Central Banks

All posts tagged Central Banks

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.

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.