Valuation

All posts tagged Valuation

The plight of insurance companies in an era of low interest rates has led some to predict the total collapse of the industry. The sector is a bellwether for the stock market, because so much of its profit comes from investment returns. The chart of the PE of European insurers relative to the broader market shows that extreme valuation for the sector is a precursor of major market corrections.

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European Insurance Valuation Relative to the Market

On this logic things are fine, because at two thirds of the average PE, insurance stocks have only just crossed into the normal valuation range following a period in the investment doghouse. This would tie in with our recent message that the prevailing investment trends are uncertainty over the direction of interest rates and gradually rising implied volatility back to normal levels. Relative implied volatility for the insurance sector peaks at index lows.

Implied Volatility of Insurance Stocks Relative to the Market

Implied Volatility of Insurance Stocks Relative to the Market

The woes of the insurance industry are easy to identify, which is why the sector is so popular among investment bloggers, who use it to point to the coming Armageddon in Europe, without having to offer too much analysis. Insurers depend on yield, all the more so as their customers age, so if central banks reduce bond yields to zero or below, insurance companies die.

You do not have to talk to those in the industry for too long to hear them bemoaning the new capital that is driving down returns for everyone. For the insurers, this is dumb capital that lacks the long-term perspective of their industry, but which thanks to light or no regulation has a lower cost of capital than incumbents. This is two different arguments; one about time horizons and another about the shadow financial sector.

Insurance is an industry whose last great innovation was the statistical analysis that brought about mortality tables. This allowed probability as a proxy for predictability and gave rise to a legion of highly specialised mathematicians with skills finely tuned to the needs of the industry. The maths can now be done faster and more effectively by computers, and so any cost advantage that new capital has from efficient operations is a permanent one. Whether you are regulated or not, you no longer need all those actuaries, just as investment banks no longer need so many analysts and lawyers don’t require all those proof reading juniors. Regulation actually serves to slow the loss of white collar jobs, because however onerous it may seem, all regulation favours incumbency.

The longer timeframe argument is more intriguing. Factor analysis shows that the inverse correlation between equity values and bond yields has weakened over several decades, most likely due to lower inflation, which had globalisation as its primary cause. The relationship has actually inverted since 2008, so that bonds and equities rise and fall in sync. Initial observations since 2013 suggest that the traditional correlation is reasserting itself.

This is due to the end of quantitative easing in the US and the political reaction to globalisation across the western world. Rising protectionism and constraints on immigration are the most evident backlash. These measures are designed to push up local wages and hence will be inflationary, and could herald the reversal of a long period of ascendancy of capital over labour.

It should be stressed that the jury is out on this. Most of our blogs reference the standoff between those who believe in the continuation of easy money and those thinking its time has passed, because this is the largest investment argument to be resolved. It is also one that OTAS indicators are ideally placed to track, including our fear gauge and low volatility performance monitor.

If the worm has turned however, and the ineffectiveness of monetary policy at the zero bound combines with political pressure to trigger policies that lead to higher interest rates, then the insurance sector will be back in business. Returns on insurance equities should discount this long before it happens. Those cautious mathematicians who have survived in the sector will have won the argument about the long-term, because underwriting in the industry should be priced using a higher cost-of-capital.

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 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.