17/2/16: Markets Do Come Back... But Not ISEQ

Back in 2008, when the Irish markets were tanking, one of the managing partners in a large Irish stock brokerage issued an infamous research note, telling clients that while things were bad, things will be good again.  The main point of the note was that "markets do come back" no matter what.

As evidence of such "comebacks", the author of the note offered an anecdote of his relative trying to sell property prior to the onset of the Asian Financial Crisis at the end of the 1999. The sale, having fallen through due to the crisis hitting hard, was completed at 2/3rds of the original offered price some 8 years ago. This was the analyst's evidence for the 'inevitability of recovery'.

Back at the time the note was issued, I pointed out to the said analyst that he missed a major problem: inflation. By the time his relative did conclude the sale, the price he/she got for the property was down 80% or more, not 33%, because 8 years of inflation chewed through his/her returns.

Ever since then, I have been tracking (occasionally - usually once a year) Irish stock exchange broadest index, ISEQ, for the signs that "markets do come back". Here is the latest update: we are still waiting for when they "come back".

In nominal terms, things are dire:

Even though ISEQ no longer contains the hardest hit, by the crisis, equities - a little cheat trick used by Irish Stuffbrokers to sell ISEQ 'returns' is never correcting them for survivourship bias, but let us indulge them on this - ISEQ is still massively below pre-crisis peak. It has not 'come back', but instead, on its peak-to-trough way, in nominal terms, it was falling 972.6 points per month on average and on its 'coming back' way from the trough it has been averaging gains of just 46.2 points per month. Which means the market drop rate was 20 times faster than the market's 'coming back' rate.

However, in real (inflation-adjusted) terms, ISEQ is in a horrific shape. even though inflation has been extremely low, it has been present nonetheless. And chart below shows ISEQ in inflation-adjusted terms:

The freak show of Irish stocks is self-evidently not in a rude health. The 'coming back' of the Irish markets is so bad, that if you invested in them during October 1997-December 1999 period, today you would have lost, on average 10% of your investment, and if you invested in ISEQ back in 1Q 1998, you would be down 15.8% once inflation is factored in.

Worse, compared to pre-crisis peak, we are nowhere near that 'come back' territory, some 8 years and 9 months after reaching the peak, the index is still 41.4% down in real terms. Current level (using last 3 months average) of the index is below all period averages for the index, save for the period of post-dot.com crash, but using latest ISEQ reading (instead of a 3mo average), the market now is below even that abysmal period average.

Thus, overall, at current position, ISEQ offers us not the lesson of a market that "comes back", but a market that goes nowhere over the last 18 years. And that, folks, is the combined power of inflation and nonsense that is Irish Stuffbrokerage research... err... marketing.

Economics 23/12/2009: Ending 2009 in Red

As 2009 is drawing to a close, let's take a quick look at the broad shares performance in Ireland. starting with a 10-year picture for ISEQ, S&P500 and Nasdaq:
This clearly shows just how dreadful the crisis has been for Ireland - in terms of total decline on the peak valuations. A five-year view confirms this:
But it also shows that 2008 was much worse for Ireland Inc than it was for the benchmarks. And despite the deceptive nature of statistics (remember - we started 2009 at a much lower valuation than other indices, so we could have expected a much stronger bounce from the bottom over 2009 bear rally), we remain heavy underperformers over 5 year horizon.
Ditto over the two year horizon although much closer/tighter view on the 2009 alone:
And if you were swayed by the 'buy' signals from our ever-optimistic brokers in the H2 2009, here is what you've been aiming for:
Yeeeks... At the beginning of the year, I predicted that the markets will continue discounting Ireland throughout 2009 on the back of the adverse news flow (deeper recession, failures in fiscal governance and collapse of banking) relative to the broader global indices. Clearly, they did.

Oh and one more reminder - back in July-August 2008 an MD of our top-5 stockbrokerage firms issued a fanfare-sounding Green Jersey note telling his clients that 'markets come back'.
Were we to listen - we would be buying ISEQ at 5,070 and valuing it today at under 3,000 - a 40.8% drop. Some price for a Green Jersey.

