Thursday, May 29, 2008

Waiting for a ride on the Phoenix

As a follow up to my previous post on Altman Z score, investors who use solvency analysis to avoid bankrupt companies should beware of the effects of an economic recovery. The other side of the coin of solvency analysis is the Phoenix effect.

When the economy comes out of recession, shares of near-bankrupt companies see eye-popping returns as they rise Phoenix-like from the ashes of near insolvency. Examples include Chrysler moving from $2 to over $30 in the 1982-3 recovery; Magna International from under $2 to over $80 in 1991-2; and Akamai Technologies from under $2 to over $18 in 2003-4.

Buying shares of near bankrupt companies is a dangerous but exciting game. To be successful, an investor needs to identify the Phoenix candidates and correctly time the turn in the market. The rewards are can be big. Buying a basket Phoenix stocks can yield returns of 100-200% over a 12-18 month period.

Phoenix is partly a small cap effect
The Phoenix effect can be characterized partly as a small cap effect. The chart below shows the relative returns of the small cap Russell 1000 relative to the large cap S&P 500. I indexed the start value of 100, at dates representing stock market lows coinciding with economic slowdowns since 1980. On average, the Russell 1000 outperformed the S&P 500 by about 17% one year after the market low. The initial upward thrust in the market has always been marked by large cap outperformance.

Interestingly, the recent March 2008 low was characterized by small cap outperformance which leads me to conclude that this rally is just a bear market rally and the March low was probably not THE BOTTOM in this bear.

Looking for Phoenix candidates
Phoenix candidates are not just small cap stocks, but shares of companies that are at risk of insolvency and benefit from the tremendous positive operating leverage from an improving economy and high financial leverage which put them at risk of bankruptcy. The obvious quantitative way of finding Phoenix candidates is to screen the market for shares of companies that are at risk of insolvency. However, there is a simpler heuristic: low-priced stocks.

Stock price is a factor that’s not in most equity quants’ factor lists. However, it is a deceptively simple way of screening for Phoenix recovery candidates. I remember that Jeff deGraaf, who was at Lehman Brothers at the time, reported in late 2003 that the return spread between the lowest and highest decile of stock price was about 70% - an astounding return to a factor for less than one year.

I roughly confirmed these results by running a backtest using the current components of the Russell 1000. Had you bought the lowest decile by stock price in December 2002 and held them for a year, the median outperformance compared to the top decile was about 110%. This simple study has problems, mainly in the form of a survivorship bias. The use of a median return instead of an average return does mitigate some of the survivorship bias issues. Nevertheless, it does illustrate the magnitude of the effect. Using a long-only approach, this study over the 2003 and previous recovery period suggest that a basket of Phoenix stocks has the potential to rise by a factor of between 2 and 3 over a 12-18 month period.

Phoenix candidate = low stock price + dramatic fall + insider activity
Just buying low priced stocks gets you partly there but we should eliminate stocks that have always traded at low prices. Phoenix candidates are stocks that have taken a pounding, or stocks that have fallen dramatically (70-90%) from the 52-week high. This is a likely indication that it is at risk of insolvency.

These companies are on the verge of Chapter 11 so buying their shares is highly risky. To mitigate downside risk of possible bankruptcy, add an additional insider activity screen. Ideally I would like to see recent insider buying in Phoenix candidates, which indicates that the fundamentals may be turning. At the very least, I would like to see the lack of insider selling, a sign that the worst is may over for the company under consideration.

Timing: Be patient, the Phoenix will rise
Right now, the weight of the evidence suggests that the turn has not occurred yet. I am preparing a list of Phoenix candidates for my portfolio but waiting for signals of a bottom before buying. In a future post I will write about how I would time the buy decision of these stocks.

Tuesday, May 27, 2008

Oil overbought but no signs of excessive commodity speculation

As oil prices topped $130 and later $135 there was a cacophony of calls from market commentators that the parabolic rise in crude signaled a top in commodity prices and that this is a commodity bubble that would end badly soon.

