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The potential to use investor sentiment as a gauge for future market trajectory is an appealing proposition. Sentiment is often cited as a contrarian indicator; excessive bullishness signals market exuberance poised for a reversal, whilst extreme bearishness may be the precursor to a market recovery. Such indicators are most useful when they are at extremes, and less so when the readings are neutral, which tends to be most of the time.

The reason for assessing sentiment is that, when investors are extremely bullish, they tend to be fully invested, leaving little available cash to drive asset prices higher. On the other hand, when extreme bearishness prevails, the abundance of cash sitting in portfolios can be deployed to buy cheap assets, creating the foundation for a bull market.

There are broadly two approaches to quantifying investor sentiment: attitude and activity. The former are typically surveys, gathered through proxies, of near-term expectations of active investors or market commentators. The second method maps risk appetite through trading activity, measured by asset flows, positioning and market volatility. In practice, the usefulness of these sentiment indicators for predicting stock market returns is somewhat uncertain. In this note we will examine a few of the most quoted metrics.

Starting with surveys, we look at both institutional investment advisor sentiment as well as individual investor sentiment, represented by US Investor Intelligence (II) and the American Association of Individual Investors (AAII), respectively. The US Investor Intelligence series is one of the oldest sentiment indicators, dating back to 1963, collating the opinions of over 100 newsletter writers through weekly surveys. Currently, the series is displaying extreme pessimism. The bull/bear ratio dipped below 95th percentile for the first time since 2008, or 2011, if you include the very close encounter of that year. We use percentiles instead of the usual standard deviation measure due to the skewed nature of the series (positive skew, in this case), defining extreme observations as the outermost 5% on either end of the bullish and bearish spectrum.

Exhibit 1: US Investor Intelligence Bulls/Bears RatioSentiment_1Source: Investors Intelligence

On this measure, some simple analysis shows that it does in fact have predictability, albeit rather one-sided and, somewhat surprisingly, more reliable over the longer term of 2-3 years and less useful for near-term returns of one year or under. The caveat here is the limitation of a small sample size, as this level of pessimism has only occurred a handful of times in history.

The table below shows the average forward returns of the S&P 500 index from the point which sentiments become extreme. Given this is a contrarian indicator, we would expect to find negative future returns if one invest at the point of bullish extremes, and vice versa. And indeed, we do observe visible predictability at bearish levels, whereby future returns are generally positive, and becomes more pronounced as the horizons extend. The quality of the return pattern also improves towards the longer end of the time horizon as the number of negative observations decreases drastically for 2-3 years (from 45% at 1M to 5% at 3Y), meaning you will make money most of the time, whilst in the short-term (<6M), it can be an almost 50:50 chance of getting positive or negative future returns.

Exhibit 2: Forward S&P 500 Index returns at extreme sentiment levelsSentiment_2Source: Cerno Capital

By contrast, on the extreme bullish levels, there is no emergence of a contrarian indication as the future returns tend to still be positive on average, and the quality of the result remains mixed even as time progresses. One possible explanation for this may be that the bears can be too early to call a market top, as an irrational bull market can extend for several years before it eventually crashes, as it did in the Global Financial Crisis, thereby making the reading less predictable.

The main difference between professional investors and individual investors seem to be a matter of emphasis. For example, the bullish sentiment leading up to the TMT bubble is much more pronounced on the AAII but barely registered on the II. The peak bullishness in 2015 displayed in II, on the other hand, is much more muted on AAII. On this occasion, both surveys appears to be giving a similarly extreme signal where the bears outnumber the bulls by a hefty margin, as illustrated by the AAII Bulls-Bears spread chart below.

Exhibit: 3: AAII Bulls-Bears SpreadSentiment_3Source: AAII, Bloomberg

In forecasting returns, it is also the case for AAII that extreme negative sentiment provides a better indication of future performance than positive sentiment, on both standard deviation and 5th/95th percentile basis, as we see in the table below. Although compared to Investor Intelligence, the level of mixed result remains higher even at the longer horizon of 3Y, whereas the chance of getting a negative return after 3Y is all but eliminated for II (% of negative return in 3 years: 17% vs. 5%), which means that the chance of being too bearish too early is still relatively high. The bullish side does give consistently low or negative future returns up to 2 years on average, but again, the quality of the result is questionable given the high percentage of positive readings.

Exhibit 4: Forward S&P 500 Index returns at extreme sentiment levelsSentiment_4Source: Cerno Capital

Other commonly used investor activity indicators are also trending towards extremes, including the CBOE equity put/call ratio, which records simply the total volume of equity puts traded divided by the calls traded in the options market, also a contrarian metric.

Exhibit 5: CBOE Put/Call Ratio 30-Day Moving AverageSentiment_5Source: CBOE

Flow data which measures the pace at which investors are rotating out of equity is gaining momentum, signalling that they are becoming more risk-averse, as shown in the ICI mutual fund flows data for equity funds:

Exhibit 6: ICI Mutual Fund Flows: Net New Cash Flow – All Equity Funds (USD, Millions)Sentiment_6Source: ICE

The bearish sentiment reflected in the shift out of equities is also mirrored by a rise in the price of gold, where gold is typically regarded as a safe haven asset and a good gauge for market uncertainty, having the tendency to perform well in times of stress. This trend is supportive of an increasingly uneasy investment community, with its 3 month price change the quickest gain in value just short of two standard deviations above the long-term mean.

Exhibit 7: 3M % Change in Gold PriceSentiment_7Source: Bloomberg

Finally the VIX, also known as the ‘fear indicator’, is a measure of the 30-day implied volatility of S&P 500 index options. Whilst not extreme, it has recently surpassed values last reached in 2011.

Exhibit 8: The VIX IndexSentiment_8Source: Bloomberg, CBOE

Summary & Conclusion

Such indicators are most useful when they are at extremes, and less so when the readings are neutral, which tends to be most of the time.

Each sentiment indicator measures the market from a slightly different perspective, therefore should never be used on a standalone basis, and it is advisable to monitor in conjunction with other market indicators (especially fundamental).

This is by no means a comprehensive list of all the possible sentiment metrics. Not surprisingly, those which we have surveyed are consistent in implying a growing bearishness.

It is too early to call a bottom as not all of the indicators have reached extreme levels. The danger with sentiment watching is that theoretically it can always become more optimistic or pessimistic, driven primarily by price momentum.

As portfolio managers, who have a keen interest in odds (and tipping them in our favour) we monitor sentiment indicators to look for extremes. Should such an extreme be reached, our understanding of these readings will influence asset allocation.

Extracts from this article first appeared in The Daily Telegraph on 5th March 2016

http://www.telegraph.co.uk/investing/isas/if-you-want-to-profit-from-market-despair-wait-it-needs-to-get-m/

 

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The S&P 500 index peaked in late May 2015 at 2130, having enjoyed a seven year bull run. (more…)

The trade-weighted U.S. Dollar Index (DXY) is the de facto benchmark used to gauge the value of the US dollar devised by the ICE. The index is a weighted geometric mean of the dollar’s value relative to a basket of six currencies, where both the constituents and the weights have little changed since the series began in 1973, except to account for the creation of the Euro. The index can be decomposed as follows:

Exhibit 1: The composition of the trade-weighted US dollar index (DXY)

Currency Weight
Euro 57.6%
Japanese Yen 13.6%
Pound Sterling 11.9%
Canadian Dollar 9.1%
Swedish Krona 4.2%
Swiss Franc 3.6%

Source: ICE

The term ‘trade-weighted’, however, appears somewhat inappropriate on this occasion. For one, with the Euro accounting for nearly 60% of the index weight, it renders the DXY Index into a predominantly USD/EUR phenomenon, where the fate of the Euro has an outsized impact on the index value. For the period 1975-2015, the correlation coefficient between the two are as high as 0.98 based on monthly data (Exhibit 2), and on average, the EUR accounted for over two-thirds (69%) of the movements in the dollar index (Exhibit 3). Adding GBP, CHF and SEK into the equation, the index becomes overwhelmingly Europe-centric at 75% weighting.

