Market-Depth

It’s always reassuring when an industry leader releases information shedding positive light on the future of an alternative investment. Today, it was derivatives marketplace Chicago Mercantile Exchange, or CME Group, discussing the promising outlook of foreign currency futures.

Since the CME is arguably the biggest futures exchange out there, is it any surprise they’re touting FX futures contracts? No, not really, but the whole concept of currency futures is still pretty interesting nonetheless. I decided this fit as a nice follow-up to a post I wrote the other day on managed futures and risk mitigation in general, since these particular investments can get a little complex.

For anyone who’s unfamiliar with them, currency futures allow investors to exchange one currency for another on a future date at a specified price that is set at the time of the agreement.  This allows investors the ability to make a purchase that will be executed sometime in the future for the price it would cost them today. In turn, they’re granted protection against exchange rate fluctuations, which could end up working for or against them depending on where the currency pair moves.

Derek Sammann, global head of foreign exchange and interest rates at CME Group, explains how, due to rapid economic globalization, cross-boarder asset flows show no sign of slowing down anytime soon. This provides both a growing opportunity for potential prosperity, as well as risk, for investors interested in tapping the $4 trillion a day foreign currency market.

As Forex continues to become a more mainstream alternative investment option, the need for a supplementary vehicle for hedging risk will inevitably rise. Currency futures are just one avenue investors can take to fill that need. Others come in the form of continuously developing advanced software controls within the realm of spot Forex trading. As various up and coming forms of alternative investments popularize, it is interesting to note what types of risk controls they will inspire and bring with them.

 

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

US stock prices have made little headway in more than thirteen years, and the cumulative real returns generated by the major market averages have lagged Treasury bonds by a substantial margin over the period.  The uber-bulls are confident however, that the more than decade-long stagnation has led to attractive valuations that should pave the way for strong returns in the years ahead, and some investment practitioners have gone as far as to predict a doubling in equity values by 2022.  Is the optimism justified?

It is important to appreciate the sources of historical real stock market returns, which can be decomposed into three building blocks – the dividend yield, real growth in earnings-per-share, and changes in valuation.  Since 1871, US stocks have delivered annualised real returns of 6.5 per cent, of which more than seventy per cent is attributable to the dividend yield, roughly one quarter to real growth in earnings-per-share, and the remainder to an increase in the valuation multiple attached to current per share profits.

Looking forward, future returns seem virtually certain to fall short of the historical experience, simply because the dividend yield is little more than two per cent today or less than half its long-term mean.  The uber-bulls will undoubtedly argue that the dividend yield understates the total payout to shareholders, due to sizable increase in share repurchase activity in recent decades.

However, share buybacks are already included in per share numbers, and adjusting the payout ratio upwards would be double-counting.  In other words, an existing shareholder can either participate in the buyback and miss out on the earnings-per-share accretion, or forego the cash distribution and benefit from the capital gain.  Thus, forecasting future returns on a per-share requires no adjustment to the dividend yield.

The second building block in estimating future returns is the real growth in earnings-per-share, which is linked to the economy’s long-term growth rate.  However, existing shareholders have a claim on publicly-quoted per share earnings and not economy-wide profits.

Initial public offerings and secondary issues account for a considerable portion of the growth in aggregate earnings through time, and as a result, the growth in per share numbers falls well short of the cumulative increase in total profits.  Indeed, real earnings-per-share have increased at an annual rate of just 1.7 per cent since 1871, or roughly half the pace of economic growth.

The optimists put forward a variety of reasons as to why earnings-per-share growth will be higher in the future, but none stands up to serious scrutiny.  It is argued that share repurchases will provide a boost to earnings, which conveniently ignores the fact that the reduction in share count through time is largely a myth.  Indeed, new share issuance in excess of buybacks has averaged 1.25 per cent a year over the past half century, and repurchases have exceeded new issuance in just eight years.

The second argument relates to the growing share of profits generated overseas in high-growth markets.  The share of revenues sourced in foreign markets has increased from about thirty per cent more than a decade ago to almost fifty per cent today.  However, roughly sixty per cent of overseas revenues come from mature European economies, with a further ten per cent coming from Canada.  All told, just one in every eight sales dollars is generated in high-growth economies, which is simply not large enough to provide a meaningful boost to earnings growth.

