How the VAR Model and Japan’s Tragedy Affect Investors

By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors

 

 

Our thoughts and prayers are with the people of Japan. The videos, images and stories of the devastation caused by last week’s earthquake and tsunami have touched our hearts and rattled investor psyches around the world.

 

The threat of disaster from the damaged Fukushima nuclear power plant unleashed a ferocious sell-off of Japanese equities, but the damage to other major markets has been limited. Already experiencing a slight pullback prior to the events on March 11, U.S. equities and emerging markets have held up quite well. The MSCI Emerging Markets Index has only pulled back 2 percent since the earthquake and the S&P 500 Index only 3 percent.

 

 

Japan has experienced similar disasters before on a smaller scale. In 1995, the Great Hanshin Earthquake severely damaged the port city of Kobe, killing more than 6,000 people. Japanese industrial production (IP) fell by 2.6 percent during the January following the earthquake, according to Societe Generale analyst Takuji Okubo. However, that drop-off was short lived. Okubo reports that IP sprang up 2.2 percent the following month and 1 percent during March.

 

 

 

Goldman Sachs estimates that the total cost of damage from the March 11 earthquake will be $198 billion—roughly 1.6 times that of the Great Hanshin earthquake. That works out to roughly 4 percent of GDP. However, Martin Wolf from the Financial Times points out that as of March 17, Japan has lost $344 billion worth of market cap since March 11, equaling nearly 7 percent of the country’s GDP.

 

Why have investors reacted this way? Investor anxiety and the selloff have been exacerbated by two trends which have plagued Wall Street over the past few years: The excessive use of Value-at-Risk (VAR) models and a risk-averse herd mentality.

 

The VAR Model is used by investment firms and others to measure the market risk of their asset portfolios by calculating the probability of maximum loss given a certain time period, i.e. “how much could I lose in a really bad day (month)?”

 

VAR models have three different components: A time period (generally a day or a month), a level of confidence (generally 95 or 99 percent confidence level) and an estimate of investment loss. There are three mathematical models used to calculate VARs: Variance-Covariance, historical simulation and Monte Carlo Simulation. (Editor’s note: For an in-depth explanation of these concepts, see Investopedia and HedgeFund-Index.)

 

All of the major investment firms have a risk management officer who uses some form of a VAR model. Their biggest concern is the daily, weekly, and monthly volatility. There’s a certain level of volatility that financial institutions can’t stomach because they are leveraged themselves.

 

It’s similar to the freezing point when water turns to ice. Once this level is reached, the risk management officers give portfolio and money managers a “tap on the shoulder” to reduce risk and raise cash levels. Since risk managers all over the world are using very similar models, it creates a herd mentality and stock sales all get triggered at the same time. Similar herd mentalities and groupthink have led to some of history’s most infamous financial calamities such as the crash of 1987 and 2008 after the fall of Lehman Brothers.

 

The VAR herd mentality shows up in the volatility index, or VIX, which is a measure of stress in the system. Currently, it’s a combination of forces (the ongoing turmoil in the Middle East and North Africa and Japan’s natural disaster) that is injecting stress into the system. The VIX pushed toward the 30 level this week, a level that has historically been associated with “extreme market turbulence.” As of mid-week, the two-week change in the VIX represented the sixth largest move in the past 20 years, according to Greg Weldon.

 

 

Once stability returns and a new equilibrium is found, the VIX then falls and the risk management officer allows the money managers to invest again.

 

Periods of high volatility and uncertainty generally cause investors to head for cover and liquidate assets but we think investors should do the opposite—classic contrarian thinking.

 

A prime example occurred two years ago. On March 18, 2009, we highlighted for investors in a special alert that a shift in government policy—an amended FASB-157 “mark to market” rule, a change to the short sell (uptick) rule and a $300 billion liquidity injection from the Federal Reserve—meant a strong wind was hitting the market’s sails and was likely to cause a massive price reversal. We were confident of this shift because these events fit into one of our core tenants of our investment process—that government policies are precursors to change.