Oil and Energy stocks overbought
The chart below shows the log price graph of crude oil futures. Prices moved to the top of the rising channel line, from which it has corrected in the past. So a pullback in oil prices in the next month or two would not be a surprise.

The relative return of Energy stocks tells a similar story. The chart below shows the returns of the Energy Select SPDR (XLE) compared to the S&P 500. The XLE moved to the top of the relative trendline against the S&P 500 and appears to be overbought. I would expect a near-term pullback but the relative uptrend would remain intact.

No sign of excessive speculation in resource stocks longer term
At the top of every mania, the junk starts to fly. Stupid deals get done. People start talking at parties about how they made a killing in this mining junior or that penny stock. Even here in Vancouver, one of the resource penny stock capitals of the world, there is no sign of that speculation.

The chart below shows the relative returns of the small cap speculative TSX Venture Index compared to the large cap S&P/TSX Index. Small caps have been underperforming large caps since the end of 2006. This is excessive speculation???

No sign of excessive speculation in gold stocks
If we were to look at the pure gold stocks, it appears that we are still early in the move. The chart below shows the relative returns of the equal weighted CBOE Gold Index (GOX), which gives bigger weight to smaller gold stocks, compared to the capitalization weighted PHLX Gold & Silver Index (XAU), which is more large cap oriented. After drastically underperforming the large cap gold stocks, small cap golds only caught up in mid-2006 and it wasn’t until October 2007 that they definitively began to outperform the bigger stocks.

Putting my technician’s hat on, this is a classic cup and handle formation. The breakout in October 2007 would yield a relative return target of roughly 70-80% outperformance of the GOX against the XAU. This suggests that small cap golds have much further to go against their large cap senior brethrens – indicating that this bull move in gold (and commodities) is nowhere close to being over.

Thursday, May 22, 2008

A warning for Tech

The chart below shows that both smart and consensus mutual funds are both selling their Technology holdings. In the face of such selling pressure it will be difficult for the sector to make any headway in the medium term.

This concerted selling is occurring just as this Bloomberg story pointed out that Bank Stocks Cede Biggest S&P Weighting to Technology. Is the story the ultimate contrary indicator?

Wednesday, May 21, 2008

Uh oh!

The technicians aren't going to like this:

Consensus sentiment from AAII is on the bullish side so the market lacks buying support from an excessively bearish sentiment reading. If there is follow-through selling tomorrow it could portend more short-term weakness.

Monday, May 19, 2008

Will the real inflation rate please stand up?

Regular readers know that I am a long-term bull on commodities. Given all the problems for the US economy, the overall direction for the greenback is down which is conversely commodity bullish. Now rising concerns about CPI understating inflation is another nail in the coffin of the US Dollar.

CPI understating inflation
These concerns are showing up in the minds of the public. USA Today recently published a story entitled Inflation may be worse than consumer price index shows. Until recently, the debate over the problems of inflation measurement have been confined to academics and a few investors with snarks of inflation ex-inflation.

This article shows the history of how the CPI has evolved over the years. John Williams of Shadow Government Statistics indicated that if we measured CPI the way it was done in 1982 it would be 11.3% (in March 2008). Even if we accept the premise that we need to strip out the more volatile components of inflation rate, the Dallas Fed’s measure of trimmed mean PCE is consistently higher than core PCE, or PCE ex-food and energy.

My take: the chickens are coming home to roost. The public participation in inflation hedges is just starting and commodity prices are going to get really parabolic before this is all over.

Thursday, May 15, 2008

A decade-long low return environment for equities?

The chart below shows the Dow Jones Industrials Average from 1947 to the present. This brief history of the Dow has been marked by two eras of rallying markets, followed by a long sideways market. We could be moving into another period of sideways markets for another decade or so.Poor macro-economic backdrop
There are valid fundamental reasons for these sideways markets. The last sideways pattern has been marked by rising inflationary expectations that begun with LBJ’s guns and butter policy in the Vietnam War. The macro-economic backdrop is not dissimilar to that of the late 1960s and 1970s. America is involved in a war with no end in sight, the fiscal deficit is spiraling out of control and the US Dollar is falling.