Exhibit: 2: The DXY Index versus USD/EUR since 1975

Source: Bloomberg

Exhibit: 3: Breakdown of the 12 Month rolling returns of the DXY Index by currency

Source: Bloomberg

Actual trade data points to a different picture. The Euro Area currently represents 16.6% of US total foreign trade (imports plus exports), its position as the largest trading partner to the US was taken over by China in 2009, who today makes up 21.5% of US total foreign trade. Sweden and Switzerland, together accounting for 7.8% of the index, are also less significant compared to 30 years ago, not to mention that the Swedish Krona weighs heavier than the Swiss Franc, which in itself begs more questions. At present, Switzerland is the 11th largest player (1.8% of total trade), while Sweden ranks much further down at 23rd in size (0.7%).

Exhibit 4: US Total trade (import plus export) by country, in percentage terms

Source: Federal Reserve

In context to this, the other shortcoming in the composition of the index is consequently the lack of Emerging Market representation. The importance of Emerging Market countries as trading partners to the United States have risen over the past twenty years, in particular, the total trade in 2014 ranks China, Brazil, Mexico, South Korea, India, and Taiwan in the top ten by size, outnumbering their traditional developed market counterparts (Euro Area, Canada, Japan, and UK). This, in turn, means that 44% of the total US foreign trade is unaccounted for by the so-called ‘trade-weighted’ US dollar index.  It therefore makes sense to consider alternative compositions and weights for the USD currency basket with a view to a more representative picture.

Such indices do already exist, although not widely adopted. A number of broad US dollar indices have been created that are closer aligned to evolving US trade patterns, including the US Trade-Weighted Broad Dollar Index[1] built by the Fed in 1998 consisting of a basket of 26 currencies that captures well over 90% of US international trade (weights as seen in Exhibit 4). The basket weights are adjusted annually, and the index can also be split into two sub-indices: Major Currencies and Other Important Trading Partners (OITP), where the weights are derived by rescaling the currencies’ respective weights in the broad index so that they sum to 1 in each sub-index.

The Major Currencies index closely resembles the DXY index in composition, consisting of the seven most liquidity-traded currencies with the only difference being the addition of the Australian dollar to the mix. The OITP index includes mainly EM trading partners and smaller players.

Exhibit 5: Federal Reserve US Trade-Weighted Indices (Real) versus DXY Index

Source: FRED, Bloomberg

Equally weighting the currencies is another alternative that has been introduced by a number of parties in recent years. The FTSE Curex USD G8 Index includes, for example, includes a basket of equally-weighted G8 currencies: Australian Dollar, Canadian Dollar, Swiss Franc, Chinese Renminbi, Euro, Sterling, Japanese Yen, and the New Zealand Dollar.

We have also experimented with an index comprising of an equally-weighted currency basket of top ten US trading partners. The series correlates relatively closely to the DXY in its return patterns with a correlation coefficient of 0.7 since 1995, albeit breaking down into the individual components, it is apparent that the underlying drivers are very different. In particular, it shows that the recent bout of USD strength is a result of BRL and MXN weakness, in contrast to the EUR driven DXY.

Exhibit 6: Equally-weight US dollar index (Top 10) versus the DXY Index

Source: Bloomberg, Cerno Capital

Other attempts to reformulate the US dollar index intend to compare the US dollar against the most liquidly-traded currencies, using either FX volume-weighted or equal-weighted methodologies, such as the Wall Street Journal Dollar Index (16 currencies) in the former category and the Dow Jones FXCM Dollar Index in the latter (4 currencies: EUR, GBP, JPY, AUD). The rationale behind this is to indicate financial market pressures on the dollar given that all the currencies trade in liquid FX markets and used as a speculative tool.

Exhibit 7: Correlation between various US dollar indices since 1975 (based on monthly data)

Source: Bloomberg

It is difficult to judge which method most effectively depicts the value of the dollar. The FX volume-weighted strategy will also have the same Euro skew as the DXY as the Euro is the second largest traded currency in the FX market (>30%).  Equal-weighted indices will overstate the importance of some currencies. The Federal Reserve’s inflation-adjusted broad dollar index is perhaps more relevant to today’s investors, in particular, being able to examine dollar value in two different dimensions through the Majors and OITP sub-indices can be a useful tool. Although the DXY, for all its inadequacies, still tracks the more diversified Fed indices reasonably well (see correlation in Exhibit 7), and it is traded widely as the underlying for dollar-index futures. Investors needs to be aware however, of the driver behind the index movements, and also that the DXY gives only a partial representation of dollar value and will not be able to capture significant movements outside its limited currency spectrum, the CNY devaluation back in August being a prime example.

Elements of this article first appeared in the Financial Times.


[1] https://research.stlouisfed.org/fred2/categories/105

The trade-weighted U.S. Dollar Index (DXY) is the de facto benchmark used to gauge the value of the US dollar devised by the ICE. The index is a weighted geometric mean of the dollar’s value relative to a basket of six currencies, where both the constituents and the weights have little changed since the series began in 1973, except to account for the creation of the Euro. The index can be decomposed as follows:

Exhibit 1: The composition of the trade-weighted US dollar index (DXY)

Currency Weight
Euro 57.6%
Japanese Yen 13.6%
Pound Sterling 11.9%
Canadian Dollar 9.1%
Swedish Krona 4.2%
Swiss Franc 3.6%

Source: ICE

The term ‘trade-weighted’, however, appears somewhat inappropriate on this occasion. For one, with the Euro accounting for nearly 60% of the index weight, it renders the DXY Index into a predominantly USD/EUR phenomenon, where the fate of the Euro has an outsized impact on the index value. For the period 1975-2015, the correlation coefficient between the two are as high as 0.98 based on monthly data (Exhibit 2), and on average, the EUR accounted for over two-thirds (69%) of the movements in the dollar index (Exhibit 3). Adding GBP, CHF and SEK into the equation, the index becomes overwhelmingly Europe-centric at 75% weighting.

Exhibit: 2: The DXY Index versus USD/EUR since 1975

Source: Bloomberg

Exhibit: 3: Breakdown of the 12 Month rolling returns of the DXY Index by currency

Source: Bloomberg

Actual trade data points to a different picture. The Euro Area currently represents 16.6% of US total foreign trade (imports plus exports), its position as the largest trading partner to the US was taken over by China in 2009, who today makes up 21.5% of US total foreign trade. Sweden and Switzerland, together accounting for 7.8% of the index, are also less significant compared to 30 years ago, not to mention that the Swedish Krona weighs heavier than the Swiss Franc, which in itself begs more questions. At present, Switzerland is the 11th largest player (1.8% of total trade), while Sweden ranks much further down at 23rd in size (0.7%).

Exhibit 4: US Total trade (import plus export) by country, in percentage terms

Source: Federal Reserve

In context to this, the other shortcoming in the composition of the index is consequently the lack of Emerging Market representation. The importance of Emerging Market countries as trading partners to the United States have risen over the past twenty years, in particular, the total trade in 2014 ranks China, Brazil, Mexico, South Korea, India, and Taiwan in the top ten by size, outnumbering their traditional developed market counterparts (Euro Area, Canada, Japan, and UK). This, in turn, means that 44% of the total US foreign trade is unaccounted for by the so-called ‘trade-weighted’ US dollar index.  It therefore makes sense to consider alternative compositions and weights for the USD currency basket with a view to a more representative picture.

Such indices do already exist, although not widely adopted. A number of broad US dollar indices have been created that are closer aligned to evolving US trade patterns, including the US Trade-Weighted Broad Dollar Index[1] built by the Fed in 1998 consisting of a basket of 26 currencies that captures well over 90% of US international trade (weights as seen in Exhibit 4). The basket weights are adjusted annually, and the index can also be split into two sub-indices: Major Currencies and Other Important Trading Partners (OITP), where the weights are derived by rescaling the currencies’ respective weights in the broad index so that they sum to 1 in each sub-index.

The Major Currencies index closely resembles the DXY index in composition, consisting of the seven most liquidity-traded currencies with the only difference being the addition of the Australian dollar to the mix. The OITP index includes mainly EM trading partners and smaller players.

Exhibit 5: Federal Reserve US Trade-Weighted Indices (Real) versus DXY Index

Source: FRED, Bloomberg

Equally weighting the currencies is another alternative that has been introduced by a number of parties in recent years. The FTSE Curex USD G8 Index includes, for example, includes a basket of equally-weighted G8 currencies: Australian Dollar, Canadian Dollar, Swiss Franc, Chinese Renminbi, Euro, Sterling, Japanese Yen, and the New Zealand Dollar.