 

Two years later, large growth funds, large value funds and world stock funds have all risen 40 percent or more, according to Morningstar. Some asset classes such as midcaps and natural resources stocks have doubled off of their lows but are still working to regain previous highs.

 

 

Unfortunately, instead of buying into the opportunity, more than $25 billion was pulled out of domestic and international stock funds while $22 billion flowed into bond funds, such as intermediate-term, short-term and intermediate government bond funds. The returns on those asset classes over the same March 2009 to March 2011 period were 11.9, 6.8 and 5 percent, respectively.

 

Another example is last year’s explosion of the Macondo Well in the Gulf of Mexico. Many investors dumped their investments in British Petroleum because of the regulatory uncertainty and growing costs of the cleanup, but BP’s stock has recovered more than 67 percent since its June 2010 lows.

 

The key difference between the events of two years ago and today is that natural disasters tend to cause great short-term anxiety but have minimal lasting effect, while shifts in government policy are generally precursors to significant change. BCA says that “natural disasters rarely change an economy’s growth trajectory and this earthquake should be no exception.” They continue to say that “the earnings picture of the Japanese corporate sector is unlikely to be significantly affected by this natural disaster.”

 

In fact, the total impact of the earthquake on Japan’s economy is likely to amount to 0.5 percent of GDP, not even comparable to the global credit crisis that reduced Japan’s GDP by 10 percent between the first quarters of 2008 and 2009, according to the Financial Times.

 

In America, following Hurricane Katrina, we saw that there are basically six to 15 weeks of misery before the rebuilding begins. Estimates show Japan will spend $500 billion to rebuild its economy and given the government’s long history of investing in the country’s infrastructure, we expect they will waste no time in rebuilding and repairing. Reconstruction spending will probably kick in some time during the second quarter, supporting the country’s growth rate, according to BCA.

 

We are also seeing nuclear projects being pushed back until engineers from around the globe can learn from this tragedy. This makes coal, natural gas and crude oil more attractive in terms of near-term demand.

 

A final variable to consider is the immense patriotism and pride inherent in Japanese culture. In his Financial Times column, Martin Wolf says “if any civilization is inured to such tragedies it is Japan’s. Its people will cope. This seems certain.” Japanese culture has a very strong family unit with high savings rates. If the picture of the family above is any indication, this strong culture of family will help them endure, adapt and move forward.

 

Director of Research John Derrick contributed to this commentary.

 

Index Summary

 

• The major market indices were lower this week. The Dow Jones Industrial Index lost 1.54 percent. The S&P 500 Index declined 1.92 percent, while the Nasdaq Composite fell 2.65 percent.
• Barra Value outperformed Barra Growth as Barra Value finished 1.56 percent lower while Barra Growth declined 2.28 percent. The Russell 2000 closed the week with a loss of 1.02 percent.
• The Hang Seng Composite Index finished lower by 3.40 percent; Taiwan was down 2.02 percent, and the KOSPI gained 1.31 percent.
• The 10-year Treasury bond yield closed 14 basis points lower at 3.27 percent.

 

Domestic Equity Market

 

The figure below shows the performance of each sector in the S&P 500 Index for the week. One sector increased and nine decreased. The best-performing sector for the week was energy which rose 0.37 percent. Other top-three sectors were materials and telecom services. Utilities was the worst performer, down 4.3 percent. Other bottom-three performers were technology and consumer discretion.

 

Within the energy sector the best-performing stock was Southwestern Energy which rose 11 percent. Other top-five performers were Peabody Energy, Consol Energy, Cabot Oil & Gas, and Range Resources Corp.