Excessive equity valuations
Some investors, like John Hussman, believe that the market is excessively priced. In a recent commentary he wrote that “the S&P 500 remains priced to deliver probable total returns of about 2-4% annually over the coming decade”. Using the methodology described here, Hussman indicates that the market’s cyclically adjusted P/E based on peak earnings is very high. Profit margins are elevated at this point of the cycle and there is the market is not pricing in any room for margin mean reversion (read analysis here).

Pension funds asset mixes likely to favor more bonds
Corporate treasurers are likely to move towards a asset-liability matching framework in defined benefits plans given the advent of changes in accounting policy such as FASB 158 and IAS 19. In Europe there are already suggestions to extend the Solvency II standard to corporate pension plans, which would further accelerate this trend (and has created scare stories like this).

We saw this effect in the UK a few years ago when companies moved towards an asset-liability matching framework. Investors drove the yield on the long-dated gilt to unbelievably low levels as they reached for duration in their portfolios. This asset shift came at the expense of equity weightings and other assets in the pension portfolio.

Sunday, May 11, 2008

More upside in oil? NatGas climbing a “wall of worry”

As oil prices top $125 and take other energy prices higher, where do oil prices go from here?

Crude oil appears to be overbought in the short term but sentiment doesn’t seem to be at a bullish extreme indicating that there may be more upside in black gold. However, oil does seem to be extended relative to other commodities.

Fast money is in a natural gas crowded short
A look at the CFTC commitment of traders data shows two different faces of sentiment in the energy complex. While natural gas prices are nowhere near their all-time highs, large speculators (read: hedge funds) are showing record levels of skepticism in natural gas and they are net short the commodity. Readings are not only at a crowded short level but their bearish positions are off the charts.Hedge funds long crude but not excessively bullishness yet
By contrast, large speculators are net long crude oil but readings are not at an extreme level despite the record oil prices. This data from the CFTC, combined with public sentiment readings, suggests that in the absence of excessive bullishness in crude oil, the commodity does have room to move a bit higher given its positive price momentum.Buying natural gas seems less risky than buying oil right now
The contrast in sentiment readings suggests that natural gas prices have more upside potential than oil prices and could hold up better should the energy complex correct. The chart below shows the price ratio of natural gas to crude oil, along with its long-term average and the one standard deviation bands around the average. I highlighted the price divergence between these two commodities in December and again in February. The natgas/oil ratio bottomed out in late December and has since turned up but likely has more to go.A long natural gas/short crude oil position would have a potential upside of 15% today, based on the conservative target of reaching the lower one standard deviation band. If we assumed that the ratio moved up to its long term average, the position would have a profit potential of 50%.

Oil looks extended against gold too
Another way to look at oil is to look at its performance against gold. The chart below shows the price ratio of gold to oil since 2000. Gold prices topped out against oil prices in late December 2007 and the ratio reversed itself dramatically. Oil now appears quite extended relative to gold, as it does against natural gas.The commitment of traders report on gold (not shown) shows that sentiment readings are relatively neutral. As a result, I would prefer a long natural gas/short oil trade rather than a long gold/short oil trade.

Friday, May 9, 2008

Risk management is becoming an art (finally)

After my series of posts on Surviving as a quant here and here, I see that there is finally some calls for reality checks on models in this article (italics are mine):

Industry experts are now saying market participants shouldn’t rely exclusively on mathematical models but should also use the social sciences to understand behaviors—of home owners, for instance.

They’re also calling for more disclosure and more transparency from market participants.“It’s time perhaps to put aside mathematics and somehow find the right balance between qualitative, quantitative and sensitive risk management,” Philippe Carrel, global head of business development at Thomson Reuters, said Wednesday at a forum in New York on valuation risk.

Risk management is becoming an art,” he said. “Risk starts to be managed now, as opposed to being merely quantified in the past.

A model is just an approximation of reality. There is no substitute for experience and intuition in building models of the world, otherwise you wind up like this.

