Stocktake

Last year was a nerve-free ride for investors, the S&P not only advancing 30 per cent but never falling below its 200-day moving average. Will volatility make a comeback this year? An increase can be presumed, given 2013’s remarkable calm, although it is clear we are in the midst of a low-volatility cycle. The first year since 2006 that the Vix, or fear index, didn’t exceed a reading of 30 was 2012. It never got above 20, its historical average, in 2013, and ended the year at 13.5. The European equivalent, the VStoxx, averaged 18 in 2013, compared to 24 in 2012 and 30 in 2011.

Deutsche Bank predicts normal earnings and normal returns but also normal volatility this year, which means at least one dip of 5-10 per cent. Goldman Sachs, too, says there is a 67 per cent chance of an official market correction – a decline of at least 10 per cent – as does S&P Capital IQ's Sam Stovall, who notes the market has gone 27 months without a double-digit decline, compared to the median figure of 12 months.

What might cause such a decline? Piper Jaffray analysts note mid-term US election years are typically volatile. Since 1930, the median pullback during such years has been 17 per cent. This may be another good year, but it will likely be a more testing one.


Look out for price declines
Might earnings be the catalyst for a market decline? FactSet notes 94 US companies have issued negative guidance for the coming quarter – the highest number since it began to track data in 2006 – while just 13 have issued positive guidance, the joint-lowest number over the same period.

It’s not all grim. Companies issuing guidance have lowered estimates by just 5.7 per cent, compared to a five-year average of 11.1 per cent and a five-year median of 7.8 per cent. Companies may miss estimates, but they won’t miss by much. However, investors are getting fussier. Companies missing estimates are being hit with two-day share price declines twice as large as the average seen over the last five years. Even companies issuing positive guidance are, on average, seeing slight share price declines – the first such incidence in five years.

Last year’s market advance was almost entirely based on an expansion in valuation multiples, investors ignoring muted earnings, but FactSet’s data indicates they may be not be as forgiving this year.

Falling for the frivolous folly of annual predictions
The best set of predictions for this year come from investment manager and blogger Barry Ritholtz. Looking at 15 separate areas such as S&P 500 and emerging market returns, Chinese GDP and more, his answers range from "no idea" and "haven't a clue" to "could not fathom a guess".

Behind the humour is a serious point regarding the folly of forecasting: no serious investor believes in silly price targets and absurdly specific predictions that almost invariably fail to materialise.

The forecasting game is frivolous and sometimes dangerous. The best approach is to be agnostic, to think in terms of probabilities. As Ritholtz notes, however, many people make predictions and then marry those forecasts. They would rather be right, it seems, than make money.


Twitter's December flutter may be just that
Sometimes Mr Market goes bananas. Take Twitter. After a calm November, the stock went skyward in December, topping out at $75 (€55) – nearly triple its $26 flotation price – before quickly tanking by 20 per cent.

The run-up left analysts scratching their heads. "Either the bankers weren't smart enough to price this right or this could be a feeding frenzy," said Cantor Fitzgerald. One can hardly argue the former. Twitter was wildly overpriced even at $26, when it traded at a higher price-sales ratio than any other major flotation over the previous four decades. After crunching the numbers in October, valuation guru Prof Aswath Damodaran said Twitter would be a "very good deal" at $10, a source of indifference to him at $17.50, and a "moon shot" at $35.

But $75? A valuation of more than $40 billion meant Twitter, which has yet to turn a profit, was trading at nearly 70 times revenues – more than triple that of Facebook and LinkedIn, which are overpriced by almost any conventional valuation metric.

Some point to the low float, the limited number of shares put on the market forcing enthused investors who wanted in on the action to bid the price up. Some are naïve folk who will always be seduced by story stocks. Others are momentum traders who know the price is crazy but realise momentum trumps valuation in the short-term.

A good trade? Maybe. A good investment? Incredibly unlikely.