All posts tagged Germany

‘I think you know,’ said Miss Marple. ‘You are a very well educated woman. Nemesis is long delayed sometimes, but it comes in the end.” ― Agatha Christie, Nemesis

I am indebted to the work of Jared Dillian who, as well as being a highly entertaining writer, shares a similar world view about how investing works to that deployed at OTAS. Jared likes to focus on anti-consensus ideas, picking on trends that appear to have run out of road, in a similar fashion to OTAS flagging extreme moves from the norm across the multiple factors that influence equity prices.

A typical Dillian argument will throw out an investment thesis, while recognising that the timing may not yet be perfect for the trade. These ideas can be of use to active managers who require a portfolio of ideas at different stages of the investment cycle, so that as one great investment comes to an end, there are already several others lined up to take its place. Jared’s latest bête noir is the low volatility trade, which has seen big, safe, high yielding stocks outperform, and the evidence from OTAS entirely supports his claims.

DVY June 2016

The chart shows the performance of the iShares Select Dividend (DVY) ETF against our index of the top 500 shares in the US. As the shares in this fund deliver a higher percentage of total return in the form of dividends, the returns are more stable and predictable than for other stocks, and hence the shares exhibit low relative volatility. Lower risk should equate to lower return, but as the chart shows this is patently not the case this year.

Similar outperformance can be seen in the Consumer Staples Select Sector SPDR Fund (XLP). As with DVY, the break above the normal trading range came around the turn of the year and the subsequent outperformance has lifted the fund to an extreme level.

XLP June 2016

We have written before about the desire of the world’s central banks to suppress volatility and the success with which this has been achieved. Interest rates are the return received for uncertainty about the future and by pushing multiple rates negative, central banks have created situations where the future appears more certain than the present. This is the logic-defying macro environment that our guardians have created for us and Jared, for one, is calling them out.

There are reasons to conclude that it is central bank action, rather than real macro trends, which is creating today’s investment extremes. Much has been made about German ten-year rates going negative this week, but inflation-adjusted bonds in Germany have not followed suit. This clearly suggests that it is the actions of the ECB and not imminent deflation that is determining bond prices.

OTAS shows that the cost of credit for the average German company has risen this month and is safely ensconced in the normal range over the past four years. A situation where the debt costs for companies stays stable, while risk-free rates fall, drives up the relative cost of investment for the private sector and creates a slow growth economy with falling productivity.

German CDS June 2016

The outperformance of low volatility ETFs illustrates that the equity markets are now captured by the cult of the central banker in the way that other asset classes have been for some while. The question is for how long this can continue, or how much more money can back these trend following strategies. Political events may shake the faith in the establishment and there are a number of upcoming events that may do just that between now and the year end. Or, like many other bubble trades, there may simply come a day when fewer new buyers show up in the morning and commentators are left scrabbling for ex post reasons to explain a major price reversal.

As Jared Dillian says, “Up on an escalator, down on an elevator.”

Every day OTAS flags extreme positioning in stocks across markets, in a neutral, unbiased fashion that brings your attention to trends and possible turning points and assists in your decision making process. The analysis may be tailored to your personal portfolio and thereby reduce the risk that your next crowded trade is to the downside.

Short VIX positions are at an all-time high, while net shorts are at an eight month high. For those not versed in financial speak, this means that investors are expecting a low level of volatility, or uncertainty, and that share prices are not expected to change much in the short to medium term.

Low levels of uncertainty are traditionally associated with gradually rising stock prices, because investors pay more when they are confident about the future. Central banks have attempted to crush volatility precisely to boost investor confidence, in the hope that this would spread to the broader economy. Whether this has happened is fiercely debated, but a leading investment bank tells us that more than 60% of US large companies are buying back shares, a similar level to the 2007 peak. This certainly helps offset any weakness in share prices when earnings disappoint.

US large co. implied volatilityThe chart above shows that option traders expect US stocks to rise or fall by 12% over the next three months. There is no bias towards rising or falling in this analysis, but the chart clearly shows that implied volatility is at the low end of the average range over the past eight years. This is down by a third since February, when economic woes and earnings concerns were at their recent peak.

The February top had briefly exceeded the June 2012 high, just before Mario Draghi’s (in)famous “whatever it takes” speech. Since then, markets have been calmed once more, chiefly due to Draghi promising to buy up any piece of debt that investors in Europe can produce for him. The impact on volatility in Germany has been much the same as in the US.

German large company Implied Volatility

Investors expect German stocks to rise or fall by 13% over three months, which is in lock step with US shares. This level of volatility is also at the low end of the long-run average range and has fallen by a little under a third since February. The February peak level also exceeded, briefly, the early summer 2012 jump in volatility that did much to trigger ECB action back then (the US having already acted long before to crush the extraordinary volatility of the financial crisis).

The chart tells us that volatility can fall further, in both the US and Europe and still be within the average long term range. At implied volatility of between 19 and 20 (+/- 10% three month share price moves) the US chart would be back at levels that were sustained from March to July last year. This was a period of high and stable values for the US stock market, but critically indices did not break through to new highs.

Once again, under the captive eye of the investment world, central banks have poured oil on troubled water and may succeed in coaxing markets back towards record levels. If so, this will have been achieved by creating copious amounts of money and having it buy back stock. The accumulation of debt for this type of investment, which has no obvious productive purpose, will do nothing for earnings growth other than create a dependency on even more buybacks next year if companies are to beat their earnings.

Once again, an extended period of low volatility is likely to be interrupted by a panic about economic growth and sustainability of earnings, and the investment world will turn to the central banks and demand another shot in the arm. By using OTAS to follow EPS Momentum changes and movements in implied volatility, traders and investors can expect to gain advance warning of impending moves.

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.