Tuesday, May 6, 2008

The limitations of Altman Z

As s we go through a period of economic stress, I thought that it would be timely to review the Altman Z formula as a predictor of bankruptcy. The formula is a function of liquidity, balance sheet strength and earnings power:

Altman Z =
1.2 X Working capital/Total assets +
1.4 X Retained earnings/Total assets +
3.3 X EBIT/Total assets +
0.6 X Market value of equity/Book value of debt +
0.999 X Sales/Total assets

The original Altman Z score assigned fixed weights to each of the components. Different ranges for Altman Z score represented different levels of risk of bankruptcy. Subsequent versions of the formula varied the weights depending on whether the analyzed company is public or private and also varied the cutoff ranges for bankruptcy risk.

Altman Z was formulated for operating industrial companies
The main problem with this formulation of solvency risk is that the formula is not suited for many industries. As an example, when I first tried to apply Altman Z I found that many regulated utilities showed up as having high bankruptcy risk.

I found that Altman Z was not industry specific enough to my liking. For instance, low or negative working capital doesn’t score well on Altman Z but some industries can operate with zero or negative working capital. For example, a restaurant gets paid in cash, but their suppliers will generally give them net 30 on their payables and the inventory (food) turns over very quickly.

Another sector that the Altman Z doesn’t analyze is the financial sector. What does “sales” mean for a bank? Financials tend to be highly levered and their operating risks and exposures are not well disclosed.

A heuristic for solvency analysis of non-financials
In a recession, the combination of high operating risk and excessive leverage combine to produce insolvency for non-financial company. A better way of forecasting solvency risk is to look for companies that show:

  • High operating risk: The top two deciles of standard deviation of EBIT or EBITDA margin over the last 5 or 10 years (pick your horizon)
  • High financial leverage: The top two deciles of financial leverage, by total debt to market equity or interest coverage. Normalized decile scores by sector.

I have found that this heuristic, or simple rule of thumb, serves as a better forecaster of solvency risk as it neutralizes many of the industry specific effects that Altman Z failed to address.

Solvency analysis of Financials is difficult
The problems of creating a solvency test for financials that operate in real-time or relative real-time is not easy. It’s not hard to do after the fact, but at any one time, no one – not even the directors of the company really know what is embedded on the books at a financial. Société Générale, Barings, Northern Rock, Bear Stearns – the list of blowup surprises go on and on.

I have had some successes with a solvency risk test for lending institutions based on the following two characteristics:

  • Excessive lending growth as a sign of lending portfolio quality: In good economic times, a bank can produce earnings growth by growing its assets, or loan book. In the long run, not all banks can grow their loan books significantly in excess of GDP. High asset growth comes at a cost of lower asset quality.
  • Loan loss provisions as a measure of the current level of stress: Instead of the standard ratio of loan loss provisions to total assets, I like to use loan loss provisions to assets three years ago. It’s not the loans that you make today that go sour, it’s the ones that you made two or three years ago that tend to get into trouble.

Friday, May 2, 2008

Economic storm clouds still gathering

With headlines like Buffett: Economy in a recession, will be worse than feared and McCain & Clinton Fail Economics 101, I thought that it is time to focus on the possible effects of the November presidential elections.

Clinton or Obama presidency = Double dip?
With the US fiscal situation as it is today, a Democrat in the White House, regardless of whether it is Clinton or Obama, would likely raise taxes to try to bring the budget more into balance. Can you say double dip recession?

It’s usually in the first two years a new administration will try to take its economic medicine and blame it on the previous president. Remember how the current Bush administration tried to position the post-Tech Bubble slowdown as the “Clinton recession”?

McCain presidency = ???
When John McCain was quoted in 2005 as “I'm going to be honest: I know a lot less about economics than I do about military and foreign policy issues. I still need to be educated” in that bastion of left wing politics, the Wall Street Journal, the country could be rudderless economically.

A more recent quote shows that he still has no economic direction: “The issue of economics is not something I’ve understood as well as I should. I’ve got Greenspan’s book.”