We have also experimented with an index comprising of an equally-weighted currency basket of top ten US trading partners. The series correlates relatively closely to the DXY in its return patterns with a correlation coefficient of 0.7 since 1995, albeit breaking down into the individual components, it is apparent that the underlying drivers are very different. In particular, it shows that the recent bout of USD strength is a result of BRL and MXN weakness, in contrast to the EUR driven DXY.

Exhibit 6: Equally-weight US dollar index (Top 10) versus the DXY Index

Source: Bloomberg, Cerno Capital

Other attempts to reformulate the US dollar index intend to compare the US dollar against the most liquidly-traded currencies, using either FX volume-weighted or equal-weighted methodologies, such as the Wall Street Journal Dollar Index (16 currencies) in the former category and the Dow Jones FXCM Dollar Index in the latter (4 currencies: EUR, GBP, JPY, AUD). The rationale behind this is to indicate financial market pressures on the dollar given that all the currencies trade in liquid FX markets and used as a speculative tool.

Exhibit 7: Correlation between various US dollar indices since 1975 (based on monthly data)

Source: Bloomberg

It is difficult to judge which method most effectively depicts the value of the dollar. The FX volume-weighted strategy will also have the same Euro skew as the DXY as the Euro is the second largest traded currency in the FX market (>30%).  Equal-weighted indices will overstate the importance of some currencies. The Federal Reserve’s inflation-adjusted broad dollar index is perhaps more relevant to today’s investors, in particular, being able to examine dollar value in two different dimensions through the Majors and OITP sub-indices can be a useful tool. Although the DXY, for all its inadequacies, still tracks the more diversified Fed indices reasonably well (see correlation in Exhibit 7), and it is traded widely as the underlying for dollar-index futures. Investors needs to be aware however, of the driver behind the index movements, and also that the DXY gives only a partial representation of dollar value and will not be able to capture significant movements outside its limited currency spectrum, the CNY devaluation back in August being a prime example.


[1] https://research.stlouisfed.org/fred2/categories/105

In recent weeks, China has dominated the headlines; in particular the recent stock market and currency volatility have sparked fear across global markets. Looking forward, we would highlight a less discussed market that has been concerning us in recent periods: – Turkey.

Turkey is significant, due to the size of its economy (13th largest among OECD countries) and its geographical and economic proximity to Europe, which accepts circa 55% of its exports. Turkey is in a more vulnerable position than China in several ways: it runs one of the highest current account deficits in the EM universe owing to its dependency on short-term foreign funding to support the economy. Like its EM peers, Turkey has been a beneficiary of large foreign capital inflows, manifest in the significant external leverage built by its domestic corporate sector, masking its waning economic momentum. Gross external debt has doubled from pre-crisis levels to almost US$400 billion in Q1 2015. This  represents 50% of GDP, which, as noted by financial historian Russell Napier, exceeds the threshold of 30% where historically a country is more likely to default. In comparison, while China’s debt level is much higher in absolute terms, its ability to repay is stronger with the ratio sitting at 9% of GDP.

There are some countervailing elements, however. Falling commodity prices are beneficial to Turkey, being a net importer, in stark contrast to Brazil or South Africa. This will help improve its current account deficit somewhat, if low prices are sustained for longer. Turkey is also the least exposed to China among major EM economies, with less than 1% GDP of exports to the country.

Nonetheless, the end of quantitative easing and the expectation of rate rises in the US may see a reversal of the trend of flows that have been fundamental to Turkey’s economy, signs of this are just beginning to emerge. This will make funding more expensive and debt more difficult to repay, thus making Turkey more vulnerable to capital flight, taking into consideration that almost 25% of their bonds are held by foreigners. These eventualities are often precursors to the introduction of the foreign investors nemesis – capital controls.

Flows within dedicated EM bond funds are increasingly negative. The most recent week has seen $2.5bn of outflows, the worst level since February 2014, although still significantly below the 2013 taper tantrum period.

Exhibit: Dedicated EM bond fund flows

Dedicated EM bond fund flows

Source: Barclays Capital

On average, Turkey account for 5% of hard currency and almost 10% of local currency EM bond indices, and is weighted similarly in the largest EM Bond funds with few exceptions. Given this level of exposure, coupled with the accelerating negative unwinding trend in emerging market debt, Turkey’s weak fundamentals, high debt levels, and sensitivity to capital flow volatility will yield an increased risk of capital controls being introduced as a counter measure. Should this happen, we will likely experience significant turmoil in EM debt markets and renewed focus on the lending banks.

Since mid-2014, the trade-weighted dollar index has surged 21%. If this is indeed a new bull market in the US dollar, it is not yet fully fledged. The previous two major US dollar bull markets during the open currency era traced rises of 88% and 47% between 1980-1985 and 1995-2002, respectively.

Divergent monetary policies remain the key driver, predicated on the assumption that the Fed tightens first, whilst other major blocs retain looser monetary policy, increasing interest rate differentials. Speculative long dollar bets reached a record high earlier this year with the most extended positions against the Euro and the Yen. However, since March, with the renewal of the Greek Crisis and Chinese equity volatility grabbing headlines, the dollar has traded sideways and given up some of its earlier gains.

A stronger dollar also exerts pressure on emerging market economies, who traditionally suffer under this scenario. History suggests that disruptions occur when the Fed tightens and the dollar rises in tandem. The previous two dollar bull markets proved traumatic for, respectively, the Latin American and Asian economies in the early 1980s and late 1990s, as the burden of repaying dollar-denominated debts became intolerably expensive.

This time may also be painful for countries that have borrowed extensively in US dollars during the QE phase post the Global Financial Crisis, especially those with large currency mismatches (aka. where foreign currency borrowings is not matched by foreign currency earnings). Until 2008, developed nations have led the global debt accumulation, but since then, the emerging markets have taken over the driver’s seat as capital flowed in from investors chasing after yields overseas. Data from the Bank of International Settlements (BIS) estimates that offshore US dollar lending has grown to US$9 trillion from US$6 trillion pre-2008. Emerging markets are, once again, on the receiving end of a large proportion of this credit, as seen below.

Exhibit: US dollar credit to non-banks outside the United States (in USD Trillions)

US dollar credit to non-banks outstanding stocks1US dollar credit to non-banks by counterparty country

Source: BIS

Whilst Southeast Asia learned hard lessons from 1998, China, which escaped the Asian Financial Crisis, appears to have not. It has become a fervent borrower: out of the estimated US$4 trillion that flowed into the emerging markets, it alone accounted for over US$1.1 trillion, with the majority of the credit disbursed in the form of loans. In the below chart, the other two BRIC nations, Brazil and India, pale by comparison.

Exhibit: US dollar credit to Brazil, China and India (in USD Billions)

US dollar credit to Brazil, China and India (in billions of dollars)

Source: BIS

China’s corporate debt sector currently stands at close to 200% of GDP (including financials), having doubled from 2007 levels. Its issuance of US dollar bonds is also 11 times larger than it was in January 2007, as illustrated by the chart below.

Exhibit: China foreign currency bonds outstanding by issuer (in USD Billions)

China Foreign currency bonds outstanding by issuer

Source: Asian Bonds Online

Almost 25% of aggregate Chinese corporate debt is dollar-denominated, but only 9% of Chinese corporate earnings are. The difference between these two figures defines the mismatch. The Chinese real estate sector is the worst offender, where approximately 50% of the debt is concentrated. The second biggest borrower is the utilities sector. These sectors also have the greatest currency mismatch as the majority of the revenues will be in local currency, with exposures generally unhedged.

Exhibit: China currency mismatch by debt and EBITDA

China Debt by Currency China EBITDA by Currency

Source: Morgan Stanley

However, whilst China’s aggregate debt level appears high in absolute terms, it must be noted that a large proportion of this is domestically held. The triggering factor for most major defaults is often a consequence of large external borrowings, an area where China remains relatively robust. Its overall gross external indebtedness is low at 9% of GDP as at end-2014, not a level that raises immediate concern (conventionally alarm bells ring when level reaches 35% of GDP). China has ample foreign reserves for coverage (US$3.6 trillion or 4x covered) in the event of distress. On the other hand, many other emerging nations appear vulnerable on this measure, including much of EEMEA. In emerging Asia, the weak link is Malaysia and in Latam, Chile.

Exhibit: Gross external debt as a % of GDP, Q4 2014 (in USD Billions)

Gross External Debt as a percentage of GDP Q4 2014

Source: World Bank

Outside China, the picture in emerging Asia seems more reassuring in general: on average 22% of their overall debt is dollar-denominated, balanced in large by their 21% dollar earnings. With flexible currencies, adequate FX reserves and a larger proportion of local currency denominated bonds, the Asian economies should be more resilient than during previous periods of dollar strength.