Oh, and it wasn't exactly a ride for the risk-averse, even compared to the scary trender like Nasdaq:
So markets do come back, don't take me wrong - except in their own time and at their own speed. Better luck in 2010, folks!

Daily Economics Update 21/03/2009

Weekly analysis: Irish shares

The volume of shares traded on the New York Stock Exchange has topped the 50-day moving average on six of the seven days that the stock market has been up since March 6 (the day on which the S&P 500 touched its most recent low). The broad benchmark index has gained 15% since that low, sparking hopes of a recovery. The significant issue here is in the volume figure, not in the actual rise in the index, as stronger volumes on a rising trend tend to support more risk-taking and signal investors' support for the trend.

Interestingly, the same, but less pronounced, process has been starting on Friday in the Irish markets.
Chart above shows last week's movements in ISE Total Price Index (IETP), Irish Financials Index (IFIN), AIB, BofI and IL&P shares. Strong upward trajectories here, with significant volatility. But all underpinned by good (well above the average) volumes, as per chart below.This is less pronounced when we normalize daily volumes by historical average, as done in the chart below.
Less extraordinary change is underway above, because we are using moving averages as normalizing variable, implying that we actually capture the inherently rising volatility in volumes traded here. So the above chart actually suggests that while Friday up-tick in share prices (and pretty much the last three day's rally) was reasonably well underpinned, it will take some time to see if market establishes a solid floor under the share prices.

Monthly results so far remain weak. Only BofI was able, so far, to recover all monthly losses and post some gains. AIB is just hitting the point of return to late February valuations. Given that at the point of sale - at the end of February, beginning of March - the volumes traded were 5-7 times those of the current week's peak, it is hard to see the present recovery as being driven by pure psychology and the spillover from the broader global markets (US' momentary lapse of optimism).

Two more charts: recall that in mid February I argued that downgrades in all three financials will come to an end by February's expiration and all three will settle into a nice slow bear rally, running at virtually parallel rates of growth. Chart below shows that this is happening, indeed.Once we normalize prices and account for volumes traded, there is nothing surprising in the share prices movements since the beginning of March. And this is exactly where, as I argued before, the markets should be: awaiting news catalysts...

Daily economics update 19/03/2009

Excellent piece on Irish Nationwide excesses here - I would certainly encourage everyone to read through it.


On the news front -

Ireland:
Per CSO (here): the number of overseas trips by Irish residents fell by 8.4% to 502,100 in January 2009 compared to the 548,400 a year ago. Brian^2+Mary's tax on travel and recession biting. And euro's steady rise has taken a bite out of travel to Ireland too: there were 424,200 overseas trips to Ireland in January 2009 - down ca3% on 2008. "Visits by residents of Great Britain accounted for virtually all of this decrease, falling by almost 16,000 (7%) to 208,300." Needless to say - this is costing this country. Visits by residents of Other Europe and North America recorded slight increases to 149,500 and 45,200 respectively. No breakdown on vitally important length of stay and locations visited by foreign tourists here was made available. The crucial point missing here is just how bad is it going to get for Irish hotels, located outside Dublin. In recent months, these palaces of rural kitsch built on the back of senile tax breaks to developers, courtesy (in part) of Brian Cowen in his tenure as Minister for Finance, have been popping out of business like flies in late autumn.

Also courtesy of CSO:
Monthly factory gate prices increased by 0.9% in February 2009, as compared with an 0.2% rise recorded a year ago, the annual increase of 3.9% in February 2009, compared with and annual rate of growth of 3.2% in January 2009. Inflation cometh? Well, possibly. In the year the price index for export sales was up 4.3% while the price index for home sales was up 1.7%.