 

 

Strengths

 

• The coal & consumable fuel group was the best-performing group for the week, up 10 percent. All three stocks in the group increased for the week as investors appeared to seek out coal stocks in the expectation that coal usage for power plants would increase due to uncertainty over the future of nuclear power as a result of the damage to the nuclear plant in Japan.
• The diversified metals & mining group outperformed, rising 4 percent, led by its largest member, Freeport McMoRan Copper & Gold. A major brokerage firm reiterated its “outperform” rating on the stock, citing their view that the shares are pricing in a lower copper price than they believe is warranted. The price of copper increased during the week.
• The construction & farm machinery group rose 3 percent, led by its largest member Caterpillar, which reported that retail sales were up 59 percent in the three months ended in February, an acceleration from the 49 percent gain reported for the three months ended in January. It was the tenth-straight month of improving sales.

 

 

Weaknesses

 

• The footwear group was the worst-performing group for the week, down 11 percent, led by its single member, Nike. The firm reported third-quarter earnings below the consensus estimate, and it said that gross margins fell 1.1 percentage points in the third quarter. Also, margins are expected to narrow by 3 percentage points in the fourth quarter and continue to decline in the next fiscal year. The company has been hurt by higher product costs, elevated freight costs, and a smaller proportion of license revenue.
• The apparel & accessories group declined 9 percent, led by Coach and Polo Ralph Lauren. Luxury goods retailers sold off in response to the nuclear power plant disaster in Japan.
• The electronic manufacturing services group underperformed, falling 8 percent. Group members Jabil Circuit and Molex sold off after electronics contract manufacturer Sanmina-SCI warned that its fiscal second quarter ending in March will be below analysts estimates.

 

Opportunities

 

• There may be an opportunity for gain in merger & acquisition (M&A) transactions in 2011. Corporate liquidity is high, thereby providing the means to pursue acquisitions.

 

Threats

 

• Should investors’ expectations for an improving economy not come to fruition on a reasonable time frame, it could be a threat to stock prices.
• Quantitative easing (QE2) currently being implemented by the Federal Reserve might result in unintended consequences.
• The nuclear disaster in Japan creates uncertainly, which is not good for stock prices.

 

The Economy and Bond Market

 

Treasury bond yields fell again this week as safe haven buying continued due to concerns surrounding the unrest in the Middle East and North Africa and the evolving potential nuclear disaster following the Japanese earthquake and tsunami on March 11.

 

The graph below shows the month-over-month change in the Consumer Price Index (CPI). CPI has been accelerating at a fairly rapid clip over the past few months. Food and energy prices have been the primary drivers which most economists exclude when divining the “true” inflation trend. This thought process is fine when prices quickly revert to the mean but that has not been the case in recent years and consumers are feeling the pinch on everyday items. Recent inflation data has not been favorable: For example, producer prices rose sharply as food costs at the wholesale level rose 3.9 percent, the largest increase since 1974. Import prices were also elevated as was Eurozone inflation, which at 2.4 percent was the most since October 2008. This situation bears watching and has the potential to quickly change when the Fed may change direction.

 

 

Strengths

 

• The Conference Board’s Index of Leading Economic Indicators rose for the eighth straight month, indicating continued economic expansion.
• The Philadelphia Fed Manufacturing Index hit a 27-year high in a sign that the manufacturing segment of the economy remains robust.
• At the Fed’s regularly scheduled Federal Open Market Committee (FOMC) meeting this week, the Fed acknowledged an improving economy but also reiterated no change in monetary policy.

 

Weaknesses

 

• Inflation indicators were higher across the board and raise the stakes on continued loose monetary policy.
• Housing starts fell sharply in February, near record lows set in April 2009. Building permits fell to record lows and home loan demand fell 4 percent last week as the housing market remains very weak.

 

Opportunities

 

• In an interesting twist, higher oil prices may actually act as a deflationary force if they materially slow global economic growth.

 

Threats

 

• Treasury yields could come under pressure as demand for Treasuries wanes. QE2 will end in June and China is already reducing Treasury holdings and Japan is likely to curb its purchases in order to rebuild the earthquake-damaged areas.

