorted names listed in OTAS, with the highest days-to-cover and loan fees.

A third measure of risk is the implied volatility in the options market. This both follows the underlying move and is an indicator of by how much investors believe shares could move. Within OTAS, we measure this over the upcoming three months.

Banks IV 2 yr view

Rising volatility indicates greater uncertainty

Option volatility is a measure of uncertainty about the future. You should pay a higher price for something that you are more sure about, which is why the favourite in a horse race has the lowest odds. Low implied volatility typically suggests that investors believe the good times will keep rolling.

Investors predict, using money not words, that the average bank will move in a range of over 36% by mid-June. This is either up or down by more than 18%. Follow the CDS and short interest for European banks within OTAS  in order to gain a better understanding of whether investors believe that move will be up or down.

OTAS also provides in depth analysis of risks for individual equities, as well as easy to access summaries of sectors and markets, which highlight the individual companies most expected to face difficulties.