Wholesale price changes by sector of use shows that: Building and Construction All material prices decreased by 1.2% in the year since February 2008 (surprisingly, very small deflation in the face of all but collapsed construction), and there were increases in Cement (+8.0%), and Stone, sand and gravel (+4.8%). At least Sean Quinn can always go back to mining boulders. Year on year, the price of Capital Goods decreased by 0.1%, and the rate is accelerating to -0.4% last month. The price of Energy products increased by 5.2% in the year since February
2008, while Petroleum fuels decreased by 17.9%. So ESB and Board Gais are still ripping us off, while teh Government is fast asleep. In February 2009, there was a monthly increase in Energy products of 0.4%, while Petroleum fuels increased by 1.6%.

But hey, the good news is that we are now in a 'breeding boom'. According to the CSO, there were 19,027 births registered in Q2 2008, an increase of 1,900 on 2007. Q2 2008 total is 40% higher than in 1999. "This represents an annual birth rate of 17.2 per 1,000 of the population, 1.4 above quarter 2 of 2007. This rate is 2.7 per 1,000 population higher than in
1999."

Incidentally, the latest US data shows that the country population is also booming. The preliminary estimate of births in 2007 rose 1% to 4,317,119, the highest number of births ever registered for the US. The general fertility rate increased also by 1% in 2007, to 69.5 births per 1,000 women aged 15–44 years, the highest level since 1990.

Clearly a good sign for Brian^2+Mary, who can now rest asured that Irish families are producing more future taxpayers for the Government to continue ripping off ordinary families. The bright future is at hand at last for public sector wages and pensions.


US:
There are some signs of longer-term lead indicators revival in the US. Much has been said about housing starts bottoming out and the fact that these are only long-term lead indicators for house prices (see here).

Unemployment - new claims have fallen by 12,000 to 646,000 in t he week ending March 14, while the numbers collecting unemployment benefits rose by 185,000 to a record seasonally adjusted 5.47 million by March 7th. The four-week average of new claims also rose by 3,750 to 654,750, the highest level in 26 years. Still, at least some things are starting to move in the right direction.

In the mean time, General Electric said it now expects GE Capital Finance unit to be profitable in Q1 and for the full year 2009. This follows a recent $9.5bn injection of capital by the parent. This, if holds through the year, is good news, as GEFC has been at the forefront of writing dodgy loans and mortgages to distressed consumers in 2005-2007.

Of course, Wednesday data was also showing some signs of the bottoming in the US recessionary dynamics. US consumer prices increased a seasonally adjusted 0.4% in February, primarily on the back of a 3.3% rise in energy costs (8.3% rise in gasoline prices). Food prices fell 0.1% in the first decline since mid 2007. Core CPI (ex Food and Energy) was up 0.2% - a nice range signaling possible end of deflation.

This is not to say that the current rallies are sustainable. So far, we are starting to see some early stage recovery indicators attempting to find the floor. It will take couple of months for them to start turning. But the markets will remain bearish until the second stage indicators start flashing upward turn-around. These are existent unemployment claims, construction indices, pick up in resale markets activity, PMIs etc. Until then, you'll have to be brave to wade out of the cash safety into individual equities.

And the latest news on the second stage indicators is poor. The index of leading economic indicators - designed to forecast economic activity 6-9 months ahead - fell 0.4% in February, following a gain of 0.1% in January 2009. Overall, 6 out of 10 indicators were up in February and 4 were down. According to Ian Shepherdson, chief economist with High Frequency Economics, "The trend remains clearly downwards, consistent with continued outright contraction in the economy."

Market View: Lenihan's Cod Oil Sales Trip?

Weekly round up
We are in a thaw though don’t bet on this being a sign of global warming. The markets have shown some (to some not surprising) bounce in the latest (bear) rally. Across the world and here in Ireland. But the winter isn’t over, yet.

