EPS Momentum

All posts tagged EPS Momentum

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.

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.

With little over a day to go before the UK referendum, we present a last look at the state of play across equity markets using the multi-asset analysis within OTAS.

The pattern for the valuation of the STOXX 600 is established. At above 16.5x 12 months forward earnings the market is stretched beyond its normal range and has reverted in fairly short order. Much below 15x and the index attracts buyers, especially around 14x.

STOXX Jun 2016

This narrow range of values has persisted for many months and means that the Brexit vote in the UK is having little impact on investors’ views on the prospects for European equities. Rather investors should focus on 12 month EPS Momentum and the stocks being upgraded. A two-step filter within OTAS reveals nine shares in the STOXX 600 where upgrades were at least 5% in the last month and 10% in the past three months. Eight of these nine companies have EPS Momentum in the top decile across their respective sectors. Contact us for details.

STOXX CDS Jun 2016

The average cost of credit for European companies has been rising since March of last year, most likely to be when economic growth momentum was at its best. This is in spite of the ECB announcing and now launching purchases of corporate debt. Unless the cost of credit falls there is unlikely to be any change in productive investment across the continent’s listed sector, although recycling new debt into buybacks is one probable consequence of ECB action.

STOXX IV Jun 2016

Risk, as measured by three month implied volatility in the shares of Europe’s largest companies, has been rising gradually since September 2014. Even if we allow that the most recent spike to over 30 was Brexit related, the peak was no higher than the August 2015 move that took far longer to dissipate, and was well below the February 2016 period. At this time investors were focused on the risks of a global slowdown, so for all the publicity surrounding the potential damage Brexit could do to growth across Europe, equity option investors are dismissive of the risks.

The prevailing trends in European equities are a declining valuation, punctuated by central bank induced temporary recovery, mirrored by rising risk recorded in both credit default swap and equity option markets. This speaks to a gathering economic slowdown as a far more important trend than anything Brexit could cook up for European shares.

This is of course what the calm voices have been saying throughout the fractious UK debate, but calm voices don’t sell in the media and hence are easily drowned out by the ranting and raving of those using economic and market predictions for other ends.

White Rabbit: Don’t just do something, stand there                                                – Walt Disney, “Alice in Wonderland” 1951

Kudos to Ben Hunt for this excellent piece on the role of narrative in markets, and for using better quotes than me. Anyone who can base insightful equity analysis around a quote from the Godfather deserves special mention.

Ben takes us all the way from his overarching explanation of what is behind market moves, right down to the nitty gritty, which in this instance means Salesforce.com. The image below shows the inexorable rise of analysts’ forecasts for the company’s earnings, even though Ben notes that he is “pretty sure that Salesforce.com has never had a single penny of GAAP earnings in its existence”. The chart also shows the large wobble that the shares had earlier in the year, although the doubters have since seen the error of their ways.

Salesforce.com Share Price and Estimates

In a simple but telling piece of analysis, Ben shows that in the last five years, owning Salesforce.com on only the 21 days after its earnings releases and the 43 days that the Fed made an announcement, returned 167%. Owning Salesforce.com on the other 1,208 trading days would have lost 8%. For a stock up 138% in that time, you could have been standing around doing nothing an awful lot and avoided losing money.

Ben also notes that CEO Marc Benioff, whose ebullient narrative drives the stock’s upward trajectory when the Fed Chairman is not doing this for him, uses 10b5-1 programs to sell shares in his company every day. These programs are predetermined sales and thus do not flag on the OTAS Insiders stamp, but you can see them by unticking the Priority Transactions box in your Core Summary app.

Daily Selling by Salesforce.com Insiders

In many ways Salesforce.com is typical of the handful of software companies that truly make it. Over time the company’s success returns cash flow and eventually earnings and the rating slowly normalises. While Salesforce.com is still 3.8x the average sector multiple, the steady de-rating appears to be well underway.

Salesforce.com Eroding Valuation

Reflecting on Ben’s analysis that you make money in short bursts and could spend most of your time doing nothing, I was struck by the similarity of this to the OTAS trading mantra, which may be expressed as SLOW DOWN AND DO NOTHING. Most of the time when trading you may leave your orders in an algo and do something else. Only in exceptional circumstances do you need to intervene to adjust an order and OTAS will fire an alert to tell you when that happens.

The results are in for the first quarter earnings season in the US and do not make for pretty reading. For the sixth consecutive season, operating earnings of the largest companies have declined. A little over one fifth of companies issued earnings guidance and, of those, 71% advised analysts to lower their expectations. The gradual erosion of the earnings base of the country’s largest companies has taken its toll on the valuation of the stock market.

US May 16

The valuation of the market peaked in May 2015, just over a year ago. There was a first quarter rally on the back of more monetary easing in Europe, but the impact on US companies is likely to be short lived. When the ECB announced that it would be buying European corporate debt, this boosted the value of debt and pushed down the yield that borrowers have to pay. Large US companies can take advantage of this to raise debt in Europe and use the proceeds to buy back shares to temporarily support stock prices.