 

Gold Market

 

For the week, spot gold closed at $1,418.90, up $1.45 per ounce, or 0.10 percent for the week. Gold equities, as measured by the Philadelphia Gold & Silver Index, fell 1.21 percent. The U.S. Trade-Weighted Dollar Index slid 1.49 percent for the week.

 

Strengths

 

• In a chaotic week of fears over a nuclear plant meltdown and a new war front opening up in Libya, gold held up and the U.S. dollar fell.
• Even when gold sold off on Tuesday due to liquidity needs of certain investors to cover other losses, there turned out to be a net positive accumulation of gold bullion by exchange-traded funds.
• Across several Asian markets, premiums for gold bars and coins rose due to investor demand.

 

Weaknesses

 

• Platinum and palladium fell on expected curtailments in auto production in Japan, and renewed economic worries over a collapse in U.S. housing starts and rising fuel prices pinching economic growth.
• A recent report by the Bureau of Land Management appeared to show there was no economic contribution from hardrock mining on federal lands.

 

Opportunities

 

• Hong Kong’s Chinese Gold & Silver Exchange Society, a century old bullion trading bourse, announced plans to start trading gold quoted in yuan in May. The plan is to expand the role of the yuan in global trade as China works to reduce its dependence on the dollar as its functional foreign exchange currency.
• Historically, gold demand is about 3,000 tons per year, with new mine supply providing 2,400 tons, scrap supply about 200 tons and central bank sells supplying the balance of roughly 400 tons.
• China replaced South Africa as the world’s largest producer of gold back in 2007. However, the gold produced in China is purchased entirely by their central bank. In addition, during the first two months of 2011, China imported more gold than all its imports in the last year. At their current rate of buying, Chinese consumers could buy half of the new mine supply produced this year. Meanwhile, more than 400 tons historically supplied by Western central banks has fallen to zero.

 

Threats

 

• In the upcoming presidential race in Peru, several of the candidates are talking about imposing windfall profit taxes on miners operating within the country.
• In South Africa, Minister of Mining Susan Shabangu has conveyed that she is looking at the tax template Australia tried to implement on its mining industry last year.
• In response to China recognizing it may have to limit its exports of rare earth metals, four U.S. Senate Democrats sent the U.S. Treasury and the Secretary of the Interior a letter urging them to block Chinese mining projects in the U.S. and internationally.

 

Energy and Natural Resources Market

 

Quick Thoughts on the Oil Market

Commercial oil inventories fell another 5.1 million barrels last week as demand outpaced new supply 4-to-1. Overall stocks are now down 38 million barrels over the last five weeks and end-use product stocks down 44 million barrels, the largest decline over the past five years, according to PIRA Energy Group. PIRA reports that overall inventories are now virtually flat, the first time this has happened since July 2010.

 

Oil prices have been resilient following the tragedy in Japan and continued unrest in the Middle East-North Africa region. Increased oil demand will likely result from an aversion to nuclear power but the biggest driver will be any good news that the Japanese situation is under control. Once this happens, we could see a strong move upward in oil prices, PIRA says.

 

Strengths

 

 

• U.S. steel production continues to advance, with the latest American Iron and Steel Institute release reporting production of over 87 million tons per year at a utilization rate of 75.5 percent. As a result, year-to-date production through mid-March is up 9.6 percent on a year-over-year basis.

 

• U.S. aluminium orders (excluding can stock) rose by 0.9 percent month-over-month in February, a strong outturn given that orders seasonally fall roughly 7.3 percent month-over-month during February. Year-over-year orders were 15.3 percent higher in February and 18.2 percent higher year-over-year over the first two months of 2011. The rise was driven by strong increases in extruded products, drawing stock and bare wire, and electrical conductors sectors.

