Volatility

Below is a graph of the FTSE-100 but not over the long term that we usually look at; this chart is on an hourly basis from September 2014 where the index has traded between 6073 and 6773 - this range of 700 points equates to a change in price of over 11%!

Been here before..............................? The chart below shows the last 20 years of the same index and the FTSE-100 has clearly been here before! The blue lines show the same range and similar volatility in 1999-2000 and 2007-2008.

Oil Price still on the slide

The FTSE 350 Oil & Gas Sector is following Oil Price downwards

Weekly Round Up

This week we thought we would try a round up in a different format - click on the link below to view it on our website

Financial Planning Wales Weekly Round Up 

Building a Risk System 28th November 2014

When making an investment decision its important to consider overall market conditions and where we are in relation to history; we like to look at a number of key indicators to gauge the potential risks:- 

The above may look complex but it simply puts into context where the current indicator is in relation to its average, median, minimum and maximum levels; for example looking at the first column we see that the asset being assessed is currently 1.81% above its 20 week SMA (simple moving average). This is a bit above the average of 1.14% and close to the median, whilst being some way from the maximum of 15.75% and minimum of -22.72%; effectively a "neutral reading".

We can also look at this in a graphical context, the 10th column shows the ratio of the FTSE-100 to its volatility, a high reading tells is that the FTSE-100 is going up whilst volatility is low (the opposite would tell us a low FTSE-100 and high level of volatility). So looking at the current level of 582 is well above average and heading towards the maximum as shown below.

Looking at each of these in this was we can start to build a framework in which we can make decisions taking account of the potential risks.

Look for Consistency

The chart below show the Earnings Per Share of AG Barr and Britvic - two firms within the Beverage Sector of the FTSE 250 Index - at first glance you may be attracted to considering the higher Earnings Per Share of Britvic, and even more so when we tell you the earnings per share for Britvic has risen 35% of the last three years when compared to 24% for AG Barr; however……………………….

However look back over 10 years and AG Barr has shown more consistency with only one year when the earnings per share was lower than a previous year (in comparison to four years for Britvic). Whilst Britvic saw  its EPS rise by 58% over the next 10 years AG Barr enjoyed earning growth of almost 204%. The    results can be seen in the share price change since 2005 with AG Barr outperforming strongly as investors were willing to pay for the consistency in earnings . Remember we are looking back at this and how the earnings helped justify a higher price and how this could be applied to different scenarios rather than a recommendation on the suitability of either of these shares

Hindenburg Still Airborne!!!!

Just because we like it we updated our Hindenburg Chart! 

You may have heard of the Hindenburg Omen that is a combination of technical indicators that preceded previous market crashes in the US; since its last appearance in August 2013 the S&P500 is still going up - however there is a similar pattern. 

This shows why you should never rely on one indicator alone they have a nasty habit of surprising you!!!

Financial Repression

Yield is a good measure of an assets current value; a high yield suggests a low price and a low yield and high price, effectively falling yields mean that more people are willing to pay for that yield and the price starts to rise. For example a 10 year bond pays interest of £7 on a £100 nominal value the yield is 7%, so if investors facing declining interest rates on deposits like the idea of a 7% return and are willing to pay £110 for the same bond the yield they receive is actually 6.36% (£7 / £110) and this can go on indefinitely forcing yields ever lower. The same is true of equities, and we can have a look at the  dividend yield that is on offer. Look at the graph below that shows how yields on Cash, Gilts and Equities have all declined.

New Charts & Potential Outcomes

“More new graphs and a look at if we can use them as a sensible guideline for the future! Remember it’s the combination of  indicators that are important rather than individual ones—however compelling! ”

Over that last month or so we have been busying ourselves with the construction of a comprehensive way of    monitoring market conditions - hence the numerous charts that have appeared over the last few weeks— well we’ve still got some left to show you! Over previous weeks we looked at the PE ratio (price divided by earnings per share) and this time we have used it in a slightly different way. 

We looked at 25 of the largest companies in the FTSE-100 and their average PE ratio over 10 year periods; we then included the potential dividend yield and the potential effect of the current PE ratio reverting back to its mean allowing us to construct an indicator of potential returns over subsequent years - this current suggests returns may be around average.

It is of course interesting to see where we are in relation to history, but as with any hypothesis you need to test it! Below is the same graph but with returns for the subsequent 3 years per annum overlaid - this is inverted as it makes it easier to read, as you can see current levels suggest a possible satisfactory outcome in the order o 7% or so per annum (around average), however there have clearly been better times to commit fully to equities (2003, 2009 and 2012).

PE & Prospective Returns

Last week we had a look at a pretty reliable ratio that looked at a shares market capitalisation and how this could be used to identify periods of over and under valuation. This week we have been looking at some more, primarily the PE or Price to Earnings Ratio  that is widely used  throughout  financial services.

The PE ratio is derived from the current price divided by the earnings per share (EPS) , so if the price is 100p for a share and the earnings per share the company has generated 10p then the PE Ratio is 10.This means that investors are willing to pay 10 times the annual earnings for a share; a higher share price 200p and the same EPS would  by 20 - similarly a decline in EPS would also see the PE Ratio rise .