Nevertheless, pockets of vulnerabilities do exist and contagion risk is not improbable. Growth has slowed in many countries, markedly in China, but also in major borrowers including Brazil, Turkey, Russia and South Africa. These latter countries must service dollar debt using energy sector revenues, which have been exposed to recent falls in oil prices that may persist for longer with Iranian supplies back on the map. In other cases, current account deficits are funded by short-term capital inflows. Turkey, Argentina, Malaysia and Mexico all have short-term borrowings of over 50% of reserves.

Exhibit: EM external liabilities by currency composition

EM external liabilities by currency composition

Source: UBS, Haver

As a large proportion of emerging market debt is held by foreign investors, many will be quick to retract their capital should sentiment deteriorate materially over any signs of distress. Once the cycle begins, EM companies will find it incrementally more difficult to roll-over dollar denominated loans, which form a large percentage of their external liabilities as exhibited above. This will, in turn, drive a demand for the US dollar, causing it to appreciate in value, push up the local currency value of the debt, thus making it more burdensome to service, generating a self-reinforcing downward spiral. Foreign holders of local currency denominated debt may also want to exchange it for US dollars, further driving demand.

Capital outflows in emerging markets have begun to build since the ‘taper tantrum’ in May 2013, as illustrated by the EM debt fund flows chart below. Capital flows in China have also turned negative for four consecutive quarters, recording a capital and financial account deficit of US$78bn in the first quarter of 2015, the largest since 1998, despite the small absolute value. This is partially due to a slowing Chinese economy and the result of a rising US dollar coinciding with declining Chinese interest rates. With the Fed holding on to their expectation of a 0.5% interest rate rise this year, the tendency is for these trends to accelerate.

Exhibit: EM debt fund flows (in USD Billions)

EM debt fund flows

Source: Morningstar

Exhibit: China Capital Flows (in USD Hundred Millions)

China Capital Flows (in hundred million US dollars)

Source: Trading Economics

The argument for a stronger dollar rests on the relative strength in the US economy versus other major economies, met by interest rate rises against a background of some vulnerability in emerging markets. Now that the uncertainties brought by Greece and Chinese equities have somewhat abated, for the time being, the dollar has resumed its upward trend as focus is reverted back to the Fed’s interest rate policies.

Exhibit: Trade-weighted US dollar index (DXY) since 1970

Trade-weighted US dollar index (DXY) since 1970

Source: Bloomberg

A strong dollar creates countervailing pressures, particularly through the import of deflation and a depressant effect on US corporate earnings. Standard & Poors estimates that approximately 46% of sales of S&P 500 companies are derived internationally, thus, a strengthening dollar will directly affect US multinationals’ corporate earnings. Further, US inflation was more shielded to exchange rate fluctuations during the 1990s, and US import prices were much less volatile, as Barclays Research suggests.

Exhibit: US dollar on PPP (top) and REER (bottom) measures against a basket of DM currencies

US dollar on PPP US Dollar REER

Source: ValuTrac, Bloomberg

On valuation grounds, the US dollar is not overly expensive relative to its previous peaks on REER and PPP basis, against a basket of DM currencies, as exhibited above. Although worryingly, investor positioning remains at somewhat elevated levels: two standard deviations above the long-term average despite some moderation since the trade-weighted dollar index backtracked from its recent high in March.

Exhibit: Net speculative positions on the US dollar

Net speculative positions on the US dollar

Source: Morgan Stanley

We tend to think that there is less potential for steep dollar appreciation this time round due to better EM fundamentals than during the previous dollar bull markets, in particular emerging Asia, and also due to the possible negative implications of a strong dollar for the US economy. We, therefore, expect the dollar to resume a milder climb onward, with more volatility in tow.

When investors talk of long-term trends, they are often referring to the next three to five years. (more…)

We all know that the UK and US stock markets have risen over the past 50 years. (more…)

The Cerno Global Leaders Programme seeks to identify and invest in a group of companies worldwide which possess leadership attributes with a view to holding them for the long term.

What constitutes leadership capacity?

There are a small group of enterprises within the global equity universe that persistently exhibit above average growth, profitability and investment returns over the long-term. These companies often operate in oligopolistic industries and possess qualities that contribute to their competitive advantage and economic moats, ranging from:-

This method of understanding industries has been shaped by the work of Harvard professor Michael Porter. Porter coined five archetypal attributes: pricing power, bargaining power, threat of new entrants and substitutes, and competitive industry structure.

From a quantatively screened universe, the investment group selects stocks based on seven main criteria that were developed from Porter’s five forces:

  1. Strong and defensible competitive position or business franchise
  2. Management with a high level of integrity
  3. Above sector average growth prospects
  4. Cash returns delivered at significant excess to their cost of capital
  5. Operating in multiple markets or in the process of extending a strong domestic position internationally
  6. Companies with a robust balance sheet and low leverage
  7. Quality company at the right price

Complimentary to these, we observe that technological prowess and innovation are relevant factors in the sustenance of positive economic value in many of our candidates. In a world whose trajectory of travel is progressively technologically oriented, the strength of a firm’s intellectual property is crucial to their ability to sustain market leading positions and preserve barriers to entry, thereby protecting higher profits and margins over long time frames.

InfoTech, healthcare and automotive industries are well recognised leaders in innovation. Companies in these sectors regularly post R&D spending in excess of 10% of sales and hold a large portfolio of patents to protect their intellectual property. According to figures from Strategy&, a consultancy under PwC, Volkswagen, Samsung and Intel were the Top 3 investors in R&D worldwide in 2014, spending US$13.5bn, US$13.4bn and US$10.6bn in absolute US dollar terms, respectively. Furthermore, the top 20 R&D spenders illustrated in Exhibit 1 are comprised solely from the three sectors mentioned above.

Exhibit 1: Top 20 firms ranked by R&D expenditure in 2014 (US$ billions)

2014
Rank
2013
Rank
Company Geography Industry R&D
Spend ($Bn)
*
1 1 Volkswagen Germany Automotive 13.5
2 2 Samsung South Korea Computing and electronics 13.4
3 4 Intel United States Computing and electronics 10.6
4 5 Microsoft United States Software and internet 10.4
5 3 Roche Switzerland Healthcare 10.0
6 7 Novartis Switzerland Healthcare 9.9
7 6 Toyota Japan Automotive 9.1
8 10 Johnson & Johnson United States Healthcare 8.2
9 12 Google United States Software and internet 8.0
10 8 Merck United States Healthcare 7.5
11 11 GM United States Automotive 7.2
12 14 Daimler Germany Automotive 7.0
13 9 Pfizer United States Healthcare 6.7
14 N/A Amazon United States Software and internet 6.6
15 N/A Ford United States Automotive 6.4
16 15 Sanofi-Aventis France Healthcare 6.3
17 13 Honda Japan Automotive 6.3
18 16 IBM United States Computing and electronics 6.2
19 17 GlaxoSmithKline United Kingdom Healthcare 6.1
20 N/A Cisco United States Computing and electronics 5.9

* R&D spend data is based on the most recent full-year figures reported prior to July 1st.

Volkswagen has been the largest private sector R&D investor for 3 straight years. The Group employs over 40,000 research personnel working to expand the Group’s model range with a particular focus on the reduction of CO2 emissions. The automotive industry is undergoing a generational transformation, with Tesla leading the way in electronic cars, hybrids increasingly gaining traction, and new players like Google and Apple entering the market with driverless technologies. All of these are highly disruptive for an industry, whose power source has been fundamentally unchanged since the internal combustion engine replaced steam boilers 100 years ago. R&D investments are therefore critical for Volkswagen to sustain an edge over competition and adapt quickly to a changing industry landscape.

In the Tech space, Samsung has more than doubled their R&D spending over the past six years, as illustrated in the chart below. This is not surprising, given the cut-throat competition in two of Samsung’s major revenue generating businesses, smartphones and semiconductors. In the smartphone segment, threats from both established entities (Apple) and new low cost entrants (Lenovo, Huawei, Xiaomi) keep Samsung on its feet as switching costs in handsets is next to zero for its customers. And for semiconductors, competition is also intensifying among the largest manufactures including Intel, TSMC and Qualcomm.