 

Weaknesses

 

• Indonesia may revise its 2011 oil output target to 945,000 to 952,000 barrels per day from 970,000 under the state budget, the country’s finance minister said.
• Weighed by curbs and a four-fold rise in export tax, iron ore exports from India, the world’s third-largest exporter, are likely to fall 5 percent to about 58 million tons in the next fiscal year, a trade body official said.
• Crude exports from Libya fell “well below” 500,000 barrels per day as fighting intensified in North Africa’s largest oil producer, the International Energy Agency (IEA) said.
• With some of the world’s top auto makers forced to stop vehicle production because of the nuclear crisis in Japan, demand for platinum, used mainly in auto catalysts has fallen; the metal has recorded its biggest two-day loss in four months.
• The uranium spot price has been in freefall in recent days and was reported to have traded in the high $40s per pound earlier this week, down by over 30 percent from its recent peak of $73 per pound. Analysts at Macquarie Bank say the continued declines reflect a lack of resolution on the problems at Fukushima Daiichi nuclear facility. The announcement that Germany will shut 8.34 Gigawatt-electric of nuclear capacity for at least three months and the news that China is temporarily halting new nuclear projects in order to review the safety of its nuclear build plans added to the selloff.

 

Opportunities

 

• China, which controls about 95 percent of global shipments of rare earths, may start importing some of the material to meet rising domestic demand. There is a “strong possibility of importing heavy rare earths” in the next three to four years, an industry official said.

 

Threats

 

• A massive earthquake off of the east coast of Japan and ensuing tsunami has caused significant damage. Nearly 20 percent of the country’s nuclear power capacity has been shut down and the potential for a dangerous meltdown at one facility remains high.
• Canadian oil sands producers face hyperinflation as higher oil prices have prompted several new projects in the region, the head of Total SA’s Canadian unit said.
• The King of Bahrain declared martial law as his government struggled to quell an uprising by the island country’s Shi’ite Muslim majority that has drawn in troops from fellow Sunni-ruled neighbor Saudi Arabia.
• German Chancellor Angela Merkel announced this week that German nuclear plants commissioned before 1980 will be shut down for three months, pending the result from an in-depth safety review of all German nuclear plants.

 

Emerging Markets

 

Strengths

 

• The People’s Bank of China (PBoC) published a household survey for the first quarter of 2011 which shows the percentage of households that “expect consumer prices to rise further” dropped significantly to 47.1 percent during the first quarter, down from 61.4 percent in the fourth quarter of 2010. These results may support the view that the sequential CPI inflation has mostly peaked and the risk of an expectation-led inflation spiral has declined.
• Hong Kong unemployment dipped to 3.6 percent in February, the lowest since August 2008.
• In China, companies began reporting earnings for the fourth quarter of 2010 and full-year 2010 a week ago. So far, we have seen excellent revenue and earnings increases across all sectors for the reporting period.
• Grana y Montero, the Peruvian engineering/infrastructure firm, won a $120 million sanitation project and a $78 million mining project for the Yanacocha gold mine.
• Cencosud, a large Chilean retailer, reported stronger-than-expected fourth quarter 2010 results.
• Industrial output growth in Poland accelerated during February to 10.7 percent year-over-year, up from 10.3 percent in January. Car production grew by 2.3 percent from a year earlier.

 

Weaknesses

 

