Opportunity amidst volatility: speculation for the conservative and risk hungry
The Sterling Report
The financial markets have continued to enjoy robust levels of excitement this week. It's earnings season; the US Economic performance figures are out and the European debt crisis can always be relied on to keep investment managers on edge.
The United States economy grew at 1.5 per cent in the second quarter of the year, down from two per cent in the first quarter, reflecting lower levels of consumer spending. European Central Bank President Mario Draghi incited a rally in the euro and bond markets as he said that the "ECB will do what it takes to preserve the euro", implying a round of bond purchases of Spanish and Italian debt to lower borrowing costs for those countries. European and Emerging markets rallied, underscoring the extreme volatility (and gullibility) that characterizes the global markets. One single comment from a Central Bank President, can result in a two point gain or decline in the value of a financial instrument. If you are betting a large amount of money and using a modest amount of leverage, a two point move can produce attractive overall returns. The behaviour of the market creates tremendous opportunity, to profit from theseprice swings. It's also important to remember that opportunities are not limited to upward moves or good news. If an investor expects bad news, they can short an instrument that is likely to be negatively affected.
Earnings season presents another such opportunity. Stocks and bonds will usually rise or fall in price immediately following the announcement of their earnings. For the long term investor, this presents an opportunity to purchase assets that may be suffering from one bad quarter but have generally displayed strong earnings growth and maintain sustainable and sound business models and management. For short term investors, it's a way to take advantage of short term movements in the price of an asset. This is a more risky strategy as it involves making more assumptions on less information. In these instances, investors would analyse the most recent and available data on an entity inthe context of current macro-economic data to make an estimate of the entity's ability to meet or exceed earnings expectations.
However, there is a role and opportunity for long term conservative investors these markets. Many Investment Grade assets which are frequently beaten up by the bad news and the pervasive pessimism in the markets have experienced double digit total returns over a two or three year period. For example, in October 2011, a Bank of America 7.625 per cent 2019 bond was trading at 93 cents on the dollar. Today, these bonds are priced at a premium exceeding 114. This would represent a total return of 37.97 per cent for the investor during the nine month holding period. A similar picture is painted by bonds of other large financial institutions across the globe.
Bonds prove to be a better play for conservative investors, as they enhance the total return for an investor due to the coupon income they throw off and the capital gains that they can experience. Bonds offer some degree of principal protection as well, as the issuer must return the principal to bondholders at maturity. This is true, whether the price of a bond rises or falls. The market volatility being experienced now is an opportunity for conservative investors to capture attractive returns that may not have been obtained with an equally passive strategy in a more tame market.
Marian Ross is a business development officer with Sterling Asset Management Ltd.Sterling provides medium to long term financial advice and instruments in US and other world market currencies to the corporate, individual and institutional investor.
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