First where it all started from: the US. Some encouraging news:

• The U.S. trade deficit narrowed by 9.7% in January to $36bn, the lowest monthly gap since October 2002. This marks a sixth consecutive decline in the trade deficit, the first case of such extended contraction since the new data collection started in 1992. Oil and petroleum products deficit fell to $14.7bn in January, the lowest since September 2004. Trade deficit with China widened to $20.57bn relative to $20.31bn in the same month last year. Lower prices for inputs and commodities helped. In exports, main decreases were in the areas of capital goods and industrial goods – reflective of the global investment slowdown. Ditto in the area of imports (except that capital goods imports were down less than exports, suggesting companies continue to travel down the cost curve. Details here).
• US University of Michigan/Reuters consumer sentiment index notched up in March to 56.6 from 56.3 one month ago. While this beats analysts’ expectations (55.0), the improvement is hardly significant to signal any improvement in consumer spending and borrowing going forward. This is despite March being the first month of Obama’s massive stimulus plan – not exactly a ringing endorsement (for more on this see here)
  

So the last week came to be a somewhat bullish one with flat US Treasuries, low single-digit gains in commodities and a rally in stocks (up ca 10-14%) with commercial real estate-leading markets, like REITs. Up over 20%.
US Dollar has lost some ground on the Euro, further underlying markets desire to see continued strengthening of the US trade balance. In this beggar-thy-neighbour climate, good news for US is bad news for exports-driven Ireland.

Financials
JP Morgan and Morgan Stanley (first chart below) illustrate the rally for the financials. Most of the sector gains were probably due to rising levels of speculative news flow. If this is a signal of a renewed focus on balance sheet health, expect the rally to turn into a deep correction. Bank of America (BAC) – up some 85% during the week – is a case in point. There is no fundamentally new development, yet this week’s statements about improving outlook on profitability pushed the stock to the top of the financial shares (Citibank (C), Wells Fargo (WFC) etc) performance rankings. The second chart below illustrates, while highlighting the relatively poor performance of non-financials.

Irish Markets
Pretty much the same picture holds for Irish markets. Two of the three remaining banks led the positive momentum with few features of note:

1. Volumes were relatively weak (running at ca ½ of the 52-weeks daily averages);
2. IL&P underperformed (with the markets having little faith in the bank side of the insurer, as in the past);
3. Overall ISEQ posted a lacklustre performance for the week, signaling that the main concerns about Irish economy’s fundamentals are still there.
   

These are illustrated below and show continued theme of volatility around a relatively flat broad markets trend - something I predicted a month ago.
The above concerns, of course are to continue next week as well.

Ireland Inc Sales Pitch
It is now being rumored that Mr Lenihan is going on that 'road trip' to showcase Ireland to UK (and other international) investors. Here is a list of problems that I would put to him at such a sales meeting. All of these basically ask the same question - why would any investor expose herself to Ireland today.

1. Fiscal position: all the indications are that Minister Lenihan will opt for a ‘soft’ solution – raising taxes and refusing to inflict real cuts on the public sector. Thus, ‘savings’ on the current expenditure side will be pushed into 2011 or later as the Minister ‘cuts’ numbers through natural attrition. Taxes will hammer the economy today. Only an insanely naïve person can be convinced by such a strategy.
   
