Posts published in July 2014
The Efficient Market Hypothesis (EMH) is a theory about asset prices and information. At the heart of this theory is the assertion that capital markets are fully efficient. According to the EMH, asset prices always reflect every single piece of information that could reasonably impact the asset’s value. As new information becomes known it is instantaneously baked into the price. Anyone operating at a speed slower than Planck time could not possibly take advantage of such new information to trade profitably. Price always equals value, the market is always rational, and bubbles don’t exist, say the efficient market proponents.
Theater of the Irrational
The problem with believing in the Efficient Market Hypothesis is that every fiscal quarter delivers a compelling piece of evidence to the contrary, otherwise known as corporate earnings season. The quirky rituals of earnings season refute two key EMH tenets. First, the idea that an asset’s price is always equal to its value is very hard to square with the fact that prices can lurch up or down in double digits before, during and after earnings announcements. Second, the way that prices move in reaction to the actual information released tend to be anything but rational. Consider the following chart, which shows the price movements of two companies – Intuitive Surgical and Qualcomm – in the period leading up to and immediately after their respective second quarter earnings announcements:
What could possibly have happened to make Intuitive Surgical a more valuable company by 17.7% in just one day? Did the net present value of Qualcomm’s future free cash flows suddenly drop by 7%? Of course not. Large publicly traded companies like ISRG and QCOM continually issue guidance on their projected sales, earnings and other key data. Analysts use this forward guidance, as it is called, to model their valuation estimates. Going into earnings season there are consensus estimates for just about every company in the S&P 500. When the actual numbers are released they are compared to the earlier estimates. If the actual figures are higher than the estimates then we have a “positive surprise” or “beat”, in analyst-speak. Lower than expected results, by comparison, are “misses”. High-profile companies can generate considerable drama around their earnings announcements, and the drama often leads to these erratic – and very un-EMH – price movements.
The Fool’s Errand
But the EMH does get one thing right: attempting to profit from a company’s earnings announcement is a fool’s errand indeed. Consider again the two companies in the above chart. You would think that Intuitive Surgical had a blockbuster quarter, and that something awful must have happened to Qualcomm, right? Wrong on both counts. ISRG’s earnings were actually 3.5% lower than the consensus estimate based on the company’s earlier guidance. Qualcomm, on the other hand, delivered earnings 18.6% higher than the estimate. The ensuing price movements are basically the opposite of what a rational investor may have expected.
Markets defy rational expectations every day. Those who come into the capital markets with rigid ideological views about how assets ought to behave should expect to be disabused of their dogma in very short order. Smart investing requires an openness to all ideas and all possibilities, while knowing that no one single view or theory works in all markets at all times.
Thursday offered up a textbook case of how asset markets react to the sudden appearance of an X-factor. In this case the event was the tragic crash of a Malaysian Airlines commercial plane, which appears to have been shot down by an anti-aircraft missile near the border of Russia and eastern Ukraine. Treasury yields plummeted both in the U.S. and Europe. Stocks fell, with major indexes falling by more than 1% for the first time in (what seems like) forever. Gold and the Japanese yen rose, and the VIX volatility index snapped out of its summer slumber to soar 32% in a single day. Improbably, the VIX is actually now in positive territory for the year to date. Anyone running a traditional, by-the-book event-driven strategy probably did very well yesterday.
Uncertainty May Linger
The question is whether this turns out to be just a hiccup – another brief flare-up that quickly subsides into the dominant growth market narrative – or if it becomes a catalyst for a more sustained pullback. The magnitude of asset price movements yesterday, for the most part well within the bounds of similar X-factor events, does not yet suggest the imminence of a sizable pullback. The S&P 500 lost 1.2%, with the blue-chip DJIA losing a bit less than that and the riskier small cap sector retreating by about 10 basis points more. The 10 year Treasury yield matched its previous year to date low of 2.45%, set in late May, but hasn’t yet pushed into new valleys.