Exhibit 2: Top 3 Enterprise by R&D Expenditure 2009-2014 (US$ Billions)

Top 3 Enterprise by R&D Expenditure 2009-2014 (US$ Billions)

Source: Strategy&

But even companies that are traditionally perceived to be relatively mundane can offer surprisingly innovative initiatives. In a constantly changing macro environment, these companies are either forced to innovate themselves, or alternatively, buy into new technologies to differentiate and gain an edge over their competitors. Research and development is increasingly critical to drive their success. Here we give three examples of such companies, drawn from our approved list and which span across the consumer, industrials and materials sectors.

Givaudan, a leading provider of flavours (for the food and beverage industry) and fragrances (perfumes, personal care, consumer products), at first glance, seems far from technological. The company however, spends 10% of their sales on R&D to develop new molecules (that are patented), proprietary solutions or improve existing formulation that will create value for their customers (e.g. more use of natural ingredients, cost reduction through alternative or substitutes among others). Their products form 3-5% of their customers’ cost base, but taste and smell are highly influential factors when consumers make a decision to purchase an end product. Therefore Givaudan’s customers (for example, Nestle), are less willing to switch to a cheaper provider at risk of reputational damage should the cheaper alternatives not live up to their standard.

Assa Abloy is a leading manufacturer of security locks and automatic doors. In a highly fragmented market, the company must innovate to differentiate themselves from their peers, holding over 500 patents with another 300 applications pending. They have a robust product pipeline, in which new products developed in the last 3 years constitute 32% of sales. What makes them more interesting is their lesser known division that operates in secure solutions, embracing existing technologies including NFC, biometrics and RFID for uses in credential management, secure IDs (i.e. US green card, e-passport, drivers’ licences), asset tracking and logistics, and healthcare (RFID tags).

PPG Industries, a paint manufacturer (a more recognisable subsidiary perhaps being Dulux), also puts substantial efforts into R&D. Their industrial/specialty coatings business, in particular, requires them to adhere to universal or industry specific demands. Depending on circumstances, products must be corrosion proof, weather proof, scratch resistant, insect repellent (architectural), health conscious (for food packaging coatings). They need to think about environmental impacts, adhesion properties (to different surfaces) and application methods (e.g. electro-coat, pre-treatment, powder or liquid). Other innovations are cost or sustainability driven. For example, coatings on aeroplanes needs to be specially designed to achieve cost-savings for the client through reduction in weight/quantity without altering the finish, thereby reducing the fuel cost per flight.

We look for companies that can identify the direction of global industry trends and are flexible enough to take advantage of a changing ecosystem.

Renishaw, a £2 billion market cap, UK industrial company, has a longstanding history of innovation in metrology products with wide applications in many end-markets, including automotive, aerospace, energy, power generation, construction, agriculture, medical and consumer products. The company is a beneficiary of ongoing trends in industrial automation and demands for high precision measurement, calibration, sensory, gauging and probing tools. The company invests heavily in R&D in excess of 15% of sales, which is the highest among peers, and holds a portfolio of 1,500+ patents. More recently, they have added a 3D printing business and a healthcare portfolio leveraging Raman spectroscopy technologies, recognising the wide application potential of the two businesses across multiple industries.

In the Cerno Global Leaders Programme, we place great emphasis on finding companies that can deliver and sustain technological advantage over the long-term, driving a defensible competitive position. R&D activity provides evidence of this commitment. We deploy a wider definition for the term ‘leader’ that also includes the explicitly and implicitly technology inclined companies such as the names mentioned in the examples above.  Exhibit 3 below displays the Top 10 firms in the Global Leaders Programme with the greatest commitment to research and development.

Exhibit 3: Top 10 firms in the Cerno Global Leaders Programme by R&D expenditure (US$ billions)

Company Geography Industry R&D
Spend (US$Bn)
R&D (as % of sales)
Volkswagen Germany Automotive 4.5 6.0%
Samsung South Korea Computing and electronics 8.0 6.9%
Johnson & Johnson United States Healthcare 6.6 11.4%
Novo Nordisk Denmark Healthcare 13.4 15.5%
Nestle Switzerland Consumer Staples 0.2 1.8%
PPG Industries United States Materials 1.7 3.2%
Givaudan Switzerland Materials 4.8 9.2%
Reckitt Benckiser United Kingdom Consumer Staples 10.4 1.6%
Assa Abloy Sweden Industrials 6.2 2.6%
Zimmer Holdings United States Healthcare 2.0 4.0%

Source: Bloomberg

One final point to take note is, however, R&D spending does not automatically translate to innovation. In other words, quantity does not always equate quality. When selecting companies, it is important to understand where their R&D focuses lie, and to assess the impact on the company itself and how influential it is on the industry as a whole. Exhibit 4 below shows the Top 10 most innovative companies globally, and it is clear that the constituents have changed somewhat compared to Exhibit 1. While Apple, Google and Amazon spend less on R&D, what they have achieved is regarded to be more influential across multiple industries that are not restricted to the one they belong to and have wider implications for the global communities.

Exhibit 4: Top 10 most innovative firms of 2014

2014
Rank

2013 Rank

Company Geography Industry

R&D Spend ($Bn)*

R&D Spend (% of sales)

1

1

Apple

United States

Computing and electronics

4.5

3.3%

2

2

Google

United States

Software and internet

8.0

14.9%

3

4

Amazon

United States

Software and internet

6.6

10.4%

4

3

Samsung

South Korea

Computing and electronics

13.4

6.0%

5

9

Tesla Motors

United States

Automotive

0.2

14.5%

6

5

3M

United States

Industrials

1.7

5.6%

7

6

General Electric

United States

Industrials

4.8

3.6%

8

7

Microsoft

United States

Software and internet

10.4

13.1%

9

8

IBM

United States

Computing and electronics

6.2

5.9%

10

N/A

Procter & Gamble

United States

Consumer

2.0

4.8%

* R&D spend data is based on the most recent full-year figures reported prior to July 1st.

Source: Strategy&

The cyclically-adjusted price earnings ratio (CAPE), also known as Shiller’s P/E, continues to fascinate stock market watchers. The ratio, developed by the Nobel laureate Professor Robert Shiller of Yale University, and further popularised by market commentators such as John Authers, Andrew Smithers and Russell Napier, quantifies the relationship between the price of the stock market and its average 10 year real earnings. The CAPE has become widely used to gauge how over or undervalued a market is relative to its own history. It is often cited as a more useful metric than the conventional P/E ratio, based on a single year’s earnings, as the longer data essentially smooth out the volatilities over one business cycle.

Exhibit 1

US Equity Market Cyclically -  Adjusted PE Ratio

Source: Dr Robert Shiller, Yale University

According to data published by Dr Shiller[1], current CAPE at 26.5x is 61%, or 1.5 standard deviations, above its long-term mean of 16.6x, which does appear overvalued relative to its own history. The last time it reached this height was in October 2007, where it peaked at 27.5x before the market’s subsequent crash.

Cerno Capital studied this subject in some detail back in 2012, with a particular focus on the US market. We concluded that there is an inverse relationship between CAPE levels and future stock market returns, but that this is only significant over long horizons of 10 years and beyond. Comparing CAPE against forward market returns for short (1Y) and long (20Y) time horizons in Exhibit 2, the one year returns produce much more volatility and noise, while a clear trend is observable in the twenty year returns.

Exhibit 2

Short Horizon 1 year graph Long Horizon 20 year graph

Source: Cerno Capital

The scatter diagrams in Exhibit 3 illustrate this as well. As the time horizon stretches outward, the negative correlation becomes more evident with a tightening of returns dispersions.

Exhibit 3

Forward 1Y graph Forward 10Y graph Forward 20 year graph

Source: Cerno Capital

To test the level of significance, we mapped out the correlations between CAPE and future returns for different time horizons. In the short to medium term (1-5 years) correlations lays between a weak -0.15 to -0.35. The relationship strengthens as the years increase. Long term returns of over 10 years become more interesting as correlations rise to -0.5 and eventually tail off at -0.66 by the 20th year, a far more significant reading.

Exhibit 4

Correlation of CAPE vs. Rolling Year Returns graph

Source: Cerno Capital

So what does the current level tell us? We assessed the probability of losing capital associated with different levels of CAPE using past 100 years data. Buying into the stock market at current levels of 26x makes the future look rather bleak with over 60% chance of losing money over the next 10 years.