2. Corporate credit: debts problems continue to plague Irish companies, with more roll-overs and re-negotiations of the covenants. This will be compounded in weeks ahead by an accumulation of arrears to contractors and suppliers. Mini-Budget will spell a war of attrition between smaller services providers and larger contracting companies as the former struggle to extract payments in the environment where Messrs Lenihan and Cowen sneaking deeper into peoples' (and thus companies') pockets.
3. Corporate outlook: PE ratios are still too high for Ireland Inc, implying that there is more room for downgrades. In the US, there is more clarity as to the 2010 PE ratios supported by the markets, with a range in 15-20 perceived to be the top during the recovery part of the cycle (whenever this happens). So the expected downgrading room that is still remaining in, say S&P500 is -150 points or ca 20%. In Ireland, the same figures imply probably a range of sustainable 2010-2011 PE ratios of ca 10 (again assuming that we see some recovery starting in 2010 and companies actually living up to the idea of proper disclosure of losses and impairments – something that few of them have done to date). So the bottom line is that we can see ISEQ travelling all the way to 1,470-1,500 before hitting a sustainable U-turn, while IFin might be tumbling down to 200-215.
4. Earnings and demand are going to continue falling in months to come. Although much of this is already built into expectations, the actual numbers are not yet visible through the fog of corporate denial. Banks still lead in terms of balance sheets opacity and the Government is doing nothing less than destroying in a wholesale fashion private workers’ ability to stay afloat on mortgages repayment and consumption. Dividend yields are now poised to continue downward well into 2010 (optimistically) or even past 2011 (pessimistically). So any bottoming-out of the market will coincide with an on-set of an inverted J-styled recovery – we are not getting back to 4-5% long term growth trend once we come out of this recession. A poultry 2% would be a miracle and a Belgian-style 1.2-1.5% GDP growth over the long run is a more likely scenario.
5. Global growth for Ireland Inc is not going to be a magic bullet. The Government has wasted all chances of reforming the least productive sectors in this downturn and is hell-bent on protecting our excessively high cost base. This means we are unlikely to benefit from any serious global growth upturn.
6. Increased global reliance on Governments interventions is going to hurt Irish exports in the long run as national Governments will tend to reduce incentives for outsourcing, leading many MNCs to gradually unwind transfer pricing activities here in Ireland. There is absolutely no chance our Enterprise Ireland-sponsored companies are going to be able to take up the slack.
7. No recovery in Ireland will be possible until house prices and commercial real estate values stabilize and start improving. High debt, diminishing ability to repay existent loans (courtesy of Government raiding households finances to pay for waste in the public sector and a growing army of consultants – e.g Alan Ahearne & Co) all mean that there is no prospect for a return in house values growth until, possibly, well after 2013. Absent such a recovery, there will be no sustained rallies in other asset classes.
8. Finally, there is a psychological shift that is underway when it comes to Irish public perceptions of asset markets. This shift is now counter-positing a 40-50% decline in house prices against a 90% decline in most popular equity categories and a wipe-out of investors in nationalized (and potentially yet to be nationalized) banks. The return of a growth cycle is unlikely to trigger significant movement of households’ cash into Irish stocks. This will be further compounded by the aversion to leveraging and continued credit rationing (induced via new banking regulations and investor hysteresis).
   

So the conclusion is a simple one – Irish equities recovery is nowhere near becoming a reality. Expect further turbulence on a generally downward trajectory in weeks ahead, followed by a potential spike of misplaced short-term optimism in the wake of the mini-Budget. Once the investors work through the forthcoming Government decisions, it will be down again for ISE.

IL&P: next in line?

All this week, while the politicians were preoccupied with Anglo's saga, I've been watching what appears to be the next downgrade target: IL&P. Intimately linked to the Anglo Irish Bank's shenanigans, IL&P has had a rough ride alongside its other free-standing (for now) peers: the AIB and BofI. Towards the end of this week, it seems, this term - 'alongside' - has become far less descriptive of IL&P's share price behavior.

Are markets on to something we are yet to discover? I don't know, but here is how strange the things got in the course of last week.
Chart above shows correlation between the daily volumes for IL&P shares and the average daily volumes of AIB and BofI shares since December 2008 through February 20 close. Clearly, things gotten a bit out of pattern ever since the local low -0.5 correlation was approached on February 16. More importantly, Friday the 20th of February saw a reversion of correlation down to below 0.25.

As illustrated in the following chart, this is not surprising, given that both AIB and BofI volumes declines on Friday have been countered by a significant volume uptick in IL&P.Of course the volumes changes - especially pattern reversals over historical averages - are significant as they signal (in this case) a rising support to the general direction of share price movement. At this moment, the market appears rather committed to downgrading IL&P, while treating AIB and BofI much lighter.

Of course, the chart above lends some support to my last hypothesis: while both AIB and BofI are seeing moderating decreases in prices alongside falling volumes, IL&P is seeing increasing downward pressure on price alongside increasing volumes (note the chart above plots the product of price to historic average ratio and volume to historic average ratio). But don't take my word for this: chart below illustrates by referring directly to prices.