Uncertainty, though, may be with us for a while and could make for a more fragile environment than what we have seen for the last couple months. The implications of the airline crash, of course, go well beyond the immediate tragedy of the 298 lives lost. As of this writing little remains known apart from the basic facts of the crash, the timing and the death toll. Russia, Ukraine and the pro-Russian separatists in control of the region where the crash took place are all pointing fingers at each other. The geopolitics were tense before the crash happened: Thursday’s earlier headline was about new, tougher U.S. sanctions against four major Russian business entities including Rosneft, its largest oil company. Just hours before the Malaysian Airlines plane went down, rebel separatists had shot down two Ukrainian fighter planes. Many questions, and their economic implications, remain unanswered.
The potential for lingering uncertainty comes at a time when equity valuation metrics are at their highest levels in more than a decade. In our opinion stocks have not moved into bubble territory yet, but bargains are few and far between. It’s not an optimal time for market jitters – and the typically light volume patterns of mid-late summer trading could exacerbate any negative price trends. With 74 S&P 500 companies reporting as of this morning, 2Q14 earnings are up 5% -- a bit better than the most recent mean estimate. Strong sales and earnings data could keep the negative sentiment at bay; but a couple big misses, especially among higher-profile names, could be worrisome. The dog days are shaping up to be anything but lazy and hazy.
On Thursday morning investors on the U.S. side of the pond woke up to a whiff of 2011: trouble in the European financial sector. Shares in Banco Espírito Santo (BES), Portugal’s second largest bank, were suspended from trading as rumors spread that severe financial difficulties may threaten the bank’s viability and require a bail-out. Shares in all major European indexes were sharply lower, and in Spain two corporate bond offerings were put on hold. U.S. futures contracts turned lower. It is fair to say that the Portuguese-speaking community – in Brazil and in Portugal – has not had a good couple weeks on the bourse or on the soccer pitch.
For a while it looked like it could be the beginning of a good old-fashioned rout. But as the day wore on, the complacency so prevalent in the current environment got the better of fear. U.S. indexes closed the day with mild losses: less than half a percent for the S&P 500 and the Dow Industrials, and a bit more than that for the Nasdaq. One might have expected to see soaring spreads between Portuguese and U.S. bonds. They did widen, predictably, but not by much. As the chart below shows, benchmark 10 year spreads remain far below where they were earlier this year, before the perplexing rally in European bonds gained steam.
For now the BES affair seems to be little more than a tempest in a teapot. European equity markets are mostly stable as they approach the Friday close, and major U.S. indexes are likewise mostly quiet. BES and Portugal’s central bank both issued statements affirming that the bank has sufficient capital reserves to weather the current troubles. The extent of these “troubles” appears somewhat opaque, though. They apparently center on the bank’s loan portfolio to the non-financial interests of the Espírito Santo family group, a Luxembourg-based diversified holding company which owns 25% of BES.
Even if there is less here than initially met the eye, though, Thursday’s flare-up is a timely reminder that things in Europe are not as stable as the region’s astonishingly low interest rates would indicate. Portugal is stuck in slow-growth mode, with unemployment over 20% and GDP projected to grow by less than 1% annually through 2015. Similar conditions prevail elsewhere on the Continent, including Spain, Greece and Italy. These conditions themselves do not necessarily portend disaster, but they do add fuel to a combustible environment for potential failures in the financial system.
The main reason why investors staring into their crystal balls don’t see ominous signs of a 2011 repeat is those magical three words: Whatever It Takes. Mario Draghi pronounced those words in 2012 and Europe’s financial market has been calm ever since. There is a strong conviction among investors that the ECB, the Fed and any other central banks involved will unleash a flood of stimulus onto whatever crisis emerges. And that is a reasonable conviction in light of what central banks have done up to now.