• The earthquake and tsunami in Japan have caused concerns of a nuclear crisis at the Fukushima Daiichi facility. Alarmed by the crisis, China and Germany, along with other countries, have started immediate safety inspection programs on their existing nuclear power plants and those under construction. Particularly in China, the government has ordered a temporary suspension of new nuclear project approval until all the safety measures can guarantee a “zero” risk, as was reported by a National Development and Reform Commission (NDRC) official. Globally, uranium and stocks of nuclear power generators and equipment makers were sold off, which many believe was an over reaction. China said it will continue its grand nuclear power development plan, which currently accounts for 40 percent of the world’s nuclear power plants under construction.
• The PBoC raised the bank’s Required Reserve Rate (RRR) this week to 20 and 18 percent for large and small banks, respectively, effective on March 25. It is believed that money supply tightening will continue until China inflation is under control.
• In India, the central bank raised its benchmark interest rate by 25 basis points to curb inflation. This is the eighth time the Indian central bank has hiked rates since early last year.
• The earthquake and its damages may cause Japanese GDP to drop at least 1 percent and disrupt some Japanese industrial supply chains, such as auto parts and high quality steels. Some exporters to Japan will see their sales drop, at least temporarily, due to disruption of Japanese industrial buyers.
• Mexican home builders are facing numerous headwinds and the recently held investor day did not clear many hesitations of investors. The stocks of Homex, Ara and GEO have been major underperformers on the Mexican Bolsa this year.
• Turkish Prime Minister Recep Tayyip Erdogan’s visit to Russia capped a four-week period of spectacular changes to Russian energy transit projects in the Black Sea and beyond. According to the Jamestown Foundation, the Kremlin abandoned the South Stream gas pipeline project, designed to have stretched from the Black Sea into eight European countries.

 

 

Opportunities

 

• After the nuclear crisis and rescue efforts, Japan will soon start to rebuild the country. In the power sector, we believe Japan will use more coal and liquefied natural gas (LNG) to replace the power shortage caused by the nuclear plant closure. Japan will also need to import cement, steel and other materials for reconstruction of destroyed houses and facilities. In high-end industrial materials, such as those used in auto manufacturing, Korean and Chinese manufacturers will replace the Japanese manufacturers’ market share.
• China will further increase its natural gas consumption, as has been planned in its next five-year plan, and build more hydropower dams along inland water networks. After the nuclear crisis, it is easier to argue for solar and wind subsidies; therefore, we may expect continued growth in the sector. News in China reported China’s Energy Department and the Ministry of Industry and Information Technology (MIIT) have finished their draft plan recently for the development of seven new energy industries and have passed it to the State Council for review. The seven industries include wind, solar, nuclear and smart grid. The report also said China is to spend 5 trillion renminbi (yuan) over the next 10 years on these industries.
• Benefiting from high commodities prices, Peru is planning to launch a sovereign wealth fund later this year with capital of $5-$6 billion. The fund would support the development of local capital markets in light of the planned integration of the Peru, Chile and Colombia stock exchanges.
• S&P raised the credit rating of Colombia to investment grade – the recognition shared among Brazil, Mexico, Chile and Peru – which will likely entice even more investors into the country.
• A Stratfor Intelligence report points out that Russia may be the one country that stands to gain from various calamities in 2011. First, the general unrest in the Middle East has increased the price of oil by 18.5 percent. Second, the Libyan unrest has cut off the 11 billion cubic-meter natural gas Greenstream pipeline to Italy, causing Europe’s third largest consumer of natural gas to turn to Russia to make up the difference. Similarly, Japan’s nuclear imbroglio has forced Tokyo to turn to Russian emergency shipments of LNG to fuel its natural gas-burning power plants.

 

Threats

 

 

• Radiation from the Fukushima nuclear facility in Japan can be harmful to people elsewhere globally as it moves across the ocean. This may continue to cause market volatility. Also, a prolonged industrial production disruption in Japan will have a negative effect for global economic recovery, though this is not expected to be significant.
• In China, the market continues to watch for further PBoC tightening, the housing market direction after this year’s new tightening policies, and the inflation trend. Any improvement may indicate China’s success in managing a soft landing.
• The Japanese earthquake may disrupt the supply chain to some Latin auto parts producers, including Alfa in Mexico.
• Concerns over the disaster in Japan are likely to prompt tougher safety standards for nuclear plants around the world. Germany will keep its seven oldest reactors offline as part of a nationwide safety review. As shown in the chart, plants in Eastern Europe were built less than 20 years ago using newer, safer designs.

 

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