The bulls also fail to appreciate that globalisation is a two-way process, and just as American multinationals have made impressive share gains in overseas markets, the same is true of foreign companies in the US.  Indeed, foreign subsidiaries have captured an increasing slice of economy-wide profits over the past two decades, with the share rising from just five per cent in the early-1990s to about fifteen per cent today.

Finally, the global financial crisis and the calamitous drop in economic activity have had a lasting impact on corporate sector behaviour with elevated unemployment levels and a relatively low business investment rate threatening to lower potential future growth rates in the developed world.  All told, there is no reason to believe that long-term growth in real earnings-per-share will stray too far from its historical trend.

The final input to the return estimation process is valuation change.  The market looks reasonable value on current earnings, but the greater than twenty multiple on cycle-adjusted profits is closer to previous secular bull market peaks than bargain basement levels seen in the past.

The bulls argue that the multiple is inflated due to the collapse in corporate profitability during the crisis, but using median earnings over the past decade or a denominator based on twenty-year average earnings to correct for the recession does not paint a different picture; the stock market is expensive.

The best the bulls can really hope for is no change in valuation multiples, which could prevail if macroeconomic volatility drops from its currently elevated levels.  However, should macroeconomic volatility remain high, it is far more likely that valuation multiples will contract, and at the very least, return to their historical mean.

Careful analysis suggests that equity investors can reasonably expect annual real stock market returns of 3.5 to 4 per cent at best in the decade ahead – well below the historical experience, and could deliver far worse should valuation multiples contract.  The bullish optimism is unfounded.

 

www.charliefell.com

 

 

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

As a change of pace, I thought I’d use this post to do a little bit of market analysis looking at the market from a different perspective than the ones most often used. This type of analysis focuses more on time spent (or volume transacted) at certain levels rather than looking at simple progression of where it’s been over time as we generally see in bar and candlestick charts.

The chart below shows how EUR/USD has traded since February. Each of the clusters you see represents the distribution of trading over one month’s time. I won’t go too far into the details, but suffice it to say that the fatter a month’s distribution at a given price level, the more days the market traded at that prices, and the thinner the distribution the fewer days the market traded at that level. Think of it this way. If the market spends a lot of time at a price level it indicates agreed upon value in which both buyers and sellers are willing to transaction. Where the market doesn’t not spend much time it indicates rejection by one side or the other – value not agreed upon.

What we can see above is a trio of short, fat distributions for February, March, and April that indicate pretty narrow range trading. Then, in May, we have a long, thin distribution indicating a trend move lower. June was again mainly a consolidative month, but July started off with a trending action, then transitioned into more of a ranging set-up.

The July distribution indicates that things changed in EUR/USD near the beginning of the month and previously accepted value between about 1.2400 and 1.2700 suddenly became rejected. The market then move down to where valued was agreed upon below 1.2400.

Let’s put this in some common parlance. Think of the thin distribution of prices between 1.2350 and 1.2500 or so as a key resistance zone for EUR/USD. Selling interest far exceeded buying interest the last time the market moved through that zone. If the market can work back up there and hold the move it would tells us things have shifted and that buyers are starting to be more interested.

The concern I have, though, is that we don’t have as clear a rejection area to the downside to indicate a price level the sellers clearly found too low and/or where the buyers became much more aggressive. We have to go back to June 2010 to find the last time the market was down this low. Back then there was a final rejection near 1.1900. I think the risk, therefore, is that EUR/USD makes another move down to test those prior rejection lows.

The struggle, though, will be breaking away from the 1.2300 area. As the chart above shows, the market spent a lot of time around there in May/June of 2010. That makes it a significant attraction zone, which we’ve been seeing play out this month. If the market can start to develop more value below 1.2200, though, the odds for a run at 1.19 will increase.

There’s a bit more nuance to this type of market analysis, of course. If you find it interesting, you can learn more about it here.

Oil hit an eight-month low in Asia, keeping consistent in its recent jumpy behavior that tends to mirror news coming out of Europe. This comes down from crude oil’s up position June 11 after a European pledge that the euro zone countries would lend Spain $125B to alleviate the pain in its struggling banks. This, combined with talk about how investors have been looking into commodities as a safe place to park their capital as they wait out this passing economic storm, made me want to take a closer look at what’s going on in energy today.