Exhibit 5: Probability of loss at different levels of CAPE over different time horizons

 CAPE

Forward  12M

Forward 3Y

Forward 5Y

Forward 10Y

Forward 20Y

< 7.9x

38.1%

25.6%

14.0%

4.7%

2.3%

7.9x – 12.7x

38.3%

31.5%

30.5%

15.6%

6.5%

12.7x – 20.6x

40.4%

36.3%

39.9%

36.1%

28.8%

20.6x – 28.4x

44.7%

49.1%

54.5%

66.7%

92.2%

28.4x – 36.3x

52.9%

55.9%

67.6%

64.7%

100.0%

>36.3x

48.4%

93.5%

100.0%

100.0%

Source: Cerno Capital

The next biggest question, however, is much more difficult to answer.  And that is when will it happen?

The major caveat with CAPE is the fact that it has very limited, if any, use as a market timing tool.  Previously, it correctly signalled that the US market was overpriced prior to the dotcom bubble, and levels stayed stubbornly high for the first half of the previous decade leading up to the 2008 financial crisis. However, had investors exited too early pre-2002 or stayed out of the market between 2002-2007, they would have also missed out on fine opportunities to make money. It is difficult to foresee how long an over-exuberant market will continue its upward trajectory or how long bearish sentiments will last before mean reversion finally kicks in.

There has been increasing debate in the financial world in recent years scrutinising the statistical details of CAPE, making adjustment for changes in tax regimes and/or accounting practices. Critics of the metric argue that CAPE has not signalled cheapness in a long time, and often cite earnings as the main source for error (e.g. reported earnings are too high). Jeremy Siegel, a Professor at Wharton Business School, proposed alternatives such as using National Income and Product Accounts (NIPA) for the US series. The exhibit below shows that NIPA CAPE had always been less bearish than the standard method, and in particular the past few years display the largest discrepancy between the two measures. Indeed, on this measure, the valuation does not appear stretched.

Exhibit 6

Cape vs NIPA CAPE graph

Source: GMO, Shiller, WorldBeta

Advocates of CAPE such as James Montier from GMO on the other hand, rebuffed this argument in his paper ‘A CAPE Crusader ─ A Defence Against the Dark Arts’ earlier this year. He constructed a long-term series of 7 year predicted returns by mean reverting CAPE towards the average over the next 7 years, adding a constant growth factor (6%) to reflect growth and income. Comparing the actual realised returns with the predicted returns side by side (as shown below), he demonstrated that CAPE has done a reasonable job of capturing realised returns over the long run, countering that if anything, it over- rather than underestimates returns.

Exhibit 7

Shiller PE Predicted Returns graph

Source: GMO, Global Financial Data

Once again, this brings us to the conclusion that CAPE is still a sensible valuation metric, but only for long horizons. There are reasons to suggest that the UK and Europe, whose performances have lagged of late, will trail the trajectory of the US in terms of valuations. However, for other markets such as Japan, due to the lack of long-term data, and because valuations are wildly distorted by the 1980s bubble where levels reached over 100x, it makes no sense to suggest that at current levels of 21x the CAPE will mean revert back to the 54x average.

Exhibit 8

Japan Equity Market Cyclically Adjusted PE Ratio 1979-2014 graph

Source: MSCI

Our view remains that CAPE is a useful indicator for investors who are truly long term where the long term is defined as being periods of over 10 years or more. Over that time frame, US equity market equity returns could well disappoint. We find the inherent probabilities sufficiently convincing to have already trimmed our broad S&P exposures. On other markets, CAPE cannot be relied on to any degree as the data series are not long enough to store any trust in the average ratings.

As ever, Apple’s product launches are greatly anticipated and 9th September was no exception. At that launch the iPhone 6, iPhone 6 Plus, Apple Watch, and an intriguing new payment platform, Apple Pay were revealed to the world.

Thanks to its tightly integrated iOS ecosystem, Apple’s hardware tends to feel less commodity-like compared to its peers and, as a consequence of Apple’s integration in users’ lives, the explicit and implicit costs of switching mount.

Its iPhones, iPads, iMacs, and the newest addition to the family, the Apple Watch, complement each other well by synchronising everything from apps to media (music, films and TV shows) to personal data (contacts, calendars, photos, etc.) through its iCloud and iTunes platforms. Apple’s ever growing application universe is a clear money-spinner.

Given the typically short product replacement cycle of 2-4 years for personal electronics, building a loyal customer base is thereby essential to the success of the business over the long-term in this maturing and highly competitive market.

It is generally thought that this loyalty lies on the sleek design, interface, simplification and sheer “wow” of their products. However, whilst the techies will froth on the screen size and resolution, the more meaningful business development is Apple’s grip on users’ lives. FT’s Lex column harpooned this fact in their column of 5th September stating that “most of those who shell out for the next iPhone will not be buying a phone, they are paying a toll”.

This is a toll to a near private garden. The iOS system is relatively simple when operated from within. However, access from a different operating system (say Android) can often be fraught with difficulty. Much of the data, especially licensed media, is either non-transferable or give people a very hard time when they try. For Apple users, hardware upgrades is as much a means to maintain access to the system as enjoying increasingly smaller benefits in feature specifications.

If confirmation were sought of this, it has arrived in the form of Apple Pay. Apple Pay utilises NFC (near-field communication) technology to enable contactless credit card payments in physical stores and allows ‘one-click’ online purchases (no card details to fill in) via the new iPhone and the Watch. While it may not contribute materially to near-term revenues, it offers a potentially valuable service that will further cement customers to the iOS system, if proved successful. Once the phone or the watch becomes your wallet, it will become more challenging to persuade users to depart.

In a stroke, Apple Pay is poised to take advantage of US$12 billion of daily transactions value in the US. Already, it gained strong financial institution and retail endorsements with negotiations held in typical Apple secrecy. Early backers include eleven of the biggest US card issuers including Visa, Mastercard, American Express and several major banks, collectively representing 83% of the market. Retailers such as McDonald’s and Walgreens are also on board. Further, they will be paying Apple 15 cents for every US$100 purchase for this privilege, an impressive feat of Apple’s bargaining power in persuading the key players in the payment industry to give up a slice of their revenue, something neither Google Wallet nor CurrentC (developed by MCX – Merchant Current Exchange) has managed to achieve.

As mobile devices handles increasingly sensitive personal information such as health/fitness records and payment details, data privacy and security is paramount to the integrity of the business, especially in light of the recent iCloud hacking debacle. In attempt to address these concerns, credit card details will not be stored nor shared on the device or in Apple’s servers. Instead, a transaction is authorised via one-time payment numbers, dynamic security codes, touch ID, and Apple forfeits a potentially lucrative opportunity to monetise user data by not tracking user purchases.

Whilst the technology is nothing new, Apple has timed its launch well. A major change set to occur in the payment landscape will require the majority of some nine million merchants to deploy new hardware in their stores within the next year, in compliance with the EMV (Europay, MasterCard & Visa) standard, and to reduce fraud levels rampant in the traditional magnetic strip system. Banks have made concerted efforts to push merchants to upgrade their POS (point of sale) systems to the ‘Chip & Pin’, widespread in Europe but virtually non-existent in the US (which still uses the traditional system). From 2015 onwards, issuers like Visa and MasterCard will no longer cover the cost of credit card fraud for retailers still on the old system. The new terminals should allow both PIN and NFC transactions, and streamlining of the online payment could also help speed up the uptake of Apple Pay.

iTunes revolutionised the music industry back in the mid-2000s. For the time being, card issuers and merchants believe that Apple Pay is a benign partner, forecasting an increase in transaction volumes to offset the fees they surrender to Apple. The transition process will take time, it remains to be seen whether this system, with its 800 million credit cards already on file (via iTunes Store), will disrupt to the payment industry on a similar scale.As ever, Apple’s product launches are greatly anticipated and 9th September was no exception. At that launch the iPhone 6, iPhone 6 Plus, Apple Watch, and an intriguing new payment platform, Apple Pay were revealed to the world.

Thanks to its tightly integrated iOS ecosystem, Apple’s hardware tends to feel less commodity-like compared to its peers and, as a consequence of Apple’s integration in users’ lives, the explicit and implicit costs of switching mount.

Its iPhones, iPads, iMacs, and the newest addition to the family, the Apple Watch, complement each other well by synchronising everything from apps to media (music, films and TV shows) to personal data (contacts, calendars, photos, etc.) through its iCloud and iTunes platforms. Apple’s ever growing application universe is a clear money-spinner.