Conversely the tried and trusted strategy of buying a share with a low PE Ratio, caused either by a falling share price or decline in Earnings Per Share when  investors perceive  the shares prospects to be poor has often yielded positive results.

The PE ratio is not perfect lots of things can alter the value of a share and the earnings per share, from negative sentiment to  one off events that effect the earnings for a year; however it is useful to see where  we  are in comparison to history.

In this instance rather than look at an individual share we thought we would construct an average from some of the larger companies (based on market capitalisation)  in the FTSE-100 to see if this would give us any clear indication of market direction.

We used 25 different shares across 19 different sectors that have all had a wide and varied history over the last 20 years or so. The  graph below shows how the PE peaked in 1999/2000  and is currently higher than 2007/2008 market  high. 

The following graph shows the percentile rank for the PE e.g. 90% means that the current level is in the top 10% of high readings of the period analysed. We then overlaid a graph of actual 5 year annualised returns (inverted) from the FTSE 100 which shows  quite a close correlation and suggest that we should not be expecting too  much form the index.

Q Ratio

This is a ratio devised by James Tobin Yale University in the late 1960’s and looks at the total value of a firm on and the total value of its assets - in its simplest for the ratio is calculated as follows:

Q Ratio = Total Market Value of a Firm

Total Asset Value

So if a firm has 100m shares and a price of £2.75 is has a market capitalisation of £270.5 million; this is the total market value of a firm i.e. what investors are willing to pay for ownership of a share of a Company.

If the total assets of the same Company - this includes all things such as property, equipment, cash at the bank etc - is £200m then the Q Ratio for the company is

Q Ratio = £270.5m     = 1.35

£200m

The market is valuing the Company at 1.35 time the cost of its assets; if this ratio was less than 1 then the market could potentially be undervaluing the Firm.

This ratio can be applied and interpreted in many ways; it can be used to assess a Company, a sector or the market has a whole. To use the ratio effectively as a gauge its important to understand how changes in the numerator and the denominator  effect the ratio—for example market speculation and aggressive stock buying can increases the market value raising the ratio. When it comes to total assets what’s not included? Things such as brand name and intellectual property (intangibles) are difficult to value and a high Q ratio could be justified because of the value of these items that do not make up the total assets.

As with any indicator the best thing to do is test it! Over a decent period of 10 or more years……...

The graph below shows the Q Ratio (blue) of a share we looked at recently, the red graph is inverted and shows subsequent three year returns - the patterns are fairly similar and since 2004 a high Q ratio led to disappointing returns over the next 3 years whereas the low Q Ratio in 2009 set the scene for a excellent returns. In late December 2013 the ratio peaked at 1.30 and provided an early warning indicator as the next 40 days saw the price decline by almost 25%. As with all indicators its not perfect, and we never rely on one alone.

Buy & Hold?

With the recent declines - and especially if we see them continue - the advocates of “buy and hold” will soon be telling us “Stay invested” and “Don’t miss out on the  best days of the recovery by selling your equities “

Now I think buying investments and holding them for a long time is a great idea, however I don’t feel that you can just decide to buy at any point and be assured of the average return. I read an article recently providing facts and figures on how 3 month falls were typically followed by strong rebounds in price (often over 20%) and that missing the best 10 days of the market reduces returns by up to two thirds.

This may well be the case if you are in it from the very start but try telling it to some one who invested at the market top in 1999 or 2007 and have only recently broken even on that investment 15 or 7 years   later respectively.  No doubt returns are reduced by missing some of the best days but what if you were prudent and missed some of the worst? Capital preservation stops you taking on too much risk to try and recover your losses, here’s the maths -

· £100 invested  and lose 30% you have £70, a return of 43% (£30/£70) gets you back to £100

· £100  invested and lose 15% you have £85, the same 43% return gets you to  £121 a gain of 21%

Out of interest  we looked at the 1999 FTSE 100 top and there were two declines in 1998 and 1999 where 10% or more was lost and  the market  recovered  those losses and made gains— but the lost over 50% over the next three years! 

Look back further and in 1929/30 the US Dow Jones Industrial fell over 40% then recovered rising over 47% from that low (still over 50% what it was originally worth!) before falling again 85%. We can never say with any certainty what is going to happen but always have a look at history and consider where you are in relation to the average—buy and hold is a great strategy but only if you decide to use it at the right time.

Rough Week!

This month has seen equity markets Globally, and Europe in particular, move sharply lower for a number of reasons  but it appears clear there has definitely been a reversal in sentiment.

The Bank of International Settlement (BIS) tells us to expect more volatility in a recent article in the Telegraph

Economic Sentiment & Equity Markets

Economics and equity markets are not always closely linked but in Europe what happens in German can have a pronounced effect. Take a look at the ZEW Indicator of Economic Sentiment  in Germany (bottom graph) and how it is closely linked to the German and wider European  Stock Markets (top graph) .