Right now, Chesapeake Energy, the world’s second largest natural gas company, is a pretty entertaining case to follow. For anyone who hasn’t been doing so, the Chesapeake story started picking up June 4 as their stock saw a sudden turnaround rising 6.03 percent to $16.52 a share (previously on a longtime downward spiral as their stock had dwindled around 55 percent from its peak performance). At that time, I couldn’t help but wonder what kind of an investment this company could potentially turn into.

The change was a direct result of some democratic cuts that took place amongst the company’s board of directors. It was actually billionaire Carl Icahn, with his sturdy 7.56-percent stake in the natural gas conglomerate, who set things in motion.

In a letter he wrote to the company last month, Icahn spoke on behalf of himself and a group of disgruntled fellow Chesapeake investors voicing dismay with how the board was operating the company. In it, he expressed that he felt it was these board members who were largely responsible for the dismal Chesapeake stock performance.

On June 11, the company responded to Icahn by announcing that they planned to remove four of their nine current board members. This seemed to be just the antidote investors were looking for, as many of them openly expressed their satisfaction with the decision.

Though the company’s June 11 stock performance demonstrated Chesapeake was starting to regain traction with investors, they were and are still nowhere near a comfortable monetary state. With $12.6 billion in long-term debt, they are looking to disperse $14 billion in assets in an attempt to alleviate their weighty debt burden.

On June 8, Chesapeake announced at an annual meeting that it would be selling its Midstream Partners pipelines and Chesapeake Midstream Development to Global Infrastructure Partners June 26 for a combined $4 billion dollars. This move came at a prime time, as the company is clearly strapped for cash under their hefty debt.

The question now is, given the mitigating circumstances with both the company and the global economy, how should investors approach the wounded (but slowly recovering) beast that is Chesapeake Energy? Engage in buying off their debt via corporate bonds? Bank on materialization of a positive rebranding turnaround as Carl Icahn takes matters into his own hands? Consider commodities as a safe place to stash their dough until European turmoil cools off? Decisions, decisions.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

At what point do we stop wondering what the crystal ball will show next?  Lately, every time I turn on the TV, the newscaster is announcing a new prediction for our economic future.  Sometimes two channels are simultaneously reporting completely different forecasts.  At this rate, how can one put faith in any of these hypotheses?  Will we eventually tire of these predictions (which are really nothing more than educated guesses) or will we just give up and roll with the punches?

Our favorite Irish economist Charlie Fell explores our "Prediction Addiction" in his latest blogpost.  Read the full article here.

 

Prediction Addiction

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Human beings are hard-wired to detect patterns and identify causal relationships amidst the constant stream of new information.  This behaviour can be traced to our ancestral past on the African savannah many millennia ago, where the ability to shape expectations from small samples of data, enabled our hunter-gatherer ancestors to successfully forage for edible fruits and seeds, stalk prey, avoid predators, find shelter, and seek mates. 

Scott Huettel, a neuroeconomist at Duke University, explains that, “The brain forms expectations about patterns because events in nature often do follow regular patterns:  When lightning flashes, thunder follows.  By rapidly identifying these regularities, the brain … can expect a reward even before it is delivered.

The ability to anticipate outcomes from regular patterns undoubtedly helped our ancestors to flourish but, Huettel warns that, “in our modern world, many events don’t follow the natural physical laws that our brains evolved to interpret.” The human brain is designed to conserve scarce neural resources, and so much so, that it requires only a single confirmation to anticipate a recurring pattern.  Huettel notes that as a result, “The patterns our modern brains identify are often illusory…

Pattern recognition and subsequent tactical buy or sell decisions are part and parcel of active investment management.  Investors however, often place too much emphasis on the recent past when forming expectations about the future – top-down analysts make tactical calls based on recent economic data, while technical analysts divine the future on historical patterns in stock prices.

Investors’ ‘prediction addiction,’ as the behaviour has been called by the financial columnist, Jason Zweig, is particularly relevant today.  Economists are busy shaving their economic growth forecasts for both this calendar year and next, following a string of disappointing data that fell well short of expectations.  Meanwhile, technical analysts are arguing for a reduction in equity allocations, given price action in the major stock market averages that confirms a change in the underlying trend.

