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Where Fundamentals Affect Technicals: Return Asymmetry and the Leverage Effect

June 23, 2010

Believe it or not, fundamentals sometimes have predictable relationship with technicals. This relationship often is a function of the mathematics of balance sheet ratios, where the market value of the stock is a component. For example, balance sheet leverage—which is effectively debt divided by the market value of equity—is subject to constant change based on the stock price movements assuming a constant number of shares outstanding. Since most creditors have contractual agreements with a company based on the debt to equity ratio, the actual credit available or interest rate can be affected directly by changes in the market price. Furthermore,  access to capital can also be constrained by these factors. Effectively this means that changes in the stock price, whether rational or not, can have actual financial implications for a company’s cost of capital. But it does not stop there. Like any complex system, this process involves multiple feedback loops, where the drop in the stock price can cause increases in the cost of capital, which in turn can cause further changes in the stock price.

The “leverage effect”  and subsequent theory originated from early studies done by Fisher Black (of Black-Scholes fame). Black  found  that stock volatility tended to rise when stock prices went down and that volatility fell when prices went up. The economic rationale behind this effect is rooted in the firm’s capital structure. As a stock rises, the percentage of equity to debt rises, and the firm becomes less risky since the debt holders claims to the company value are more limited. Conversely, as the stock falls, the percentage of equity to debt falls, and the increased share of debt holder claims make the firm’s equity more risky. Thus a falling stock price should lead to an increase in future volatility.

Anecdotally, most of us recognized aspects of “the leverage effect” in the huge rally following the depths of the credit crisis: the stocks that had the biggest rebounds were the ones that had 1) the worst balance sheets 2) the lowest stock prices 3) the largest declines. For the fundamentalist-this was a complete shock- many of these investors would assume that the best companies with the fastest growth would recover the most during the rally. The technicians  often subscribe to classic relative strength theory -that predicts that the best stocks to hold are always the ones that have the best one year or six month returns. For the technicians this was equally puzzling. But actually, it shouldn’t be if you understand “the leverage effect”. Regardless of whether the leverage effect is firm specific or systematic,  in a  “credit crisis” all firms come under pressure , and the most leveraged and riskiest firms are often under unprecedented levels of financial pressure. Since risk was so systemic in this case (as opposed to firm-specific or idiosyncratic), many large firms fell under this broad umbrella and ultimately traded near bankruptcy valuations. How else does the “math” of fundamentals work in this case? Well most educated finance students understand first of all the principle of balance sheet leverage: when you add debt to the balance sheet, a given % increase in sales has a disproportionately larger increase in the % increase in earnings because you are netting out a fixed interest cost. If we all agree that 1) the market tends to discount future GDP and hence revenues, and 2) that firm value is also a function of earnings growth and total earnings, then the firms that will experience the greatest percentage change in firm value when the market forecasts a recovery should mathematically be the most leveraged firms.

This affects the technical trader in many ways whether you trade short-term or not. It means that the biggest winning stocks will have strong velocity relative to volatility (think sharpe ratio) only while the market is rising. When the market peaks, in fact, their velocity relative to volatility will have peaked at extraordinary levels. At this point the firm’s debt to equity is often at unsustainable  levels–leaving it vulnerable to the largest proportionate changes in firm leverage–and hence future volatility/downside risk. The opposite is true for the losing stocks-especially falling a major decline. This means that you have to be careful about going long a big winning stock when it has drifted upwards without any increase in volatility for too long, and conversely going short a big losing stock after it has exploded downwards without any reduction in volatility for too long. It also means that the biggest uptrends in the market emerge from the biggest downtrends and explosions in volatility, and the biggest downtrends start from extended periods in which you have persistent upward moves with extremely low volatility. It also means that you may further wish to reduce your exposure to the leverage effect if you are a relative strength investor by focusing on stocks that have little or no debt—not surprisingly these are often technology stocks such as those often found in the Nasdaq 100…….the list of choice for the Livermore Index.

7 Comments leave one →
  1. BMB permalink
    June 23, 2010 2:54 pm

    Another gem.

  2. derek permalink
    June 23, 2010 4:49 pm

    excellent. I’m surprised how little attention is paid to financial and operating leverage when people get caught extrapolating

  3. bgpl permalink
    June 23, 2010 6:11 pm

    David, how are you coming up with all this stuff ?! 😉


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