Trader's Diary

March 28, 2013 6:39 pm

Cyprus not easy to dismiss in the long term

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Stock markets have so far shrugged off the crisis

How will the Cyprus crisis affect our own stock market? No one knows with any certainty because there are no historical precedents to guide us

The troika – European Central Bank, the International Monetary Fund, and eurozone countries – charged with containing the crisis has handled events poorly. It initially attempted to circumvent EU-wide insurance for deposits up to €100,000 with a special one-off tax.

Policy changes were made quickly in response to the uproar that followed. It now appears that small deposits are safe but large depositors and bondholders will take a very significant “haircut”.

The troika’s actions shocked depositors and bondholders throughout the EU. It also undermined recent efforts to build respect and confidence in governance by Brussels.

So far, reactions by UK investors have been muted. At the recent low point, shares had slipped by just 3 per cent since their March 14 bull market peak. A decline of this size in the face of so much bad news impressed me.

Looking ahead, I anticipate two widely different stock market reactions to the Cyprus crisis: mild price swings in the near-term and extremely high volatility further down the road.

For the moment, positive economic developments on both sides of the Atlantic appear to be supporting shares.

The US economy continues to expand, a good sign for investors in all western stock markets. US unemployment is falling. Retail sales are holding their own. The residential real estate market is in a firm uptrend.

Best of all, the Federal Reserve continues to reassure investors that its quantitative easing programme will not end in the immediate future.

Here at home, many forecasters worry that our economy is on the verge of slipping into recession. But fresh economic data might be signalling a different tale. Recent retail sales figures are stronger than anyone expected. Unemployment levels are static, not rising.

But the longer-term implications of the Cyprus crisis concern me.

Senior bondholders and large depositors are destined to lose a substantial chunk of their capital. This could trigger significant behavioural changes in the future. Depositors will probably be less willing to keep large balances in their accounts.

Bondholders will question if the coupons they receive are sufficient to cover higher risks. Depositors in other countries are not blind either. The slightest hint of an escalating bank problem in any EU country, especially one on the southern rim, is now likely to trigger some degree of capital flight.

Another worry is that capital controls just instituted in Cyprus go against the central tenet of the EU banking system – the free flow of capital. Trust in EU regulators has been damaged, despite protests that this action is a one-off event.

The Cyprus incident also reveals (again) the chaotic state of EU decision making. Investors know that rules can be changed in a flash, especially if they support German domestic political requirements.

So, back to UK investors. In the short term, there is a good chance that stock market reactions will be mild, assuming agreements are honoured and economic news continues to be positive. In such an environment, shares might fall by a small margin or drift sideways as investors digest the gains of recent months.

But looking further ahead, the odds have risen that the next threat to an EU bank, especially one on the continent’s southern rim, will trigger immediate and significant reactions by depositors, bondholders and frightened investors. Welcome to a return of 2011, where double-digit stock market declines occurred all too frequently.

Turning to our stock market, I notice that the conflict between “reported” earnings – the figures companies use for tax purposes – and “adjusted” earnings is once again rearing its head.

David Schwartz
I anticipate mild price swings in the near-term and high volatility further down the road

- David Schwartz

Management believes adjusted earnings provide a truer picture of a company’s underlying performance because they eliminate one-off items. Experience teaches me that investors do not always agree. Adjusted figures are treated differently at different points in the stock market cycle.

Investors often react positively to adjusted earnings figures near the beginning of a bull market when shares are lowly rated. But once a bull market matures, adjusted figures are more readily accepted by investors in large companies in the FTSE 100 and 250 indices. Small company investors often appear to have less confidence in them.

The problem is especially significant when the reported and adjusted profit trends move in different directions. Advertising group M&C Saatchi provides a useful example.

The company just released its 2012 financial results. Adjusted figures looked positive, with earnings 7 per cent above prior year figures. Profits were boosted by several new account wins. The company expressed confidence that further advances would occur in 2013.

But the reported profits figure, before any adjustments, told a much weaker story. It fell by an eye-watering 60 per cent from a year earlier. The difference between the two figures was largely due to costs that would be incurred if the company bought out minority owners.

The current price-to-earnings ratio is around 14 if based upon adjusted profits but a much higher 29 if based upon reported profits. If past trends are any guide, I suspect that these shares have little upside potential until reported profits significantly improve.

Stock market historian David Schwartz is a short-term trader writing about his own trades
tradersdiary@ft.com

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