Daniel Lacalle

Front Row: Long Value

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Front Row represents the personal opinion of Rodrigo Rodriguez, European Head of developed cash trading for Credit Suisse.

So my dear Tej (who is currently taking his 14th sick day of the year….) has been complaining about the quality of Front Row recently without fully realising perhaps the huge amount of stress combined with severe lack of time under which these pieces were written.

Anyway without extending myself too much on this, I always take criticism on board and hopefully you will find this week themes rather more interesting as the three topics of this week are really the result of three factors that have been bothering me for a while. In all of them I had to ask some of the fantastic professionals at CS to go through them with me.

This note will probably be longer than usual ones, but the main reason is that I honestly think that the topics under discussion will be of real interest to you.

However before we start let me explain last week’s “joke of the week”… “Madeira cake”…”My dear cake” English humour I suppose…(Back to graphs and photos this week :-))

Optical Rally? Check the volume data
So this week when Gerry K asked me: “ what do you reckon this year’s volumes are compare to last year?” I confidently answered “at least 30 per cent higher”, based on our commissions and feeling.

Gerry wisely asked me to investigate further as a competitor reckoned it was the worst Jan of 10 years…

I thought it was rubbish but decided to investigate further as nothing should ever be taken for granted.

I looked at Markit data with my dear friend Asif and after triple checking the data the results were obvious I was definitely wrong (although so was my competitor) , January volumes were not at all as I was expecting, and my guess is the results will come as rather a surprise to you as well…

Results per Markit:

  • Volumes Jan 2013 : €713B vs. €740B in Jan 2012
  • Vol Avg month 2012: € 690B< than current volumes.

Then on a second thought I decided to look at on Exchange data and clearly it was pointing to lower than average volumes, i.e. activity has increased on dark pool and Alternative Exchanges, so neither the competitor or myself were correct (See graphs below for volumes on Xetra and LSE for the last six months, clearly the trend is down when looking at 30 days mov average however this data will not include any dark pool or alternative exchanges.)

But me, being the stubborn guy I am, moved to Mr Buchannan ,my data guru and Lisbeth the real brain behind the engine to prove Asif’s was wrong. Unfortunately for me the results were consistent…

The results as of 29th did not looked promising….

  • Volume in Jan 2013 (with still 3 days to go) was $708bn compared with $826bn last year
  • Daily volume is slightly down compared to Jan last year: $37.3bn compared with $37.5bn last year, but still above 2012 average ($35.6bn)
  • Day with lowest volume in Jan 2013 was last Monday (21/01/2013: US holiday) with $26.9bn turnover. Low volumes were also seen in the week of New Years.

Massive month end flows changed the picture..

However there was some light at the end of the tunnel as it looks like the last two days of Jan made Jan-13 better than Jan-12!!!

  • Monthly turnover of $841.53bn for Jan-13 versus $826.06bn for Jan-12
  • Average daily turnover of $38.26bn for Jan-13 versus $37.55bn for Jan-12. Also higher than the 2012 average daily turnover ($35.56bn).

Bingo after all it was not just an optical rally….

However this still did not explain why the perception I had from our commission number was much higher than the real volume.

There was only one more place to go , our AES platform , but one again that daily volume of approximately €37B was confirmed by Mr Vincent however for every Yin there is a Yang and Chris Marsh pointed to me that maybe I was looking at it the wrong way. Clearly High Frequency trading had reduced their activity massively ( Getco, Citadel, Eladian etc..?) but Institutions had not.

If this was the case then the real volume ,that is the one that we perceive, could be reason why our com numbers and the volumes did not tied up .

While this is a good explanation when Drew run the data the evidence was not that clear , truth is that the GAP between “Feels like” and “looks like” is tightening (See zoom in graph on the right) but still far from pre-2007 levels.

Therefore the evidence is mixed , and as much as I would like to say different , there might be something of an optical rally and if that is the case then it would be a very dangerous technically speaking rally, the one that is not supported by volumes…I honestly think a consolidation is due and I say it once again vol, if not cheap, is definitely VERY LOW.

Do not get me wrong ! I am still VERY bullish medium term, (how could not I after an equivalent of “350/400bps of monetary easing” see graph ) but clearly we see signs of indigestion on the sovereign debt market, high yield issuance might have gone too far too quick, credit is starting to widening…and equities can not continue doing new highs forever… TACTICALLY I would play safe for the next 2 to 3 weeks. (There is nothing wrong on locking profits or hedging your portfolio)

Check Trader’s Almanac stats( reflected also) in a very good technical piece from DBK : Historical S&P 500 price performance has seasonality. January is typically strong with an avg. 1.1% gain. A strong January normally leads to higher full year returns. There are 9 years since 1960 with 5%+ gains in January: 1961, 1967, 1975, 1976, 1980, 1985, 1987, 1989, 1997. The avg. whole year price gain for these years was 23%. Furthermore, in each of these years the S&P 500 climbed over 19% except for 1987 given the October crash.

