Georg Oehm August 17, 2018

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Yes, even if you don‘t believe it—our risk indicator is showing a GREEN light

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On Stocks I 09.2018 August 17, 2018

In risk management we use different systems providing indica-tors so that we can get an idea of the markets that goes beyond a superficial analysis of the situation.

Of course there‘s no master indicator. The situation as far as information goes is like that in the cockpit of an airplane with numerous instruments. Some are used more regularly, others less. But in the end—just like in an airplane—it is a human who decides and who can make a mistake in his interpretation of indicators.

In the following, we are briefly discussing a risk indicator that we have followed with interest, that has a longstanding history and that has offered great indications about the market risk so far.

I. Prices

It may be a platitude, but it‘s true: It’s the prices that make news—not the news that make prices. The process is always the same. Important prices change, and subsequent-ly the interns at the news desks are looking for explanations in the agency reports. And when none can be found, longterm observers become particularly alert.

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On Stocks I 09.2018 August 17, 2018

II. Indicators

Prices are created through actions, whether it‘s from private persons, institutional in-vestors, or computer programs (algorithms). And all three groups also use—consciously or subconsciously—indicators that influence their decision-making. Among them are, for example, the much quoted (but in their meaning probably way overrated) 50-, 100-, or 200-day lines of the charts. So are relative strength, relative weakness, Bollinger bands, advances and declines, and many more. The variety of indicators can easily keep up with the selection in a well-assorted wine store.

III. Risk and the stock market (short and sweet)

Harry Markowitz laid the foundation with his basic model. The so called Capital Asset Pricing Model (CAPM) describes how investors combine different investments to put together their portfolio. The Nobel Prize was awarded for combining various investment-specific returns with the corresponding investment-specific risk. The definition of risk is relatively simple according to Markowitz: high fluctuations in price = high risk, low fluc-tuations in price = low risk.

William F. Sharpe (also a Nobel Prize recipient) recommended to always add a stock to the portfolio when additional returns aren‘t correlated with that of the portfolio. The lower the correlation of the returns the more interesting the inclusion of a new invest-ment into an existing portfolio.

Barra is the third name in this context. Not Mary Barra, CEO of GM, but Barra, the world-wide leading company for systems for risk managment, which after its acquisition in 2004 is now part of MSCI. The probability that big institutions make their decisions on stock investments after consulting with Barra Systems is certainly higher than the proba-bility that Bayern München will win be the German soccer champion.

The main topic in this context is the question how different investments and portfolios are correlated. An important problem is which period of time is used to calculate the correlation. Options are daily, monthly, and yearly data. “For the long run“ or, as I like to put it, for invest-ment horizons until the grave (i.e., 40 years and more) the recommendation is oftentimes to calculate the correclation based on the observation of historic periods over five years.

One problem remains: what do investors do, whose horizon is less than 40 years?Systems designed for the long term could be predicted neither in 2002 nor in 2008 in the situa-tion of crisis. But precisely for this purpose many investors would have needed risk systems.

IV. Value at Risk

One solution is the use of Value at Risk (VaR). These types of systems try to avoid the problem of the five-year-period, which would always make them too late. Hence, VaR changes the perspective. The goal is to answer the question how much a given portfolio would lose in a crash.

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On Stocks I 09.2018 August 17, 2018

The use of Value at Risk comes with problems, too. In market situations with low vola-tility (as was the case, for example, in 2017) the systems systematically underestimate the potential risks. Ultimately, volatility itself is one of the most volatile and hardest to predict influencing variables at the capital market. Physicists might say: Welcome to Heisenberg’s uncertainty principle.

The first quarter of 2018 is a great example. VaR calculations with the volatility of 2017 led to completely inaccurate results (have fun with your robo advisor is all we can say).

V. Our risk indicators

That said, this is where the exact mechanics of the risk indicator introduced today ends. We‘ll be happy to go into more detail—but only in a personal conversation. Because we collaborate with proven experts for risk assessment, we are able to offer together with them individual solutions for other asset managers. The following graphic is an interesting example on this day.

Depicted is the period since early 2001. The curve is always showing peaks when crises occurred. Easily identifiable are the peaks in 2008 (Lehman) and 2011 (first Greece crisis with first price parity EUR/CHF at 1.00). The crisis in August/September 2015 and Q1 2016 can be detected as well.

The indicator is negative (the light is RED) as soon as values above zero are indica-ted. It doesn’t go lower than -100%. On the bottom at -100% the risk light is basically triple GREEN. We classify phases as yellow when the indicator is moving from the bottom upward toward zero. It‘s not hard to see that this was the case “until recently.“ The indicator is currently falling massively—which means that the risk situation is improving.

Mar 1, 2002 Jul 1, 2004 Nov 1, 2006 Mar 1, 2009 Jul 1, 2011 Nov 1, 2013 Mar 1, 2016 Jul 1, 2018

Mellinckrodt I Risk indication January 2001 to August 2018

150%

100%

50%

- 50%

0%

-100%

Risk indication January 2001 to August 2018

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On Stocks I 09.2018 August 17, 2018

An unpleasant surprise may still be waiting behind the next street corner, and this in-dicator doesn’t really help with the question what should be bought or sold. It simply says: if you want to sail out on the sea or plan to climb a tall mountain, do it now. The general weather situation is more favorable than before.

Because we currently don’t have an intern, we had to look up the explanations for the current improvement ourselves. And we did. I‘ll spare you the current interme-diate status though and recommend: subscribe to our newsletter, and you‘ll find out right away when there are news about the stock market.

Mellinckrodt 2 SICAV 4, rue Thomas Edison L-1445 Strassen, Luxembourg

Phone +352 2 030 1739 E-Mail g.oehm@mellinckrodt.com

www.mellinckrodt.com

With our publication “On Stocks“ we inform investors and interested parties monthly and on current events about our present market assessment and important investment hypotheses. Furthermore we publish expositions of the investment advisor about the current positioning of our fund in our “Fund Information“.

© 2018 Georg Oehm, Mellinckrodt 2 SICAV / Mellinckrodt & Cie. AG

Georg OehmSince his banking apprenticeship in the mid-80s, Dr. Georg Oehm has been working in stock exchange-related fields in Frankfurt. Not only his degree thesis on the slump in 1987 and his doctoral thesis on copper trade pertained to the stock exchange. His responsibilities included the acquisition and sale of companies as well as IPOs. Dr. Georg Oehm has been with Mellinckrodt since 2008 and is currently a member of the administrative board of Mellinckrodt 2 SICAV in Luxembourg.The investment company offers a UCITS fund, which is covering the whole universe of European stocks. The initiators use a private equity approach to protect investors from the pitfalls of behavioral finance.

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