March 13: This is just an unprecedented period of intraday volatility. I can't remember another period of such wild daily swings in leading shares prices or such large percentages of companies "changing hands". We are almost at the point where the biggest value you can add is writing daily trading strategy that more often than not coincides with a market bottom. With Easter falling early this year, there are now only 11 trading days (including today) in Australian equities until the end of the quarter. We all know how important quarterly performance numbers are.
Daily percentage moves we are seeing in leading stocks, particularly financials and resources, are truly unprecedented. If you are a nimble enough trader you could potentially generate a better-than-cash annual return by simply trading leading stocks at extremes. For example, on Tuesday (See There will be bounces) we wrote about a pending 10-15% trading bounce/short squeeze in financials and by Thursday the first 10% of that rally had already occurred. It is that quick and that violent. It's the speed at which everything happens that is stunning and we need to be vigilant in attempting to be one step ahead of the next mass market move. There is no prize for being late. In fact there is severe punishment for being late.
This is not about fundamentals at the moment and I am sure that is the part that frustrates corporate management teams and long-only investors. This is all about psychology and liquidity. I genuinely think a psychology degree would be more useful than an economics degree at the moment in writing equity strategy. We are in between reporting seasons and this is all about global trading sentiment and the short-term power of leveraged investors.
Volatility provides opportunities
Last week the ASX 200 fell by 5.5%, representing the worst week for Australian equities since October 1987. In the year to date the ASX 200 has fallen 17% and fear has clearly replaced greed as the main driver of domestic equities. Consequently, fundamentals are viewed as some bull market phenomenon from times long past. At present all news is bad news, and once again the domestic equity market is in classic capitulation mode. The fact winners have been dumped confirms the capitulation phase.
In the current environment, domestic equities remain hostage to rumours and speculation and it appears the major motivation for many investment decisions is purely capital preservation. As a result, the daily domestic equity market action has been characterised by massive 10% intra-day trading ranges for even the big-cap, high-quality stocks. However, as history reveals, when fear is the major driver of investor sentiment and fundamentals are obscured by bearish sentiment, opportunity invariably emerges.
In our recent strategy outlook I expected volatility to remain a feature of global and domestic equity markets for at least the first quarter of this year. However, events last week elevated volatility to new extremes. I think it is important to view volatility as an opportunity. In this regard, I believe the current extreme intra-day volatility is highlighting some real mispricing anomalies and excellent trading opportunities in big-cap, high-quality companies.
The fear index
At times of extreme negativity we often look at the VIX, or the fear index, as a classic indicator of bearish sentiment. However, we also view the VIX as the classic reverse indicator of equity market performance. In this regard the VIX rose to 29.3 on Monday in the US, which is currently at levels consistent with strong equity rebounds in the past.
The first chart shows the Chicago VIX index, which clearly indicates bearish sentiment has peaked four times in the past 12 months around the 30 level. The second chart overlays the S&P 500 with the VIX index, revealing a strong correlation with extreme levels of bearish sentiment and a strong rally in the S&P 500. As a rule, every time the VIX has approached the 30 level and the height of bearish sentiment, the corresponding rally in US equities has averaged 8.5%. Although history is no guide to the future, I believe the overwhelming bearish sentiment and extreme volatility is highlighting some great trading opportunities.
nVIX hits 30, a trading buy signal in global equities
Global equity market direction is all about the direction of financials and Australian financials are simply tracking global financials sentiment. The trading world is treating all financials as guilty and the punishment is indiscriminate. Clearly that is not rational but that is what's occurring. To prove the point below is a 12-month chart of the Amex Broker/Dealer Index (XBD) versus Macquarie Bank (MQG). As you can see it is a perfect correlation.
nMacquarie Bank (red) vs Amex Broker/Dealer index
Macquarie Group has now underperformed the Amex Broker/Dealer index over the past 12 months, which is unbelievable considering the Amex index consists of such heavyweights as Merrill Lynch, Morgan Stanley, and Bear Stearns. Those three alone have already written off $US37 billion in sub-prime trading-related losses, yet Macquarie Group has underperformed an index dominated by them. For Macquarie to underperform that group is quite unbelievable.
This is an example of how volatility and indiscriminate liquidity provide opportunity. On pretty much all investment criteria, most noteably balance sheet criteria, Macquarie Group is a stronger company than all the members of this index. It has more annuity style income streams than its peers and far less reliance on trading income, yet here it is underperforming an index of companies some of whom are having a genuine capital crisis and have required "hurt money" funding from global sovereign funds.