Still, it is never a good idea to let yourself become complacent to the point where you think that central banks or any other institutions can eliminate all risks, all the time. Here in the U.S., the S&P 500 has not experienced a one day price movement of more than 1% - either up or down – for three months. European bonds, as we have commented on extensively in recent weeks, remain at their lowest levels in literally centuries. The Banco Espírito Santo situation has not radically altered our worldview of where markets may be trending. But it serves as a good reminder that vigilance is just as important in a low risk environment as it is in stormier climes.
We normally think of commodities as a single asset class: an alternative investment exposure alongside equities and fixed income. An examination of commodities trends in 2014 to date should disabuse anyone of the idea that there is much in the way of close correlation between the major commodities sub-classes. Global macroeconomic trends, geopolitics, Mother Nature and quirky human behavioral economics all have an impact on commodities prices. In this piece we look at four representative exposures to the main commodities groupings of energy, industrial materials, precious metals and agriculture.
Crude Oil: The Economics of Geopolitics
“Geopolitics” is the term we use to describe socio-political flashpoints around the world, but more often than not the term could be substituted with “whatever is happening in the Middle East this week”. Unsurprisingly, the major action in crude oil trends so far this year has taken place in the last couple weeks, as violent civil unrest once again threatens the sustainability of a single government in Iraq. Prices for Brent crude, a key benchmark, shot up 8.5% from mid-April to mid-June (they have subsided somewhat since then). With the summer driving season in full swing we should not be surprised to see continued upward pressure on crude – and its downstream refined products – in the weeks ahead.
Copper: As Goes China…
Copper is widely used as a proxy for industrial metals, the fortunes of which very much track trends in the world’s major manufacturing centers. Today that means China more than anywhere else, and copper’s rather volatile trajectory in 2014 reflects investor perceptions of how well China is managing its dual objectives of economic growth and rebalancing its GDP mix to a more stable allocation between consumption and investment. At the beginning of the year those perceptions were negative, and a “China hard landing” turned into one of the driving motifs of the first twelve weeks or so of the year. Copper prices plunged 12.3% through mid-March, at which point data coming out of China were conflicting enough to indicate that a major negative event was not imminent. Prices have regained strength since then, and have recently regained position above key technical support levels, though still down year to date.
Corn: The Climate Change Commodity
Two years ago a scorching drought hit the Midwest, America’s breadbasket, and agricultural prices soared. Since then, extreme weather events have become a familiar part of the daily news refrain. 2014 started with one of the coldest, nastiest winters on record, and investors appeared to believe this signaled another rough year for crop harvests. Corn futures prices, one of the benchmark agricultural commodities, soared 20% from January to early May. Then, a bevy of crop reports indicated that this year’s harvests are actually likely to be some of the best in recent years. That has resulted in a dramatic plunge over the past six weeks, to where corn futures prices are now just below where they started the year. Climate change is a reality, but it would seem that betting against Mother Nature remains a fool’s errand.
Gold: The Risk-Off Mindset Continues
Precious metals occupy a strange place in the popular mindset. The storied role of gold throughout human economic history gives it a luster as something special: an asset towards which to run when things start to look grim. In 2011 gold prices soared as the Eurozone seemed on the edge of collapse and political dysfunction drove the U.S. to the brink of a debt default. But what the gold bugs never seem to comprehend is that gold is just another commodity, the price of which rises and falls like any other. Currently prices are about 30% below those highs reached in 2011. Gold is up about 7.2% in 2014; recently it has followed crude oil up as a hard-asset play amid uncertainty in the Middle East. But there’s no magic here. There is no floor to gold prices, there are no contractual obligations to repay principal to investors (as there are with fixed income instruments), and so it is hard to make a compelling case for gold being a safe haven.
So there we are: two key commodities sectors up (crude oil and gold) and two down (copper and corn) as the second half gets underway. As the tone of this paper should indicate, we tend to be skeptical of the value in predicting near-term commodities price trends. But we do pay attention to correlation relationships between commodities, equities and fixed income. These have been much higher in recent years than historical norms, but we see some evidence of potential mean reversion. That may afford an opportunity to bring commodities back into our asset allocation mix.