And the weekly moving average of correlations between closing prices for AIB and BofI with IL&P are starting to show strain as well.On the net, out of the four main parameters I usually use to gauge the possible shifts in market attitude toward a specific stock:

• divergent price moves relative to historic average and peers;
• volume changes to signal increasing support for one share relative to its peers;
• moving price correlations relative to peers diverging away from strong positive values; and
• moving volume correlations diverging from strong positive values

all four are currently signaling some potentially new concerns about IL&P emerging in the market. Can it be the aftermath of the Anglo affair? Possible. But how likely is such a scenario given extensive downgrades to IL&P on the back Anglo's news in the past and given that by now the company has been devalued as if it were a pure banking sector play, effectively discounting the insurance side of business to nil (chart below).

Can it be that the markets are becoming aware of some new set of skeletons in IL&P's closets? Also, possible. And, given the scandals surrounding Anglo, Irish Nationwide and other players, somewhat probable as well.

Of course, time will tell for sure, but I would watch IL&P very closely on Monday...

PS: Oh, yes and intraday volatility for IL&P is also moving against the peers:

Mushroom Cloud Redux II

Per excellent comment (see here and scroll to comment) to an earlier post on this matter, here are comparatives for Irish Banks index vis-a-vis European Banks. The first chart plots, as before, time series of indices.
In many ways, the series do indeed co-move much closer together until about October 2008, when things are starting to go per-shape for Ireland. This trend of significant deviations in Irish Banks from their peers in Europe accelerated through today, although to see this more clearly, consider the second chart below.
If you look at the correlations between Irish bank shares and both indices, it should be pretty clear that a relatively close link between Irish and European financials broke down around September 29th and was never repaired since. (Note that these are weekly moving correlations, so that a date of 13/10/2008 corresponds to data from 7/10/2008 through 13/10/2008.)

In fact things have spun completely out of sync starting in mid November - precisely when Irish Government got busy 'repairing' our Banking sector. In fact, things got much more dramatic in terms of Irish v EU Banks than in terms of Irish Banks v EU markets since the end of December.

Overall, my strategy still stands, but it is even more pronounced in terms of Irish Banks v European Financials: "Lenihan/Cowen are about to speak? Short Ireland, long Europe"... The only thing worth examining at this junction is whether 'long Europe' might be inferior to, say, 'long US' or UK. But that has nothing to do with our Government's ability or with the topic of this post.

Update: Irish bank shares correlations with both EU Financials and EU total price index are now moving down - ca 96% last night's close (in weekly moving correlations terms) to 86% today... Watch these!

Mushroom Cloud Redux

Per my earlier posts, here are the latest comparisons between our Financials and the broader European markets.

A new dip is courtesy of our Government's 'Best 5 Ways to Ruin a Country' Framework that I released yesterday (beating the Irish Times in bringing it to public attention by some 12 hours - here).

But enough bragging - back to charts.

The first one is self-explanatory:Mass of volatility (risk) being dumped onto Irish shares by our Government wobbling on economic crisis and banks is self evident. If the Government was really accountable for its actions, maybe investors could have taken it to courts for value destruction.

Alas, this is not how the real world works. Here, on Planet reality, Brian-Brian-Mary prevaricate (in taking hard decisions), we pay. And so it looks like we've had a bear rally and now we are back on a downward track. The only hope - it might bottom out at somewhere above 550 for ISEQ FIN this time around, fingers crossed.

It is the second chart that opens up a more detailed picture of the latest outbreak of the Irish markets disease.
As shown above, weekly correlation between Irish Financials (ISEQ FIN) shares index and the broader Eurozone markets had a series of rollercoaster rides ever since the current Government took up a task of 'fixing' our economy. In particular, Irish markets forays outside the 'No Hedge' territory - into low positive (below 0.25 or negative) correlation values implies that at virtually every point of change in the Government policy, an investor would have done better by betting against the Irish market and in favour of the broader European indices. As powerful of an indication as one can get that markets do not trust this Government in resolving Ireland's economic crisis.

I mean, how bad can the things get for a Government if selling into Brian-Brian-Mary's statements can become a winning strategy for investors?..

Renewing appetite for risk?

