Judicious Volatility

The market has a tendency to take an extreme position, either everything is on the up or the sky is about to fall in. Well, fear is the flavour of the markets these days and that’s no bad thing given where we have come from. Still it’s annoying to hear the media full of hysterical noise on Ebola, the Middle East, Europe, Japan, Russia, oil, end of QE, deflation, etc. Hopefully, we’ll start to get some more considered arguments on what the medium term economic and earnings outlook may look like. Vitaliy Katsenelson had a nice piece on thinking through the effects of a few scenarios. Hopefully, the end of the happy-clappy market (it will likely not go easily and may well return before long) will lead to some more thoughtful pieces like that.

For now though, the smell of fear is in the air and the graph below on the ups and downs in the S&P500 show that the recent volatility is not even near correction territory (i.e. greater than 10% fall). In fact, we really haven’t had a proper correction since late 2011. As to whether this volatility will turn into a correction, I have no idea (I suspect it might take a while yet but it will get there).

click to enlargeS&P500 ups and downs

The graph below shows that the high beta stocks as measured by the Powershares high beta ETF (SPHB), as you would expect, have been hit hard here compared to the S&P500 and the low volatility ETF.

click to enlargeS&P high beta ETF

It will be interesting to see how the market develops over the coming weeks. Earnings, particularly guidance for Q4, will likely play a large part it how it plays out.

On the debate about whether historically high earnings can continue, McKinsey had an interesting article recently on the earnings and the market. The graph below from McKinsey illustrates the increased important of technology, pharma, and financials in the higher profits.

click to enlargeMckinsey Share of S&P500 profits

Spending time looking for thoughtful arguments on the impact of macro-economic, demographic and social pressure in today’s world on these sectors is a better way to understanding the medium term direction of the market. As McKinsey says “assessing the market’s current value ultimately depends on whether the profit margins are sustainable”. The rest is really just noise, best ignored or viewed from a distance.

TRIB Follow-up: D’OH!

Well, I have to put my hands up on this one, my timing couldn’t have been worse with TRIB off about 20% since this post. Reading it back, you can see that I knew I was going against my instincts and it shows the result of indiscipline on my part.

The analysts all revised their estimates in early September to take account of delays in product take-up – revenue and EPS are estimated at a tad over $27M and 0.19 respectively for Q3. Although my estimates agree on EPS, I think revenue could miss & come in below $26.5M. Add in the uncertainty on the impact of Ebola on African revenues (approx. 12% of total revenues are from Africa in HIV segment), the push out to H2 2015 for the target commercial launch of the cardiac troponin test (assuming FDA approval), the continued selling by the shareholder(s) who has been selling down through the 20’s and beyond.

All in all, this is one to own up to as a badly timed call. My risk management allowed me to only establish a small position so it’s not a disaster and I’m not beating myself up (too much!!). Ironically, TRIB is trading now around where the level my original post targeted. However, I don’t have the conviction to follow this one down. I’ll see what is said at the earnings call next week before I decide what to do but I’m not positive short term in today’s market (which I welcome as a dose of reality is needed).

Longer term TRIB may still be interesting as the main points of my assessment still hold. But as Yra Harris said “if you’re right at the wrong time, you’re wrong“. Well, hands up, I was wrong on TRIB.

Delirious Deleveraging

Michael Lewis, in his 2011 book “Boomerang” on the consequences of the financial crisis, said that “leverage buys you a glimpse of a prosperity you haven’t earned”. Well, if that is true, we are all in trouble based upon the findings from the fascinating Geneva report “Deleveraging? What Deleveraging?” from Luigi Buttiglione, Philip Lane, Lucrezia Reichlin and Vincent Reinhart, published yesterday.

The report paints a stark picture, as the following statements illustrate:

“Contrary to widely held beliefs, the world has not yet begun to delever and the global debt-to-GDP is still growing, breaking new highs. At the same time, in a poisonous combination, world growth and inflation are also lower than previously expected, also – though not only – as a legacy of the past crisis. Deleveraging and slower nominal growth are in many cases interacting in a vicious loop, with the latter making the deleveraging process harder and the former exacerbating the economic slowdown. Moreover, the global capacity to take on debt has been reduced through the combination of slower expansion in real output and lower inflation.”

The report has a number of attention grabbing graphs on debt levels as a % of GDP like the one below on the US and others on Europe, China and global debt levels, as below.

click to enlargeUS Debt as % of GDP

click to enlargeDebt as % of GDP

The report is particularly pessimistic about China’s medium term prospects after its rapid 72% rise in debt levels since the crisis. On the US and the UK, for the countries who “managed the trade-off between deleveraging policies and output costs better so far, by avoiding a credit crunch while achieving a meaningful reduction of debt exposure of the private sector and the financial system” the legacy of “a substantial re-leveraging of the public sector, including the central banks” leaves a considerable challenge for the future.

