Parallels with Q4 2008? – where to go long or short

Many of us feel a great sense of déjà-vu when watching red share price screens this past quarter. Some say that things can’t be as bad as 2008 since the world has deleveraged considerably since then. Others say this crisis is worse since Chinese consumption is slowing down and the emerging markets will not pull the developed world out of its malaise. Eclectica’s Hugh Hendry believes we are in a depression rather than a recession (click here). Ever eager to treat all moments as opportunities rather than to sit around being gloomy (in a Jim Cramer-esque fit of bullishness) we have looked at which investor sentiment indicators might work best in the months ahead based on what happened from Q4 2008. Of course, the world currently has a nasty habit of throwing the form book out of the window but here goes.

Webinar

Do tune in for our Webinar today on performance benchmarking and trading (click here)

Definitions and methodology

Across three selected regions, U.S. large cap, FTSE all caps and Hang Seng all caps, we have assessed the cumulative quarterly returns from buying shares according to four factors based on securities lending flow: short selling activity (high or low utilization) and holdings of long only asset manager who lend (high or low lendable).

Stocks are ranked according to these factors and placed in four categories. The model reselects securities each month but the share price returns for each quarter are the sum of the monthly returns in more technical terms, the geometric product of the returns. We have looked at each quarter going back to August 2006.

The importance of knowing the “regime”

Half the battle with managing money by screening according to various ‘technical’ data points is to know what mood the market is in. When a market is trending steadily in one direction, up or down, some quants do well but find life very challenging when politics and fear set the tone. Short sellers can go against a rising market in predicting price falls and be wrong for a long period before being proved right when a correction occurs.

This was the case in 2007 as you can see from the S&P chart. If you were contrarian and bought stocks with high short interest (‘high active utilization’ in green) you would have made money every quarter from August 2006 until Q2 2008. But, in the quarter when Lehman defaulted, the market was down 8% and those same shares were down 23%. The short sellers got it right but only after suffering losses for many quarters in the run up.
There are moments to follow the short sellers regardless of the borrow cost or risk but moments to go against them when the chances of small short squeezes are higher. So the aim is to find out where we might be now.

U.S. large Cap

For those thinking that August/September 2011 was akin to Sept 2008, there are two important questions to address when anticipating the future. Are we about to witness a new “junk rally” such as the one launched by the central bank stimulus in March 2009, whereby the most shorted and least “fundamentally sound” companies outperformed the market until September of that year? Or, are we pre that stage and in a moment more akin to the final quarter of 2008?

In Q4 2008 there were multiple short sale bans, the Tarp stimulus package was signed off and forced bank recapitalization took place. This time, we have only four short sale bans but none in the U.S. (in fact the NY Fed just published a paper highlighted that short selling bans do not work www.dataexplorers.com/research). We have a new USD 800m infrastructure stimulus and European banks look set for fresh capital before the year is out. Essentially, it is as if time has stood still and we are back in Q4 2008.

Which companies outperformed the market most in Q4 2008? Stocks with low short interest (low utilization) with a high degree of institutional ownership were the assets to own in this period in the U.S. This basket was up about 3% when the market was down 20%. But, when the junk rally kicked off, the stocks to be long were the most shorted ones, see the green bars on the chart during Q2 and Q3 2009. The question to ask is will we see another prolonged junk rally?

FTSE All Share

With USD 112.5bn of new quantitative easing in the UK it is an open question as to whether things look more like Q4 2008 than Q1 2009. Back in the final quarter of 2008, highly shorted companies fell hard (green bar) and the only names that outperformed the index were the ones with high institutional ownership (light blue bar), mirroring the situation in the US large cap world. You only have to look at the share price performance of high levels of short interest in Supergroup (LSE:SGP), which recently issued a profits warning and recent examples in Ocado and across the struggling second tier UK retailers to see current evidence of this working again.

The following quarter of Q1 2009 saw outperformance from names with low ownership from funds that lend. As the junk rally hit full swing, highly shorted names were up 23% more than the market which was up 38%!

Hang Seng

The current ‘regime’ in Hong Kong could be said to be rather different. It is not so much the continuation of a three year old problem that is haunting the region, but the slowdown of the great Chinese cash machine and the forced pricing of a real estate boom. Does this mean that Hong Kong is going through its own 2007 moment as some have suggested? The property slow down mirrors what happened at the end of 2007. At that moment, the market was down 2% and then down over 20% in early 2008. The best performing sentiment factor then was to own shares with very low short interest (the purple bar).

If we forget the regime for a second, the best performing factor in Hong Kong, with some enormous returns, is going long Hong Kong companies with low ownership from offshore/international funds who lend (red bars). The Data Explorers inventory for HK names mirrors the holdings of US and European Custodians who hold assets on behalf of the global super funds. The data shows that these funds are NOT the ones to follow! If you followed their choice you would buy the shares in the light blue bars yet it pays to buy shares where they are under-invested by contrast, in the red bars!

Final Word

Stock markets are in limbo until the Cannes meeting of the G7 in early November. We are told that the bold and big new rescue package will be announced. Will this herald the moment when market confidence returns and a new (junk) rally kicks off?