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Exuberance and Gloom - Q4 2018

Exuberance and Gloom is a global financial markets analysis made by Stephen Rufino Ph.D, CIIA, Galeo's financial analyst.

“May you live in interesting times” goes the curse and Q4 was certainly interesting. The SP 500 tumbled 14% over the quarter to finish the year down 6%. This reversal was driven by the re-emergence of worries about a hawkish fed, European softness, trade barriers and slowing Chinese growth but also by declining US earning expectations. In Q4, the US markets joined other world markets in making 2018 a terrible year for investors. 

In the quarter, the SP 500 plummeted 14% while its 10-year historical earnings grew 4%, crushing equity valuations and driving sentiment away from the exuberance zone. Implied volatility more than doubled to finish the quarter at 25.4, leading sentiment well below its historical average. Credit spreads widened considerably pushing sentiment down to its historical average. US sovereign short-term rates rose while long-term rates fell, reducing slope of the curve to nearly flat and increasing bond sentiment further towards the exuberance zone. 

In the corporate arena, initial claims rose but remained very low, keeping employment sentiment exuberant. With 12-month earnings rising, profitability sentiment was driven further above its historical average. 

 

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 Exuberance and Gloom - Q4 2018

 
Exuberance and Gloom - Q3 2018

Exuberance and Gloom is a global financial markets analysis made by Stephen Rufino Ph.D, CIIA, Galeo's financial analyst.

 We look at four US market indicators (equity valuation, 10y bonds, corporate bonds and options) and determine whether these reflect rational expectations of market participants or excessively optimistic (Exuberance) or pessimistic (Gloom) ones. Similarly we look at two indicators affecting companies, corporate earnings and new jobless claims. For each indicator the Exuberance and Gloom zones are defined on the basis of its historical behaviour. To facilitate reading of the various charts we have constructed them to ensure that observations in the upper part of the chart indicate Exuberance and those in the lower part Gloom.

 When several indicators are in the Exuberance zone it is a strong indication that investors are allocating their capital based on irrationally optimistic assumptions and that markets are susceptible in the midterm to considerable downside. Conversely when several indicators are in the Gloom zone there is potential for substantial upside.

 The quarter saw a sweeping improvement in market sentiment. After regaining their composure in the second quarter, investors were emboldened in the third quarter as they drove the SP500 up 7.2%. With SP500 prices rising more than 10-year earnings the cyclically adjusted P/E ratio rose from 30.4 to 31.8, leading sentiment higher towards the limit of the exuberance zone. Implied volatility dropped from 16 to 12 driving sentiment to just below the exuberance zone. The slope of the US sovereign bond curve flattened, leading sentiment higher above its historical average. High-yield spreads fell over the quarter driving credit sentiment higher towards the exuberance zone.

 In the corporate arena, initial claims remain extraordinarily low maintaining employment sentiment in the exuberance zone. SP500 earnings increased faster than their historical trend leading sentiment higher above the historical average.

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 Exuberance and Gloom - Q3 2018

 
Article in Financial Risk Management

Paradoxes of Portfolio Performance Calculation for Wealth Management: Avoiding Reporting Pitfalls

 This year, we have worked on a paper with Prof. Emmanuel Fragnière that has been published in the Journal of Financial Risk Management.

 Abstract:

 Clients of wealth management banks are usually informed about their portfolio through regular reporting. To maintain client trust, it is important that this reporting be both comprehensive and comprehensible. This reporting is grounded on complex mathematics in order to calculate myriads of profit and loss, performance and risk indicators. As the amount of information provided to clients increases so does the chance that certain elements will be confusing to them, at the risk of undermining their confidence in their wealth management bank. This risk is compounded by the general increase in portfolios of complex financial products involving different time horizons. The reporting is typically a decision aid tool for the client to monitor and control and make investment decisions. One example of such risk is that the calculated risk and performance indicators are delivered to the client with no explanation and can, in some cases, lead to incorrect perception due to misunderstanding of these numbers, even if calculations are correct. A typical example could be that the client is informed that the performance of the portfolio is 7% and in reality, the portfolio is losing money. In this paper, we want to address this kind of problem. As such we have identified a set of typical pitfalls that we are faced within the profession. Then, based on a rigorous reference to the scientific literature we have popularized these pitfalls and employed a series of simple and didactic illustrations to provide an appropriate toolbox in order to reduce the risk of financial reporting misunderstanding. In order to maintain client confidence, we highlight the importance of identifying areas of potential misunderstanding prior to providing reports to clients and of offering clear explanations for unusual numbers. We address the following themes: Profit and Loss Analysis, Performance Calculation, Performance Contribution, Realized and Unrealized Profits and Losses, and Bond Yields.

Download the paper here.

 Journal of Financial Risk Management