What can go wrong?

So on the basis of the previous analysis I reached to Neville hill , our European Strategist , and someone who in my 5 years at CS has nailed the economic crisis recovery.

My fears were clear we have moved from “Headline trading” to absolute complacency: no one talks about the Spanish or Italian 10 years, or the Italian elections, France, Cyprus , Greece etc….everything is fine… the world is a safe place…I am sorry but I am always scared of the unknown. So my question was clear: “Neville what can go wrong?”

To my surprise he put a very clear note that I summarize below, and that has been the origin of our now familiar for you all “binomial tree approach” the main conclusions are: Buy S&P skew, Buy Eur, Stay long USD/JPY and be very careful about GOLD.

These are the main highlights of his great analysis together with some personal comments from our follow up meeting:

I can think of several specific sources of risk for Europe.

1. Growth. This remains key. While the prospects for growth continue to improve, markets can sit pretty in a virtuous circle. If the prospect for recovery starts to diminish, things can quickly fall apart. So where are the risks here?

a. The cycle. Since 2009 the global business cycle has been characterised by a short-term “saw tooth” pattern. We’ve basically had 6-9 months up, 6-9 months down. That volatility has in part been thanks to the low levels of inventory businesses have been carrying. But it has sometimes been a cause and sometimes an effect of financial volatility. On the basis of past experience, then, the upswing we’re currently seeing should peter out in Q2. Even it’s a little moderation in momentum, it would still provide a meaningful check to market euphoria.

b. External shocks. Things that could bring that peak in global cyclical momentum to a head earlier than Q2 would include a new impasse over the US debt ceiling (the risks for which seem to be diminishing), or a full imposition of spending cuts from 1 March. Any unexpected slowdown in Asia would pose a risk too.

c. Oil prices. These have been remarkable stable since early 2011. However, that sharp rise in prices in late 2010-early 2011 did a lot to knock the stuffing out of the recovery at that stage. So a major spike in oil prices would also pose a risk.

d. The currency. I can see this becoming an issue for the ECB. There are two strong macro reasons for the euro to go up. One, structural adjustment in the periphery but not in the core is leading to ever-higher euro area trade and current account surpluses that should, from a macro perspective, lead to a stronger currency. Two, the Fed, BoJ and (once the Carney-vore is in place), BoE are all undertaking large, open ended, asset purchases. The ECB isn’t. Our FX team look for the euro to get to $1.40 in 3 months. In the absence of any ECB intervention (verbal or policy), it could well rise to levels at which the recent improvement in competitiveness in the periphery is cancelled out and the prospects for growth diminish. I think that’d happen closer to $1.50 than $1.40, but a big rally in the euro could raise renewed concerns about the prospects for peripheral growth in the absence of further policy easing from the ECB.

If you have some doubts of why growth is important , think in terms of debt sustainability for the periphery. Such sustainability depends on growth ; GDP growth depends on export growth ( now that these economies have moved into trade surplus) So basically the speed limit of such sustainability is the exports growth that would cause the GDP to accelerate and the debt to be sustainable. One turnaround on global growth and it is game over for periphery.

And we should remember that since 2009 the global recovery has come in fits and starts, we might be on the “start” but with possible debt ceiling shenanigans, slowdown in China or a higher oil price we could easily talk about a different picture.

2. Spanish& Italian bond indigestion. Spanish debt auctions in January went well. They’ve sold €18.5bn so far, 15% of their annual target. But they had reached a similar level this time last year, and it all looked a success. Markets still have a lot of Spanish debt to digest. That might become harder after another month of heavy issuance – Spanish yields stopped falling in January.

3. Politics. Italy is the obvious place to look. Although central expectations are that a fairly functional government will be elected, the risks are that the election doesn’t produce such an outcome, or that coalition negotiations are difficult. A government without the will or ability to continue Italy’s reform path would appear vulnerable to not getting OMT support if needed, and that would panic markets. Greece has moved away from the headlines, but discontent and support for Syriza etc. runs high. The coalition has got through the challenges of the end of last year, but it is weaker. Any evidence of terminal fragility in the coalition would be a fright.

This for me is a major after 17 different parliaments in 6 years, with Berlusconi still a candidate, people are confident that Italy will do the right thing? Southern European politicians have proved that they are only able to act when they see the Abyss I put my money on Italian elections becoming a much bigger risk that market is pricing. Come on they even got BALLOTELLI back!!!!

