utilities

All posts tagged utilities

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.

This week the Federal Reserve is expected to keep interest rates unchanged. Generally speaking, lower interest rates are considered a drag on the profitability of banks and a boon to leveraged investors such as utilities. This is because the two industries may be seen as opposites, as banks’ traditional role was to supply the debt that utilities used to fund power projects. Both institutions are highly geared, but one to rising rates and the other to lower.

The implied volatility of banks tends to rise relative to utilities at times of market panic. Not only is bank leverage higher than that of utilities, or any other sector, and hence the business model more risky, but the response of the Fed to market panics is to lower rates, which hurts bank profitability. This is a highly simplistic view of investing, but it is not hard to see how it has become a dominant one in a world of repeated accommodation by the Fed.

Bank risk relative to utilities

Bank risk relative to utilities

The chart shows the median implied volatility of banks in North America against that of utilities. In other words, it is a measure of how risky banks are relative to power companies. Typically banks are greater risk because the value of the index is over one, although in periods of high complacency such as Spring 2015, this was not the case. While the spikes in the chart show when selloffs in the market occurred, it is the periods prior to the spikes that we might contemplate.

The chart runs from the beginning of the second quarter of 2010 to date. There is no compelling rationale for this time period, but it illustrates neatly the periods of extreme weakness in markets and that the two most recent sell offs, in February and June, were mild compared with the late 2011 and mid 2012 events. Investors are pretty benign about the risks to banks relative to utilities at this point and, using this as a gauge of market sentiment, pretty pleased with how the market should behave through the next three months.

This may be surprising given the impending US elections and an Italian referendum that could become a vote on the EU and membership of the Euro. It does, however, show how reliant investors are on central banks keeping asset prices high.

Thus it is worth considering Ben Hunt’s latest missive, in which he puts the odds of Fed hike at three times those implied by consensus. Why should we pay attention to a lone voice when so many are of a different opinion? Because if the consensus consists of a majority that all thinks the same thing for the same reason, then it is dogma rather than the wisdom of crowds.

The other reason for contemplating what might happen should the Fed raise rates is another look at our alternative fear gauge. While bank risk relative to utilities rose last week, it remains at a low level, creating an asymmetric risk-return payoff. A few basis point on, rather than off interest rates, will not be sufficient to restore bank profitability, but it would probably be enough to cause a major rethink among portfolio managers.