“I have some good news, at least for the intermediate term: Investors are slowly regaining their appetite for risk”, wrote Marketwatch’s Mark Hulbert in his today’s column (here)
“This represents a big shift from the situation that prevailed last fall, when investors became so repulsed by any kind of risk that the yields on safe-haven investments like Treasury bills actually went negative.”

But now, says Hulbert, with January effect in full swing, things are looking up – investors are looking for risk once again.

“Of the several straws in the wind that point to at least a partial return of a risk appetite, one of the more compelling is the recent relative strength of risky small-cap stocks over the more conservative large caps. So far this year through Tuesday night, for example, large-cap stocks (as measured by the Standard & Poor's 500 index (SPX: S&P 500 Index) have fallen 3.5%. Small-cap stocks, as measured by the Value Line Arithmetic Index (92040310), have declined by just 1.1%.”

Now, I am not convinced by Hulbert’s main argument.

January effect is a tax-minimization event, driven by heavier sales of shares with lowest capital gains potential to maximize losses in December (blue chips down) and re-balancing portfolio toward higher capital gains potential (small cap) in the new year. In normal years, movements correlate positively with risk, i.e. small cap – higher expected return, higher risk, blue chip - smaller expected returns, lower risk. But is that the case this time around? In other words, the markets might be going into smaller cap because the larger cap is actually relatively riskier (controlling for current valuations), not because they are seeking higher risk-return strategies.

Chart below illustrates Mark Hulbert’s point – at its right-hand margin. Indeed, the short-term performance by the two indices does suggest that the markets are placing more faith in the small-caps. But it shows that this was true for much of the 2008 with exception of the late autumn. In other words, if current divergence vis-à-vis S&P is a sign of new appetite for risk, what did the market have appetite for in July 2008 when small caps went up and S&P stayed relatively flat? Why did the price of risk implicit in the difference in two indices has fallen in April-June and July-early August? Were these the ‘turning’ points in underlying appetite for risk or just traditional bear rallies?
An alternative explanation for the ‘January effect’-like pattern observed is that investors' risk perception might have shifted. Consider the following scenario: You are in a market with four broad asset classes:

• large-cap,
  
• small-cap,
  
• corporate bonds and
  
• Treasuries.

You believe that too much risk-taking has taken place in the second half of December by pursuing a bear rally in S&P500 stocks and the Treasuries. If you move into relative safety, you will move into the two remaining assets. You will have an incentive to prefer the small caps if you believe that they have taken the heaviest beating to date (which they did – see peak to trough moves around September-mid November) and you invoke another powerful anomaly of the ‘Winner’s Curse”. The real question then becomes is what does the analysis of relative position changes in corporate debt and small cap shares tell us. The large cap stocks are irrelevant here.

Hence, what appears to be a renewed appetite for risk can be interpreted as a hedging strategy against rising risk levels and falling expected returns in the so-called traditionally ‘safer’ asset classes.

What Hulbert is right about is that one should not overplay the story too much. Instead, the return of the January effect pattern (or something else resembling it) might mean “that the stock market will gradually resume its normal function of assessing different securities' relative risks and returns, a function it couldn't fulfill when it was indiscriminately punishing virtually everything other than Treasuries.”

Yes, but… even if Hulbert is correct, the return to rationality in the markets will be bound to:
• trigger fresh downgrades in many companies and indices as corporate returns deteriorate throughout H1 2009, as the bath water gets muddier with longer recession; and
• this rationality will remain extremely fragile and prone to collapse every time the elephant in the room – the US Government – moves about.

Hulbert omits the latter issue, but it is non-trivial to his topic. We are in the changing political cycle – and with it – a prospect of a new stimulus that is bound to prop up smaller business. If, as is the case, Uncle Sam’s rescue packages for many blue chips were already priced into these companies valuations in late December, Obama's first 100-day sweetheart package for Congress is yet to be fully priced into stocks valuations. It might be that the ‘January effect’ is simply the reflection of this delay in recognizing that the next Uncle Sam's move will a stimulus for smaller companies?..