4. Cyprus. Negotiations there still seem fractious, and some of the more extreme outcomes (debt or deposit haircuts) have not been removed from the table. The market isn’t paying this much attention. That may be justified – there are a whole load of reasons why what happens to Cyprus shouldn’t be seen as a precedent for elsewhere. But there’s a danger the market is either ignoring it or is complacent and will freak out one morning when it discovers that Cypriot depositors have just been haircut.

Haircut on deposits above €250k have been considered and there has been no deposits leaving the country???? It makes you wonder why they are so sticky J

5. The Bundesbank. Still a threat. If recovery continues to gather momentum, it will only be a matter of time before we hear “EXIT STRATEGY!” from our friends in the Bundesbank. The euro area economy needs an exit strategy like a hole in the head. Fortunately, after their successful agitation for disastrous rate hikes in the summers of 2008 and 2011, their stock isn’t running that high. But watch out!

I am not so worried about this one for two main reasons : on one hand the “Ben Draghi” is not scared of the Bundesbank as Trichet was and also I think that Mr Soss’s theory on exit strategy is what will really happen , on his view as DD for credit reduces , the Central Banks will propose the banks a direct exchange of their reserves vs. the central Bank holdings as it happened on the 50s….This would definitely be genius!

6. France. The big short last year didn’t pay off. However, the data for France are going from bad to worse. In particular the French PMI is now going in completely the opposite direction to the rest of the euro area. Not good. This has potentially been driven by fiscal tightening and associated loss of corporate and consumer confidence. All the same, relative cyclical weakness may put pressure on French financials, and from there the sovereign.

On this one I think the market is still making a mistake….French saving ratio is at historical highs…..tax the savings and use it on proper government expenditure and see the result on the PMI…

UK. A deficit of 8.5% of GDP that is trending up more than it is trending down. A new central bank Governor apparently prepared to print like mad. A consensus trade for the currency to tank. Seems to me there are a lot of risks in the UK, and not many of them are properly priced in. Those £20 notes in your wallet are financing the sovereign with the biggest deficit in Europe

Only one comment the sooner I sell my house and put the GBP into EUR…the better I will sleep.!!!

So what does our “whatmightgowrong” binomial tree says….as usual I give you the result but not the inputs…not yet ( this for now is our IP and we need to bank on it)

Factor analysis what would work in a sustained rally.

So the last topic I kept thinking about is where are we on the market cycle? And what factors do work in such moments? My initial thoughts were that we were on a similar situation to 2005-2006 with 2012 becoming the beginning of the market recovery and 2013 the explosion and that Value was the factor to own, but this needed to be validated empirically so once again I discussed it with my friends in Holt , Leonardo and Siebert, and once again they delivered a really interesting piece.

The results I attach should not surprise to anyone…but if they are right and this period is similar to the end of 2002 then one thing it might surprise you is how the market behaved after 2003….if inflows in equities come back…fasten your belts…we are about to take off!

Does it look similar? That is why shorting it too early might kill you …

So here are their thoughts

With the new HOLT model release last week and in preparation for our presentation at the HOLT conference yesterday, we ran an updated factor analysis over time. The aim was to see on a monthly basis how the operational performance, momentum and valuation factors worked in the context of the global economy as measured by Jonathan Wilmot’s Cycle Clock, which is based on the level and change in industrial production relative to global capacity

The first point to note is that since two months ago, the global economy’s classification changed from Contraction to Recovery. As shown in the graph above, during a Recovery the best performing factor is Valuation followed by Momentum. Operational performance, while generating positive returns, does not play such an important role. Our back tests show that the best performing themes during a Recovery are Restructuring (top scores in valuation and momentum coupled with poor scores in operations), Best in Class (top scores in all factors), and Value Trap (top scores in valuation and poor scores in the other two). During a Contraction, the best performing themes are eCAPs (firms that can generate consistent, superior returns throughout the cycle), Defensives, and Quality at Any Price (high scores in operations and momentum, coupled with low ones in valuation). When transitioning specifically from Contraction to Recovery, we see that Value subsequently works almost every time – but not always (see pre-dot com boom period in 1998-1999, for instance). From the graph above we can also see the massive Value rally from 2000-2007 and that Recovery is the period that lasts the longest.

If we exclude the contraction in 2001 (which saw Value surprisingly working), the average monthly long/short returns are summarised as follows

Finally, when looking at the monthly returns, we closest resemblance we found to today’s situation was what happened at the end of 2002 (during which time the cycle clock went from a recovery in Dec 2012 to a six-month Contraction and then a Recovery thereafter)

So, have no doubts, being Long Value is the call for this year.

Una respuesta a Front Row: Long Value

  1. John 1 febrero, 2013 a 11:06 pm

    i can’t see the pictures. Update them please.

    Responder

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