Stockwatch: Risk lovers should trade the volatility

Is there any trend in the huge, day-to-day volatility? Markets are contesting growth versus deflationary scenarios, with computers and stop losses accentuating the swings.

As yet there is not enough evidence of profit warnings to compromise dividends generally; but only fools will ignore change akin to the high level "mackerel scale" clouds that often herald a weather change. For trading it's helpful to grasp essentials in the battle between warm and cold fronts.

Why stocks will be bought

Institutions and traders will continue to buy into falls because equities offer superior income while any interest rate rise will be minimal. Plenty of stocks offer 3-5% yields well covered by earnings and cash flow. Prices will go lower again on bad economic news and especially if more company outlooks turn problematic. Encouragingly, money supply figures have turned up in various economies, implying greater economic activity in 3-6 months. All this provides a blend of dividend valuation proof today, and hope for the medium term, to keep tempting buyers.

As yet there are few profit warnings outside commodities-related industries, and price deflation can help the more broadly-based economies with lower materials/fuel prices. I would highlight the UK tool hire sector, however, as being in the grip of profit warnings - the latest from HSS Hire Group which cites variable markets weakening in August. Tool and plant hire are classic cyclical indicators, so these firms need watching. It follows a 1 July warning from Speedy Hire which came across as significantly involving managerial issues, given the chief executive was stepping down.

That has also applied to APC Technology Group which has diversified from electrical components distribution into energy and water management: at end-July group trading was "in line with expectations" but on 18 August various factors meant a 2015 profit warning and by 24 August the chief executive had been replaced. It all implies difficulties in these firms' underlying markets, not simply management weakness - Rolls-Royce being the highest profile example. If more firms have to warn like this then it will affirm cyclical change, and shares involved will fall to a level where the dividend yield is perceived as fair compensation for the risks. Volatile markets are not mainly a China story, the UK corporate sector is very much implied.

WPP heralds mackerel clouds in the sky

As a truly global communications services group, WPP is probably the best bellwether of overall business confidence. Its latest interims cite like-for-like revenue up 5% in July with all regions and sectors positive. But unless chief executive Martin Sorrell is just inherently cautious, its outlook statement has plenty of "mackerel cloud" features. Tepid GDP growth and zilch inflation mean client companies are cutting costs to meet profit targets, the international picture is mixed and confused by oil price falls and currency wars.

While clients are more confident than in September 2008, with stronger balance sheets, the deflationary environment makes them unwilling to take further risks. Consumers and firms alike appear to be increasingly cautious. Sorrell has been widely reported as still a "raging bull" on Chinese growth but he would say that, wouldn't he, after WPP has effectively lured clients into China as a global marketing prospect. WPP's operating performance is very good but marketing services are a cyclical leading indicator - and the tone of WPP's outlook statement is now riddled with caution.

Medium-term risks explain why, despite excellent results, WPP's chart has since April trended down from about 1,600p to 1,300p, the market sensing a price/earnings (PE) in the high teens as too risky. Tying in with my argument on dividends however, WPP now yields 3.5% twice covered by forecast earnings - a meaningful prop. Further de-rating will need evidence of genuine downturn. Since WPP generates about 30% of revenue/profit from Asia Pacific and Latin America, it is a pertinent indicator of emerging markets' risk.

Among energy services firms, Lamprell cites a steady order book now extending to the second quarter of 2017 despite an interim results' profits plunge, explained as reflecting timing issues. Cape has cited first-half order intake up 26% with its interim results although mind "continuing operations" results benefit from acquisitions. Yet these prime cyclicals come across as robust, as if any downturn won't manifest until 2016. So the mackerel clouds don't wholly affirm a cold front approaching.

Why stocks will be sold: China is justifiably a big risk

The chief overall reason is fear of deflation spreading, as I described in last month's macro piece, such that company revenues stagnate after costs have been cut so far as practicable. This would undermine longer-term dividend valuations, the most vivid example being BHP Billiton on a near 8% yield - only covered about 0.5 times by expected earnings in the year to end-June 2016.

Holders hope for further cost cutting and commodity price recovery, and the market is exacting near 8% for the gamble this represents. If it doesn't happen then the stock will de-rate again, to a level considered a realistic payout - pricing a yield appropriate to the risks. Other stocks will adjust in their own, less extreme way. At least the UK is estimated to derive only about 3% of exports from China, so our lethargy in this regard is currently a bonus, however stocks such as Burberry are more exposed.

China remains critical because it has largely propped up the global economy since the 2008 crisis, and it faces a big risk of the economy slowing versus massive private debts. Attention tends to focus on public debt, e.g. regular reports about the murky extent of local government debt, however, in six years private debt has grown by over 80% of GDP (Bank of International Settlements' estimate), altogether the biggest credit bubble ever. Loans have increased from £5.8 trillion equivalent to £17.4 trillion in six years, and the historic fact is no country running up anywhere near China's debt without experiencing a sharp recession. So financial traders are justifiably sensitive about Chinese news; whether the Communists can manage a crisis they allowed to start in the stockmarket, by not curbing margin trading soon enough.

All this, just as central banks struggle to begin normalising monetary policy with an interest rate rise. Also US PE multiples remain high in cyclically adjusted terms, and firms' reporting is mixed. The big risk for stocks is diminished economic returns from further QE, and when interest rates are already very low: central banks lack a fresh response to deal with any new downturn.

Such is the essential bear case. After an incredibly volatile trading week, bulls appear to be wresting back control, while the true verdict will be economic data and company reports in months ahead. Risk lovers can trade the volatility and yield-hunters buy sounder dividend stocks. But mind how mackerel skies can portend trouble ahead.