The price of uncertainty II: Anglo-Irish Bank shares

To continue with my last post's theme:

According to the latest annual results, Anglo-Irish Bank’s loan book carries construction and property sectors exposure of roughly 87% (details in Table 1 below). Given this, the bank is, in effect, a property investment play in the Irish, UK and US markets.
This implies that in the longer-term Anglo’s shares should follow market expectations concerning the ongoing property contraction in Ireland, US & UK. In other words, Anglo’s shares performance should reflect (with a possible lag to account for the differences in timing across the three markets) the fate of the specialty US real estate investors, e.g REITs.

The question is – does it?

Taking weekly closing data for the period of 2006-present for 6 REITs indices:
• SPDR DJ Wilshire REI,
• I-share DJ R EST INX,
• I-share FTSE NRT Residential ID,
• I-share FTSE NRT Industrial/office IDX,
• FTSE UK Industrial REIT and
• MSCI US REIT Index,
normalized at 100% for January 1, 2008, I obtain time-series for changes in weekly prices of these indices and the Anglo’s shares. I then construct Blend 1 & Blend 2 synthetic portfolia with specialty REITs weights in each portfolio reflective of the relative share of these types of properties in the Anglo’s portfolio: 18.4% Residential REIT indices, 77% Commercial REIT Indices and 4.6% I-Wilshire Index (Blend 1) and 4.6% I-Share Index (Blend 2).

Figure 1 compares changes in the valuations of these synthetic portoflia and Anglo-Irish Bank shares.
As shown above, US & UK REITs indices, blended to reflect actual Anglo-Irish Bank’s portfolio allocations of loans across various types of property have significantly outperformed Anglo’s shares since January 2008. While year-to-date decline in Anglo-Irish shares has been a dramatic 98.55%, the same period decline in US and UK REITs with exactly the same property markets and types exposure as Anglo’s was only 44.68%. Even at their lowest point (-63.9%), REITs performance was 54% better than that of the Anglo-Irish shares.

Using synthetic portfolio approach, REITs-based analysis predicts that the Anglo-Irish share prices should trade between €3.21 and €5.66 per share. Synthetic portfolio prices Anglo's shares at €3.75 at their global minimum in the first half of October, rising to €5.70 today.

However, the above does not account for the potential upward bias in Anglo-Irish Bank’s shares valuation prior to January 2008. In other words, we must address the argument that deep discounting in Bank’s shares reflects the fact that its peak valuations were more optimistic than the market average. To do this, I computed blended portfolia discounts from peak to January 1, 2008. Controlling for these, Figure 2 reconstructs the synthetic price share performance for Anglo-Irish Bank based on property markets fundamentals and accounting for the differences in timing in real estate contraction between the UK, US and Ireland.Thus, as shown in Figure 2, Anglo-Irish Bank shares have traded at a sector discount between late June and mid October 2008 and since the beginning of December 2008. Using full-sample simulation, Anglo-Irish shares are fundamentally valued at around €1.09 per share in the current market conditions as opposed to the actual share price of €0.15 today. Note the accuracy of the synthetic portfolio in tracking Anglo's shares since, roughly May 2008.

While the above exercise is not 100% accurate, it does suggest that the markets are currently discounting Anglo’s shares at a rate much greater (ca +13.7%) than warranted by the bank’s exposure to property markets.

There are two possible explanations for this excessive risk premium:
(1) the unexplained risk premium reflects lower quality lending by the bank than the average for REITs; and
(2) the unexplained risk premium accounts for the terms and conditions of re-capitalization scheme announced by the Irish Government.

While the first argument is impossible to assess, given the lack of data on Anglo-Irish Bank’s loans time structure, the second argument can be partially ‘priced’. The re-capitalization scheme will imply a dilution of existent shareholders’ equity to ca 20%. This suggests that the actual price target for the Anglo-Irish Bank shares should be around €0.22-0.25 per share. The associated regulatory risk-premium on the Anglo’s shares is, therefore, in the neighborhood of 69% of the share price.

No coincidence this estimate is so close to the 76% regulatory risk premium for the entire Irish Financials sector estimated in the preceding post…