We explore this and a few other areas in our Weekly Round Up on our website 

Volatility and the FTSE-100

We have previously looked the how low volatility can be a good "contrarian" indicator where low volatility suggests that investor sentiment may be too buoyant (When High Risk Can Mean Low Risk). 

Well the last couple of weeks we have seen volatility on the rise for the FTSE-100 as the widely watched UK Index declined. 

You may notice the almost mirror image - well if we overlay FTSE 100 with the Volatility Index (turned upside down) you can see the similarities and we will wait to see if the FTSE 100 follows volatilities lead.

Tough Times for Food Retailers

The top graph shows how Tesco, Morrison’s and Sainsburys have been having a pretty tough time—Tesco had already been suffering after their announcement faux pas -  however was the always likely? The lower graph is an extract from a review that we undertook on the sector in March and shows how total net profits for the sector were in decline after 4 years or growth (red bars) even more worrying is the blue line that shows the net profit for these companies in the sector weighted by their market capitalisation i.e. more emphasis on the larger firms.

US Inflation and Treasury Inflation Protected Securities (TIPS)

An interesting little bit of research that we looked at this morning.

US "breakeven" rates of inflation are used to gauge investor expectation of inflation and are calculated as the yield on a conventional US Treasury less the Yield on an Inflation Protected Treasury (TIPS) of the same maturity. 

Currently 5 year inflation expectations are: - 

• Yield on 5 Year Treasury = 1.76% 
• Yield on 5 Year TIPS = 0.054% 
• Breakeven/Inflation Expectations = 1.76-0.054 = 1.706% 

This is telling us that the current 5 year implied rate of inflation is expected to be 1.706% in the US; if we then look at history we can see that over the long run inflation has tended to be a bit higher. 

So if we were to see a reversion to mean of US CPI (inflation) which is higher than the expected inflation of 1.706% then this may be positive for TIPS. Of course in the World of QE and financial repression these indicators could give conflicting signals for some time - never the less it will be interesting to see.  

Please note this is just a review of market conditions and is not a recommendation!! 

Strong US Dollar No Fun for Emerging Markets

Look at the graph below - the strength in the US Dollar has historically resulted in negative returns for the Emerging Market and BRIC indices

Removing the BRIC index and looking at just Emerging Markets we can see the correlation has existed for 20+ years. 

Remember the Emerging Market Index is upside down! 

S&P500 - Durable Goods - Inflation Expectations

Will the S&P500 Index (blue) follow the US Durable Goods Orders (red) and Inflation Expectations (green) downwards - the last 20 years shows a pretty close correlation between the three! 

Key Events in September & October for the FTSE-100

As readers of our regular weekly updates will know we are keen on history, and stock market history can provide some interesting insights. Sometimes the significance of an event does not register with us until after when with hindsight is remembered as a major inflexion point or change that precipitated market declines. 

Whilst equity markets in 2001 were already in a down trend as the "tech bubble" burst the accounting scandal that broke in October regarding Enron is remembered by many and associated with the declines that led to the market low of 2002. 

In 2008 the Financial Crisis was at its peak with the report that Lehmman Brothers had collapsed and there followed a savage decline in the FTSE-100. 

Now we are not suggesting any form wrong doing but the recent Tesco Accounting Errors could ultimately be remembered in the same way, after all market conditions are similar: - 

• Strong 4-5 year growth in the FTSE 100 as it reaches towards 7000

• Equity euphoria built on an underlying bubble - 2000 Tech Bubble, 2007 Housing Market & Mortgage Backed Securities and 2014 Quantitative Easing

• General perception that equity markets can only go upwards - euphoria 

• Just for good measure each event happened in early Autumn (Sep & Oct) 

Here is a graph below to show you the similarities 

As we always say never rely on one indicator alone but events such as these means investors should at least be on their guard. 

Citywire Interview

Back in April Citywire asked us to take part in an Interview about risk targeted portfolios - hope you find it of interest! 

Andrew Citywire Interview

When low volatility can mean high risk!

One of our favourite indicators that we monitor when looking at equity market indices is the volatility of the index - there is frequently low volatility at points when investors become complacent and risk is high, as perceptions and attitudes change the bullish become the bearish with markets falling and volatility rising. Look at the graph of the FTSE-100 below in blue and the VFTSE (FTSE volatility) in red. 

As you can see we are now at ultra low volatility and the FTSE 100 recovering to its previous peaks - will the rally run out of steam or will Central Banks Quantitative Easing keep volatility at bay?

Just to show how closely these two are correlated look what happens when we turn the volatility graph upside down, the last 10 years in particular have been pretty close.

Whilst it is a bit of a chicken or the egg - does declining equity markets cause the volatility or rising volatility cause the declining equity markets - its useful to consider the markets overall position and compare with other indicators to build a framework for investment decisions. 

New Blog

I have started this blog today (18th September 2014) and we hope to add lots of useful information and narrative on the Financial Services industry that we work in - hope you will enjoy it! 

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