Given the typically short product replacement cycle of 2-4 years for personal electronics, building a loyal customer base is thereby essential to the success of the business over the long-term in this maturing and highly competitive market.

It is generally thought that this loyalty lies on the sleek design, interface, simplification and sheer “wow” of their products. However, whilst the techies will froth on the screen size and resolution, the more meaningful business development is Apple’s grip on users’ lives. FT’s Lex column harpooned this fact in their column of 5th September stating that “most of those who shell out for the next iPhone will not be buying a phone, they are paying a toll”.

This is a toll to a near private garden. The iOS system is relatively simple when operated from within. However, access from a different operating system (say Android) can often be fraught with difficulty. Much of the data, especially licensed media, is either non-transferable or give people a very hard time when they try. For Apple users, hardware upgrades is as much a means to maintain access to the system as enjoying increasingly smaller benefits in feature specifications.

If confirmation were sought of this, it has arrived in the form of Apple Pay. Apple Pay utilises NFC (near-field communication) technology to enable contactless credit card payments in physical stores and allows ‘one-click’ online purchases (no card details to fill in) via the new iPhone and the Watch. While it may not contribute materially to near-term revenues, it offers a potentially valuable service that will further cement customers to the iOS system, if proved successful. Once the phone or the watch becomes your wallet, it will become more challenging to persuade users to depart.

In a stroke, Apple Pay is poised to take advantage of US$12 billion of daily transactions value in the US. Already, it gained strong financial institution and retail endorsements with negotiations held in typical Apple secrecy. Early backers include eleven of the biggest US card issuers including Visa, Mastercard, American Express and several major banks, collectively representing 83% of the market. Retailers such as McDonald’s and Walgreens are also on board. Further, they will be paying Apple 15 cents for every US$100 purchase for this privilege, an impressive feat of Apple’s bargaining power in persuading the key players in the payment industry to give up a slice of their revenue, something neither Google Wallet nor CurrentC (developed by MCX – Merchant Current Exchange) has managed to achieve.

As mobile devices handles increasingly sensitive personal information such as health/fitness records and payment details, data privacy and security is paramount to the integrity of the business, especially in light of the recent iCloud hacking debacle. In attempt to address these concerns, credit card details will not be stored nor shared on the device or in Apple’s servers. Instead, a transaction is authorised via one-time payment numbers, dynamic security codes, touch ID, and Apple forfeits a potentially lucrative opportunity to monetise user data by not tracking user purchases.

Whilst the technology is nothing new, Apple has timed its launch well. A major change set to occur in the payment landscape will require the majority of some nine million merchants to deploy new hardware in their stores within the next year, in compliance with the EMV (Europay, MasterCard & Visa) standard, and to reduce fraud levels rampant in the traditional magnetic strip system. Banks have made concerted efforts to push merchants to upgrade their POS (point of sale) systems to the ‘Chip & Pin’, widespread in Europe but virtually non-existent in the US (which still uses the traditional system). From 2015 onwards, issuers like Visa and MasterCard will no longer cover the cost of credit card fraud for retailers still on the old system. The new terminals should allow both PIN and NFC transactions, and streamlining of the online payment could also help speed up the uptake of Apple Pay.

iTunes revolutionised the music industry back in the mid-2000s. For the time being, card issuers and merchants believe that Apple Pay is a benign partner, forecasting an increase in transaction volumes to offset the fees they surrender to Apple. The transition process will take time, it remains to be seen whether this system, with its 800 million credit cards already on file (via iTunes Store), will disrupt to the payment industry on a similar scale.

Global Oil and Gas stocks have been rerated to levels not seen since 2000. Exhibit 1 (below) maps their relative decline in Price to Book Value (PBV) terms. In this respect, they are experiencing the mirror image phenomenon to that of Tech and Internet stocks, whose valuations have been rising. Energy companies are also asset heavy whereas Tech and Internet is often asset light.

Relative Price to Book Ratio Oil and Gas

Source: Cerno Capital, Bloomberg

Within the sector, Integrated Oil & Gas majors appear particularly cheap, trading on 1.2x book value on average (as recently as 2008, they were trading at multiples of 2-2.5x) a circa 40-50% discount to their peak valuations due to a combination of stagnant commodity prices and rising costs that have squeezed margins. Relative to the western groups, emerging National Oil Companies have fallen out of favour even more despite having greater access to resources and government support as investors are wary of a misalignment of interests between the shareholders and the government. The combined market value of state-controlled national oil companies fell 15% in 2013, while the value of the large western groups rose in aggregate by 9%, according to the analysis group IHS.

The Oilfield Services industry, on the other hand, has fared much better in general, having benefitted from the high capex of the big oil groups over the past few years. However, going forward we anticipate a reversal in industry trends as major integrated oil groups are under greater pressure from shareholders to curb spending and improve capital returns after years of heavy capex engaging in increasingly challenging environments as companies pursue opportunities in high cost ventures (e.g. ask seek knock . deep-water, arctic, oil-sands) and acquisitions. Many, independents and NOCs alike, have trimmed their capex projections in recent months and announced divestment programmes to dispose non-core operations (downstream and mature upstream) to re-emerging as leaner, more efficient businesses geared towards higher quality growth.

Price to Book vs ROE Oil and Gas

Source: Cerno Capital, Bloomberg

Aside from the attractive valuations, this sector offers a superior dividend yield and a low debt to equity ratio, on average. The trade-off between return on equity and book value is compelling on both absolute and relative terms, as displayed in Exhibit 2, in which a basket of equally-weighted global integrated O&G majors (red) sits at the bottom of the spectrum against other MSCI sectors in terms of book value with an above trend ROE.

Rather than take on the clearly high level of company specific risk entailed by stock picking in a sector with heavy government and regulatory overhang, a basket approach makes sense.

Table 1 features a putative basket of companies from Bloomberg’s global O&G universe. The criteria in this case were 1) attractive valuation 2) commanding asset position (exemplified through high proven reserves relative to market capitalisation) 3) high reserve replacement ratio from existing claims and 4) favourable cost structures. The resulting basket incorporates a mix of independent and quasi state owned majors from both developed and emerging economies, which helps to achieve diversification benefits, thereby minimising the impact of any company-specific risk.

a putative basket of  oil and gas companies

Source: Cerno Capital, Bloomberg

Global Oil & Gas companies have low growth implied in their current share prices. They have bona fide value credentials.Global Oil and Gas stocks have been rerated to levels not seen since 2000. Exhibit 1 (below) maps their relative decline in Price to Book Value (PBV) terms. In this respect, they are experiencing the mirror image phenomenon to that of Tech and Internet stocks, whose valuations have been rising. Energy companies are also asset heavy whereas Tech and Internet is often asset light.

Relative Price to Book Ratio Oil and Gas

Source: Cerno Capital, Bloomberg

Within the sector, Integrated Oil & Gas majors appear particularly cheap, trading on 1.2x book value on average (as recently as 2008, they were trading at multiples of 2-2.5x) a circa 40-50% discount to their peak valuations due to a combination of stagnant commodity prices and rising costs that have squeezed margins. Relative to the western groups, emerging National Oil Companies have fallen out of favour even more despite having greater access to resources and government support as investors are wary of a misalignment of interests between the shareholders and the government. The combined market value of state-controlled national oil companies fell 15% in 2013, while the value of the large western groups rose in aggregate by 9%, according to the analysis group IHS.

The Oilfield Services industry, on the other hand, has fared much better in general, having benefitted from the high capex of the big oil groups over the past few years. However, going forward we anticipate a reversal in industry trends as major integrated oil groups are under greater pressure from shareholders to curb spending and improve capital returns after years of heavy capex engaging in increasingly challenging environments as companies pursue opportunities in high cost ventures (e.g. ask seek knock . deep-water, arctic, oil-sands) and acquisitions. Many, independents and NOCs alike, have trimmed their capex projections in recent months and announced divestment programmes to dispose non-core operations (downstream and mature upstream) to re-emerging as leaner, more efficient businesses geared towards higher quality growth.

Price to Book vs ROE Oil and Gas

Source: Cerno Capital, Bloomberg

Aside from the attractive valuations, this sector offers a superior dividend yield and a low debt to equity ratio, on average. The trade-off between return on equity and book value is compelling on both absolute and relative terms, as displayed in Exhibit 2, in which a basket of equally-weighted global integrated O&G majors (red) sits at the bottom of the spectrum against other MSCI sectors in terms of book value with an above trend ROE.

