OTAS

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There is a debate in the UK about how David Cameron will be remembered. Further from the mainstream, the New Statesman attempts to define the legacy of New Labour’s “Golden Generation”, whose political careers appear to be over. A common theme of the conclusions is that no matter how intelligent you may be; an inability to connect with the electorate will be your undoing.

The aura of technology is painted by Apple, Google and Facebook; companies that tell consumers what their hearts desire before they know it themselves. The reality of much of the tech world is more mundane, and an inability to provide customers with what they want will kill off innovation.

At OTAS, our quest is to simplify efficient equity trading to the point where all that you need to know is encapsulated in a single chart. To arrive at that point however, is a journey of a thousand marginal improvements, more in keeping with the mantra of an Olympic coach than a Silicon Valley visionary. At each point we test our innovations with the heavy users of our software, collect their feedback and adapt the service to be of incremental use.

The barrier to our one-chart-world is the plurality of use cases for the software; differences that are largely unknown outside of equity trading desks, but which create a number of competing demands. One trader may focus only on the liquidity of orders, while another wants to see unusual price patterns. Some desks desire an automated dealing solution that sends regulation trades for low touch execution, while others require frequent updating on delivery versus benchmark. The quest for one-chartism continues.

To this end we are launching the Intraday Screener. This may be connected to an order book, portfolio, sector or market index and will show you at a glance the outliers in real-time trading.

OTAS Intraday Screener

OTAS Intraday Screener

The example above is of the UK non-life insurance sector. The size of the bubble represents the value of shares traded, while its position shows the deviation from normal in terms of both volume and return. In this snapshot, seven of the eight shares are trading up, a couple of which to an unusual degree (to the right of the chart). Four of the shares are trading with exceptional volume, the most extreme of which is down on the day. By hovering over this bubble we reveal real-time performance data for this outlier, Jardine Lloyd Thompson.

In truth, Intraday Screener is not a single chart. You may change the axes to show whichever combination of performance metrics you desire, be that absolute or relative to normal, relative to a basket of similar shares, liquidity, spread or predicted volume. You may also change the variables defined in the size and colour of the bubble, as well as alter the chart to show a map format. Yet we believe the screener represents meaningful progress towards the one chart to rule them all.

The chart above makes an important point about efficient trading, which is that it is not the biggest order or most liquid name that should automatically command your attention. Trading in such names is most likely to be within the normal range, so that steady execution using a risk-adjusted schedule is the optimum way to complete an order. Often the exceptional action is in other order book names, where close attention is required to avoid losing precious performance. The Intraday Screener shows you immediately the names that require your trading skill.

There are users who trade too few names a day to be concerned about relative dispersion. There are others who trade too many for a single chart to capture effectively. There is even a third category that has to be finished before the portfolio manager makes another tour of the floor. Yet we hope that Intraday Screener proves to be a most useful tool for our customers and one that effectively combines machine learning with their human intelligence.

“Because as any coup-launcher or Fed-fighter or volatility-embracer knows, if you’re wrong on timing … you’re just wrong” – Ben Hunt, Epsilon Theory July 26, 2016

The number of short bets on sterling through the futures market is at a multi-year high ahead of next week’s expected cut in interest rates in the UK. While these may be the speculations of the same hedge funds that lost money on the UK referendum, there is a strong consensus that the pound is headed lower. As recent events have shown, this is putting UK companies in the shop window, but can OTAS provide a way of figuring out who is next to be taken over?

There have been strong suspicions and some academic research suggesting option market activity pre-empts M&A announcements. What the research cannot determine is whether trading was due to inside information or informed opinion. Typically it is out-of-the-money call option activity that is more informative than at-the-money or put options.

Before we look at the evidence from OTAS, will the Bank of England cut rates next week? This is a different discussion to whether it should. Jeremy Warner argues in the Telegraph that the sledgehammer-to-crack-a-nut response to a knee jerk, post Brexit survey of disappointed corporate Remainers is not the right way to run an economy. He points out that the acquisition of ARM Holdings funds the current account deficit for three months. Speculators may not be “fighting the Fed”, but they are battling investment flows.

The post referendum narrative is that the economically disadvantaged swung the result and new Prime Minister Theresa May has aimed her pitch squarely at where she believes this constituency lies. Politicians still fail to appreciate that many of those who feel left behind are middle class savers whose retirement plans are decimated by central bank group-think. Unfortunately, the prospects for this small-c conservative demographic are very poor, as explained by Ben Hunt in his latest Epsilon Theory.

If Ben is right and that nothing will stop the central banks from flooding markets with cash, as Brexit, data dependence and such-like are just excuses for more of the only thing the authorities want to do, then stocks should rise and the pound fall. Typically bull markets take place over longer periods than bear markets, and are associated with lower implied volatility as the direction of travel becomes more certain.

UK Large Cap Implied Volatility

UK Large Cap Implied Volatility

Implied volatility for UK large cap stocks is back in the average range of the past two years, but five points above the stable state of the first half of 2015 that saw UK stocks rising steadily. The two recent peaks reflect Brexit worries immediately before and after the referendum. The one before, which was a bigger shock regardless of what the media may tell you, was the global recession fears of February, now long forgotten in large part thanks to desperate/determined[1] action by the ECB.

The US market appears to be leading the UK, which is worth bearing in mind as the Brexit furore subsides and the Trump-panic-hype really takes off.

US Large Cap Implied Volatility

US Large Cap Implied Volatility

M&A activity may mean stock specific rises in implied volatility. OTAS shows that among UK large caps only BHP Billiton has seen such a rise over a month, while Anglo American and GlaxoSmithKline have risen over a week. This is based on at-the-money options, but OTAS users with desktop access may dig deeper to see at what level recent trading has taken place. The bulk of the activity for Anglo American, for example, has been out-of-the-money puts (no take-over expected here).

AAL 1-Week Exchange Traded Option Activity

AAL 1-Week Exchange Traded Option Activity

The chart for ARM Holdings shows that the take-over by Softbank was a surprise. The subsequent sharp fall in implied volatility reflects a done deal at a fixed price, while any continuing option activity is by arbitrage specialists using leverage to magnify small price movements.

ARM Holdings Implied Volatility

ARM Holdings Implied Volatility

There is much more to the option market than M&A. Specialist take-over investors will have lists of potential acquirers and targets and stay on top of many more factors than market signals. For the part-time speculator it is worth creating your own list of sectors and stocks that you believe could be vulnerable to approach were the pound to fall further. Putting these in a portfolio in OTAS will allow easy filtering for unusual activity, whether that is in the options market, dealings by directors, or idiosyncratic price performance.

For those interested in potential acquirers, checking the CDS of the companies may be a means of investigating which managements are planning leveraged take-overs. There are, however, other reasons why credit costs can jump, such as a shortage of cash from operations. For this reason, while OTAS provides an initial view on the world of potential M&A that goes further than press speculation, it is only suggesting stocks on which the user will need to do additional research.

Right now there is little unusual option market activity among UK large cap stocks. This may be because, as the quote at the top of the blog indicates, timing is everything. Or it may be because so few people seem to have been able to contemplate that the UK would have a corporate future outside the EU, any M&A activity comes as a complete surprise.

[1] Delete as per your preferred narrative

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.

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.

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.