The decline in earnings also has a short term impact on valuation, by raising the market multiple, but as the chart shows, the more powerful force is the growing momentum out of US equities in response to declining profitability.

There is some good news, however. OTAS makes it easy to filter a market or portfolio of stocks to find those where the trend in earnings is bucking the general malaise. There are 33 companies with falling share prices and rising EPS estimates, where this contrast is sufficiently significant to stand out from the rest of the market. Ten of these shares are in the energy and materials sectors, which are whipsawed by the anticipated moves in currency and commodity markets, but the remaining 23 shares are trading at a 22% discount to the average valuation of the broader market.

The US stocks bucking the earnings malaise

By applying one filter for stocks with significant divergence between falling price and rising EPS estimates, and a second excluding energy and materials shares, in just a handful of clicks we are left with a chart showing only the outliers across the whole market. Hovering over each yellow disc reveals the name and recent performance of the company. Frontier Communications is highlighted below.

Another look at the stocks bucking the negative trendDouble clicking the name takes you to the EPS Momentum page for Frontier Communications and to a chart that shows the relationship between the share price and estimates of upcoming earnings. In the case of Frontier, investors were faster than analysts to realise the downgrades that plagued the last nine months of 2015, but both analysts and investors have been in step since the beginning of this year. Then the share price weakness over the past month contrasts sharply with the average 8% upgrade to forward earnings posted by the analyst community.

Frontier Communications' Loss Estimates Fall

Obviously it is up to investors to decide whether the recent share price weakness heralds another false dawn for the company, but OTAS provides layers of analysis to help make this judgement. For example, Frontier’s estimates have risen for the years to December 2016 and 2018, but fallen for 2017, so it may be that investors are most focused on next year. Frontier’s borrowing costs over seven times that of its industry peers and the shares may thus have reacted to the renewed prospects for a summer rate hike. Frontier will also pay a dividend in 20 days times and has a forward yield of 8.6%, but while free cash flow covers the pay-out, earnings do not.

All of these factors influence the decision to buy or sell Frontier, or indeed any stock. OTAS provides a one-stop shop for all the market intelligence that you need to make sure that you are as fully informed in your trading or investment decision as you can be. OTAS also draws out the priority issues that are impacting share prices, to help fundamental investors frame the most pertinent and timely questions when they interrogate a company’s performance, its financials and its management.

The striking thing about European equity markets is how stable they are right now. EPS Momentum is mildly negative in most major markets, valuations are very similar and implied volatility is as expected, with Switzerland deemed least risky and Spain the most. More importantly, the country markets are trading relative to each other precisely as you would expect.

So where is the Brexit risk, the great fear that the UK will dive off a cliff should the population defy the European elites and vote to quit the European Union (note to editors, the UK would not be leaving Europe, which is not possible geographically). Equally, where is the fear that a UK exit after the June 23rd vote will lead to a tailspin for European markets. Answer; there isn’t any.

In OTAS we track three month implied volatility more than any other duration. We do this because there is plenty of liquidity at this point relative to at other times. As of April 11, we are less than three months from the UK vote and hence today’s numbers reflect perceptions about where markets will trade on the other side of the decision.

The strongest evidence of a Brexit effect

The strongest evidence of a Brexit effect

The chart above represents the strongest evidence of a Brexit effect, in that implied volatility (read uncertainty) for leading UK shares is slightly above the average range over the past two years relative to France. This, however, is a relative rating, and the implied volatility of the two markets is very similar. Option traders expect UK stocks to be +/-14% by July 8 and French ones to be +/-14.5%. So uncertainty is marginally greater in France.

Over the same time, traders expect Spanish stocks will be +/-18%, Italian +/-17%, German +/-13% and Swiss +/-11%. This is how these markets line up next to one another most of the time, except when there are perceived problems on the horizon. What is more, the current level of volatility is in the average range of the last two years, having been much higher in February, before the date of the UK vote was announced.

Uncertainty in France is in the normal range

Uncertainty in France is in the normal range

Stock market valuations are normal as well, safely in the average range, where you would expect relative to one another and at very similar levels. France, Italy and Spain trade on 15x 12 months’ forward earnings, the UK on 16x alongside Switzerland, and Germany on its typical slightly lower rating of 14x due to the composition of its more cyclical stock market. The UK has re-rated relative to Europe so far this year and not because EPS Momentum has fallen relative to elsewhere. If anything, the UK market is looking toppy.

The inverse Brexit effect

The inverse Brexit effect

What is behind the complete absence of Brexit panic in stock markets? One answer is concerted and coordinated central bank action to crush volatility. Another is that the world has bigger problems, in terms of an economic slowdown precipitated by nearly two years of falling global trade volumes, than the possible changes in an inward-looking Europe. A third is that those people who put money on these matters, day-in, day-out, do not think that anything very much will change whether the UK is in the EU, or votes to leave.