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).