Recession fears are afoot and investors are in need of guidance that will preserve capital and/or yield profits amid the uncertainty.  Indeed, anticipating turning points in the business cycle and, adjusting asset allocation accordingly, is central to successful top-down investing.

Unfortunately, economists have a patchy forecasting record at best, having failed to anticipate every one of the last five recessions.  Indeed, the monthly publication, Blue Chip Economic Indicators, noted in July 1990 that, “the year-ago consensus forecast of a soft landing in 1990 remains intact” – the economic expansion peaked that very month!

More than a decade later in March 2001, fewer than five per cent of economists anticipated that there would be a recession that year, even though a downturn was set to begin just days later.  More recently during the spring of 2008, the calls for a soft landing were almost deafening, despite the fact that the deepest recession since the 1930s was already underway.

Perhaps the study of historical price patterns performs better.  After all, stock price data is not reported with a lag and, unlike economic data, is not subject to revisions that continue several quarters after the fact.  As William Hamilton, the fourth editor of the Wall Street Journal wrote in his 1922 classic, ‘The Stock Market Barometer’ – “The market represents everything everybody knows, hopes, believes, anticipates, with all that knowledge sifted down to ... the bloodless verdict of the market place.”

The study of historical price patterns suggests that a further decline in the major market averages may lie in wait.  The 18 per cent fall in stock prices from their recent peak late-April, resulted in a bearish ‘Death Cross’ signal on August 12, as the stock market’s 50-day moving average of closing prices dropped below its 200-day moving average.

The ‘Death Cross’ is considered by technical analysts to be a portent of future weakness, but is the signal’s presumed ability to anticipate turning points and enhance investment performance supported by the historical record?  To find out, the ‘Death Cross’ and its converse, the ‘Golden Cross’, are employed as tactical sell and buy signals respectively, for a simple long/short strategy and, the investment results – excluding dividends – are compared with those generated from a straightforward buy-and-hold strategy.

The historical record shows that before the most recent ‘Death Cross,’ there had been 63 tactical signals since the summer of 1949 – 32 buy and 31 sell signals – which, gives weight to the late Paul Samuelson’s criticism in 1966, that ‘The stock market has predicted nine out of the last five recessions.

The buy and sell signals resulted in 33 winning trades and 30 losing trades, which is not much better than a coin toss.  More importantly, the price return generated by the long/short strategy saw an initial $10,000 investment compound to $537,000 over the period, as against $775,000 for the buy-and-hold strategy.

The historical evidence suggests that the ‘Death Cross’ adds no value to the investment process.  However, a more complete examination of its credentials reveals that it subtracts from investment performance during secular bull markets, which are characterised by powerful up-trends with only the briefest of interruptions; it adds to performance during secular bear markets, which are characterised by a protracted sideways pattern that is punctuated by violent downward price swings.

The bearish indicator provided ample warning to investors of impending danger, close to a market top in both the autumn of 2000 and the winter of 2007.  Has the ‘Death Cross’ sounded an early warning bell once again?  Time will tell.

 

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Anyone who as been following the financial crisis in the past year has noticed the market has been driven mainly by the sentiment (and panic) of investors.

Since markets are driven by people, a few analytical methods have been developed over the years to better visualize human behavior as it’s being reflected on historical price charts, methods like Elliot Waves or Fibonacci attempt to use the movement in prices to predict human behavior and by predicting the behavior try to predict future price changes.

"Because humans are themselves rhythmical, their activities and decisions could be predicted in rhythms" - Ralph Nelson Elliot

The reality is that we are all different. Each one of us has a different agenda when trading, different expectation and different analysis of the market even though we are exposed to the same information; especially in a crisis situation where human behavior is anything but predictable.

Since human behavior plays an important role in market behavior, we’re developing a unique way of looking at the market by developing our own algorithm which computes a real-time market depth that can, at any time, be sliced by the trading style, technique, holding period etc.

Market Depth

New Feature: Market Depth

This means I can visualize how the day traders that specialize in the EUR/USD, have an average trade duration of 4 hours, and use the Fibonacci method see the market and how their analysis is changing in real time.

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Be sure to read the full risk disclosure before trading Forex.  Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.