Europe

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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.

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.

 

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.