Quick check on AIG

My last post on AIG concluded that a target of $60-$70 per share over the medium term did not seem unreasonable. However, given the difficulty in predicting a number of moving items in their results and the competitive insurance market, AIG didn’t excite me enough to get involved. Based upon a quick review of the results over H1 2014, that remains my view.

Q2 results were flattered by a gain of over $2 billion on the aircraft leasing sale. Overall the operating results were steady for H1, as the graph below shows, trending towards an approximate $10 billion operating income for 2014. Core earnings from P&C and life & retirement have been steady at approximately $2.5 billion each for the year to date.

click to enlargeAIG OpIncome 2011 to 2014H1

Analysts have an average EPS estimate of $4.62 for 2014, roughly the same as 2013, and $5.00 for 2015 which supports a target share price in the low to mid sixties. The AIG “discount” continues with the stock trading around 80% of book (excluding Accumulated Other Comprehensive Income), as per the graph below.

click to enlargeAIG Book Multiples 2009 to Sept2014

Some may argue that this discount is harsh given how far AIG has come. I’m not yet convinced that AIG deserves to come off the naughty step and get a more normal valuation.

An ice age or a golden one?

The debate on whether the US stock market is overvalued, as measured by the cyclically adjusted price to earnings ratio (CAPE) as developed by Robert Shiller, or whether CAPE is not relevant due to weaknesses in comparing past cycles with today’s mixed up macro-economic world, continues to rage. I have posted several times on this, most recently here and here. In an article in this week’s Economist, Buttonwood outlines some of the bull and bear arguments on the prospects for US corporate growth and concludes that “America is an exception but not as big an exception as markets suggest”.

Bulls argue that, although the CAPE for the S&P500 is currently historically high at 26.5, earnings growth remains strong as the US economy picks up speed and that at a forward PE around 16 the S&P500 is not at excessive levels indicative of a bubble. The latest statistics compiled by the excellent Yardeni Research from sources such as the Bureau of Economic Analysis show that earnings, whether S&P reported or operating earnings or NIPA after tax profits from current production or based upon tax returns, continue to trend along a 7% growth projection. Jim Paulsen, chief investment strategist at Wells Capital Management, believes that “this recovery will last several more years” and “earnings will grow”. Even the prospect of increased US interest rates does not perturb some bulls who assert that rates will remain low relative to history for some time and that S&P500 firms still have plenty of cash with an aggregate cash-pile of over $1 trillion. The king of the bulls, Jeremy Siegel recently said that “If you look at history, the bull markets do not end when the Fed starts raising interest rates. Bull markets could go on for another 9 months to 2 years“.

Bears point to high corporate profits to GDP and argue that they are as a direct result of low real wages and are therefore unsustainable when normal macro conditions return. Others point to the surge in share buybacks, estimated at nearly $2 trillion by S&P500 firms since 2009, as a significant factor behind EPS growth. Société Générale estimate a 20% fall in Q2 buybacks and (the always to be listened to) Andrew Lapthorne warns that as debt gets dearer firms will find it hard to maintain this key support to stock prices as in the “absence of the largest buyers of US equity going forward is likely to have significant consequence on stock prices”. The (current) king of the bears, Albert Edwards, also at SocGen, provided good copy in a recent report “Is that a hissing I can hear?” saying that “companies themselves have been the only substantive buyers of equity, but the most recent data suggests that this party is over and as profits also stall out, the equity market is now running on fumes“. Edwards believes that an economic Ice Age is possible due to global deflationary pressures. Another contender for king of the bears is fund manager John Hussman and he recently commented: “make no mistake, this is an equity bubble, and a highly advanced one“.

One commentator who I also respect is the author behind the excellent blog Philosophical Economics. A post last month on CAPE highlighted the obvious but often forgotten fact thatthe market’s valuation arises as an inadvertent byproduct of the equilibriation of supply and demand: the process through which the quantity of equity being supplied by sellers achieves an equilibrium with the quantity of equity being demanded by buyers”. As such, the current macro-economic situation makes any reference to an average or a “normal period” questionable. The post is well worth a read and concludes that the author expects the market to be volatile but continue its upward trajectory, albeit at a slower pace, until signs that the real economy is in trouble.

For me, the easy position is to remain negative as I see valuations and behaviour that frightens me (hello AAPL?). I see volatility but not necessarily a major correction. Unless political events get messy, I think the conclusion in a previous Buttonwood piece still holds true: “investors are reluctant bulls; there seems no alternative”. Sticking only to high conviction names and careful risk management through buying insurance where possible remain my core principles. That and trying to keep my greed in check…..