Rather than take on the clearly high level of company specific risk entailed by stock picking in a sector with heavy government and regulatory overhang, a basket approach makes sense.

Table 1 features a putative basket of companies from Bloomberg’s global O&G universe. The criteria in this case were 1) attractive valuation 2) commanding asset position (exemplified through high proven reserves relative to market capitalisation) 3) high reserve replacement ratio from existing claims and 4) favourable cost structures. The resulting basket incorporates a mix of independent and quasi state owned majors from both developed and emerging economies, which helps to achieve diversification benefits, thereby minimising the impact of any company-specific risk.

a putative basket of  oil and gas companies

Source: Cerno Capital, Bloomberg

Global Oil & Gas companies have low growth implied in their current share prices. They have bona fide value credentials.

Of great interest to us are the internal workings of markets. These are often very good indicators of where we are in the ebb and flow of valuation cycles. Valuations work, provided you are patient. They especially work if the constructed relationship is mean reverting and also non-mainstream.

Recently, we have been looking at equity valuation dispersions: that is, the gap between highly valued equities at one end and lowly valued equities at the other. It is unproductive to guess at where the natural relationship lies: it can be plotted and therefore a mean or average level can be observed, but does the average mean anything in this instance?

Of greater interest is when the range relationship becomes distorted due to the radical re-pricing of one group, or a thematically linked group of stocks.

 

normalised

 

A glance at the above chart indicates that, in recent financial times, this happened most dramatically in the TMT bubble which burst in 2000. In 2000 the ratio of the book multiple of the high price to book value stocks ran up to a multiple of 2x that of low price to book value stocks. Bear in mind, this is a measurement of all listed equities, not the most highly rated, nor is it sector specific. In the TMT boom, a group of telecom and tech companies became so spectacularly overvalued that they pushed the averages.

The most recent plot of this relationship is suggestive that another wave of enthusiasm is engulfing markets and in some of the same places: tech and biotech, two sectors that are very well represented in the NASDAQ index. The cumulative annual rate of outperformance of the NASDAQ compared with global equities has reached.

A simple chart of the world internet index against a world equities index reveals the magnum of outperformance very clearly.

BBIvsBBW

Turning back to our valuation dispersion chart: we note that an upswing is clearly underway. We also note that at a multiple of 1.3x, the relative valuation contortion is nothing compared to the 2000 period. Limited comfort can be drawn from this; the 2000 period measures as a 3.5x standard deviation event. It was the mother of all bubbles, unsurpassed by anything of the past 100 years and comparable only to the Japanese equity market bubble of the late ‘80s and the US residential bubbles of the ‘00s.

Financial commentators have become very sensitive in this area and the tendency to cry bubble has multiplied in recent years. Whereas we would certainly question the valuations on offer in some of the hotter concept areas, it is hard to entirely back the bubble claim.

The growth oriented equity investor is left in an uncomfortable place. In a world where the paths to commercialising intellectual property have become admirably short, we wish to invest in new technologies where human inventiveness is at its best. On the other hand, investors of every stamp know that one of the greatest determinants of value obtained is the price paid.

A cooling would be helpful now, it has just started.

 

We remain of the view that investment returns from gold will disappoint.

It is a widely held belief that gold is an inflation hedge. We challenged this view in a recent piece entitled Inflation protection is a noble aim, but not a reliable strategy (see What normalisation means for investors elsewhere on this website http://cernocapital.com/investment-view/).

The “Golden Constant,” was coined by Roy Jastram (1978) in which he observed that historically gold has been a poor hedge of inflation in the short run but a good hedge of inflation in the long run. The real price of gold maintained its purchasing power over long periods of time and gold’s long-run average real return is zero.  If we assume this long term relationship to be true, then plotting the gold price against CPI would reveal if current gold prices are above or below CPI. Historical data from 1875 shows that the gold price today is significantly above CPI, or put differently, to revert to the long term trend of zero real return, gold should continue its downward path and stands currently 70% above the price suggested by the CPI trend line.  Gold is often referred to as possessing insurance attributes but at today’s prices it is an expensive inflation hedge.

Another approach to understanding the price fluctuations of gold in shorter time periods is to consider real interest rates. Real rates in the US can be observed through inflation linked bonds (TIPS). The measured correlation between 10-year TIPS real yield and the real price of gold is -0.82 (from 1997 and the present day). When real rates rise, the gold price tends to fall and when real rates fall then gold rises. We might assume causality based on the opportunity cost of holding gold. This data goes back only 16 years to when TIPS were first introduced in 1997. We have created a synthetic real yield for the US with the help of Jan Groen and Menno Middeldorp from Bank of New York Fed/Liberty Street Economics for the synthetic series and examined the data from 1971 (when gold was no longer fixed) to reveal a similar result: the correlation between the real yield and the real price of gold was -0.64 which again is significant.

Chart: Historical gold price vs. US 10Y real yield (1971-2013)

Gold Graph

Source: Federal Reserve Bank of New York, Bloomberg, Cerno Capital

It is still necessary to make assumptions about real yields in order to forecast the price of gold. Over a three year horizon, if we assume normalisation of interest rates and that inflation will be relatively stable in that time period, this would suggest higher real rates. Assuming stable correlations, the implication is for a lower price of gold.

 

Cross asset correlations have been rising for a number of years as the commodification of finance proceeds apace. In tandem with this, cross regional international equity market correlations have risen with the penetration of emerging markets’ consumer markets and the infiltration of emerging markets in the global production chain. Apple sells as much stuff in Asia as it does in Europe these days.

These factors alone have been challenging the Yale Model of endowment management where an investor seeks to avail himself of diversification benefits. The 2008 financial crisis blew these correlations up to levels never before seen.

Our view is that these effects are now dissipating, a process hastened by normalisation.

Correlation analysis, as practiced by financial firms, is riddled with mischievous thinking and scurrilous salesmanship. When correlations are deployed to make a point, or sell a security, beware! The Fed Model, which suggests that there is some relationship between bonds and equities is bunku

Industry profitability, as measured by a firm’s return on capital employed (ROCE), is determined by how successfully a firm can capture the value it creates for its buyers, which can differ depending on the structure of the industry.  When the structure is favourable, companies are typically able to retain a decent proportion of the value (e.g. medical supplies). Conversely, in an unfavourable environment, much of this value would be competed away to others (e.g. autos), be it customers (driving down prices), suppliers (inflating costs), substitute products (reducing differentiation) or potential or existing rivals (eroding market share).

It is also important to distinguish between cyclical factors that affect short-term profitability, such as the weather or a particular business cycle, from the structural fundamentals that shape long-term profitability. This is manifested through the collective strength of the five key competitive forces (defined by the consultant, Michael E. Porter) that governs price, cost, and investment input required:

 

5ForzePorter1

Often one or more of the five forces will take prominence in an industry. For example, in an industry with an oligopolistic market structure, natural barriers exist inhibiting new entrants via cost economies of scale. Further, these companies command superior pricing power as consumers have limited alternatives; therefore the main threat lies with its existing adversaries. expired domain list On the other end of the scale, in an industry comprising of many competitors where entry barriera are low, substitutes can easily transpire and so the bargaining power of customers becomes a greater risk. In this case the firm suffers intense pressure from a multitude of the ‘forces’, weighing down profitability.

A firm must be able to identify the dominant force(s) within its industry and position defensively against them to stay relevant in the long-run. Thereby, industry structure will become a critical influence on the competitive strategy undertaken.  It is also essential to realise that industry trends can change over time. A firm is not tied down by its industry, on the contrary, it can actively improve the industry’s intrinsic attractiveness by finding innovative ways to compete and alter the overall industry dynamics for the better as long as the strategy they employ is a constructive one.

The application of classic Porterian criteria is central to our selection of “global franchise companies”.  Although the underlying thinking can be critiqued as having become generic, even homespun, it is remarkable how strong these factors are in explaining long term equity returns at the individual company level. The key words here are “long-term” as most investors, including institutional investors, simply do not invest with long enough time horizons for Porterian forces to exact their toll. The impatient human mind is drawn into shorter term trends and is prone to overreact to temporal data changes. A watchword for this over-caffeinated approach is “thematic investing”. Beware the thematic investor.

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