Why has Macquarie Group underperformed this index? Well, as I mention above, it hasn't appeared to do anything to fight the shorting attack. Its listed satellites are being attacked and its head stock is being attacked. Macquarie Group seems to think that reiterating profit guidance will end the attack but it has not. Sure, Macquarie has had some high-profile, long-standing, management departures but that doesn't explain the underperformance. The real reason in my opinion is it hasn’t dealt effectively with the liquidity and rumour attack on itself and its satellites, and that requires immediate action. I know it's a cliché, but actions speak much louder than words – particularly in a market like this.
Prey becomes predator
I spend way to much time watching the Discovery Chanel and I love documentaries on natural selection. I particularly enjoy when the prey turns on the predator. On this basis I find difficult to understand is why so few Australian companies are standing up and buying back their scrip at discounted prices.
Macquarie Bank (MQG) is rightly regarded as financially savvy, but its stock is trading on just seven times 2007-08 earnings (after falling 50% from its peak, with 155% of the company changing hands); it has excess capital to deploy, and it’s beyond me why it doesn’t embark on a 10% buyback that would be solidly earnings per share positive and be the catalyst for a short squeeze in their massively shorted stock.
Action – not talking – is how you end shorting attacks. I just can't work out why more Australian companies aren't buying back their stock. In most cases the best investment they could make would be in their own shares and I think Macquarie is a classic example. This may well prove a once-in-a-decade opportunity to buy back significant amounts of stock at deep discounts from shorters. Macquarie should do a 10% buyback and it should do it right now. It should also defend its discounted satellites or, in fact, bid for a listed satellite.
Macquarie Group could hardly be criticised for buying back its scrip 50% below where it was most recently issued. Unlike just about every other Australian bank, Macquarie issued scrip at the top rather than bought it back. Now, it is capital rich and in a position to reduce its capital base and turn on the shorter predators. I can't believe any Macquarie director could seriously and believe the company’s shares should have done worse than the Amex Broker/Dealer index.
If that is the case they need to act and act now. I think Macquarie is a grossly oversold Buy and a world leading franchise. However, I also need the company to join the fight with us. The biggest short squeeze potential of all Australian financials is in Macquarie, but the company needs to enter the fray with some decisive on-market action. Macquarie shares will rally 25% if it follows our advice.
Here's one other metric why I like Macquarie down here. Macquarie employs 11,000 staff in 25 countries. The current market cap is $13.8 billion. That works out at $1.25 million of market cap per employee. I think that genuinely undervalues its intellectual property. Buying into Macquarie at a market cap of $1.25 million per employee is a cheap entry price.
Macquarie’s situation is somewhat symptomatic of a broader market that is experiencing unprecedented volatility. Excess volatility, particularly mass-attack shorting, eventually has an effect on both investor and corporate confidence. The volatility makes people freeze and debate the merits of decisions that make absolute economic and financial sense. People start considering "what if" downside scenarios, and corporates worry way too much about how the market will respond rather than if the idea is financially compelling. Trying to second-guess the knee-jerk market response is not how to run a company for the long term. In the current environment, almost all corporate decisions will be greeted by a sceptical market, but remember it wasn't that long ago that every move made by Centro Properties, MFS, Allco and ABC Learnings Centres was greeted with a positive share price and analyst response.
Right now is the time to embark on the true companymaker transaction. Don't worry about what the market or analysts think in the short term. This is the time and I would love to see more Australian companies (outside of resources) either stand up and buy their own shares back or embark on some genuine risk-adjusted M&A. This is when you buy assets well: when prices are lower, competition for assets is lower and funding harder to get.
Unfortunately many people seem to think the right strategy is to buy assets when money is easy to get and earnings per share accretion is easy to create. As you can see from recent implosions that is not how to build a sustainable business model. The equity market will give you capital for sensible M&A. The equity market is always open to fund sensible M&A. It requires guts and conviction but I am certain this is the right time to buy franchise and marquee assets even if that is simply via buying back your own shares. It's time that corporate Australia stopped whingeing about "shorters" and started taking advantage of them. One thing you do know for certain about shorters is eventually they will have to buy back their shorts.
MQG Price at posting:
0.0¢ Sentiment: None Disclosure: Held
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