Wednesday, February 22, 2012

Cognitive Dissonance: What To Make of a Divergence Between Share Prices and Fundamentals?

Divergence Between Dry Bulk Share Prices and Rates Leaves Many Scratching Heads

Over the past two months, there has been a very large divergence between dry bulk day rates and equity prices, with day rates plunging on the order of 50+% since the beginning of 2012 while equities in the sector have done almost exactly the opposite. The above chart is illustrative of this trend, showing the Baltic Dry Index (an index of day rates earned by various types of dry bulk ships) dropping while a representative equity (EGLE, a leveraged owner of Supramax class ships) rises significantly. This has caused a lot of head scratching and profanity among the people who follow this sector closely. The short to medium term outlook for the industry is anything but positive, so it is quite frustrating to the sector specialists to see such a huge difference between what they know is happening in their industry of focus and the stock prices of companies in that industry. As an analyst I encounter this conundrum frequently, especially in the case of beaten up sectors and hated companies. So what are we to make of such cases? Is this just a temporary flash in the pan caused by the unwashed masses trading securities they don’t understand? Have all the “experts” missed some massive, obvious fact?

For the past 6 weeks I have been reading the howls of outrage from knowledgeable people who follow dry bulk quite closely. The following posted by the fine folks at is fairly typical:

“So a heavily shorted sector runs up on something that has nothing to do with that sector (Nothing!) – and shorts cover – and now everyone is calling for a return to the golden years of 2007 and early 2008?  And that’s my point.  We are indeed returning that era – but, we are returning a poor man’s sub prime debacle.

With all this said – if someone wants to make the case that physical rates will be well above what the futures curve calls for – please do…and if the case is good, I will go long.  (And maybe Mike will send you an autographed picture of Megan, as he says he has no hoodies left). 

Meantime, recall what Lippmann, Eisman and Burry went through – and realize this is a big boys game.  Do you want to be short subprime in 2005-2006, or closer to the collapse?  I guess it depends on knowing when the collapse is going to come.”

It is terribly frustrating to follow an industry intensely, know as much as anyone about it, and have the market move in completely the opposite direction of the fundamentals. Been there, done that, many a time. So when this happens, what is driving it? Why the clashes between a specialist’s expert knowledge and what securities prices are doing? I think that there are usually three plausible explanations: 1) the divergence is temporary and driven by idiots and speculators; 2) the experts have overlooked a counter-argument that is or is becoming important; or 3) there are factors external to the narrow level of the industry in question that the market is reflecting in securities prices.

The “flash in the pan” explanation that the divergence between stock prices and fundamentals is a temporary phenomenon is a popular one. It is a comforting thought to the diligent analyst that this is only a blip, likely occasioned by speculators, fools, idiots and day traders piling something they don’t understand, possibly lead by a pied piper in the media (CNBC, etc.) and potentially magnified by a high short interest that gets squeezed a bit. This fits with the analyst’s view of themselves as the expert who simply cannot be wrong and anyone who has been investing for a period of years has seen exactly this scenario play out repeatedly: commentator pounds the table for a stock or sector, the recommended stuff jumps spectacularly, then reality sets in and prices lose all the hot air they recently gained (and sometimes more). The problem with accepting this explanation is that the trading position usually taken is to either wait it out or (more aggressively) short the stocks into the spike and expect to cover when the short term buyers depart. If the spike is not just a flash in the pan but rather the start of a fundamental shift upward in an industry or company’s fortunes, you have just set yourself up for a very painful and expensive experience.

The second explanation is very unsettling to most analysts (myself included). If you are an expert in a particular industry and you are in the position of having to make buy/sell/hold decisions and live with them, it is hard to imagine that you could have missed a critical issue that undermines your analysis. However, this can and does happen from time to time and when it does it can be the undoing of a career, as Bill Miller found out when he blew up at the end of a 15 year run of besting the S&P500.

The third case can be the hardest to see before it happens. After all, most fundamental analysts are keenly attuned to what is going on in their industry and they have a tendency to develop tunnel vision after spending hundreds of hours really understanding their chosen industry. I think that what many people refer to as “black swan” events are really just changes that happen outside of the fairly narrow view most analysts have cultivated by training and inclination. For example, if you were keenly focused on the oil industry and specific companies within it, you might well have not noticed that the wheels were coming off the bus in the raging housing market, eventually leading to a crash in oil prices.

So which of these potential mechanisms explains the disconnect between the Baltic Dry Index (shipping day rates) and the equities in the sector? One could make a strong case that this is a flash in the pan, as the interest and trading volume in the sector is low, short interest in many names is high, and a couple of ill-informed commentators have recently talked up the sector. Certainly the meteoric rise of several of the stocks suggests that there are some short term and momentum traders at work. However, I believe it is wise to be humble in these cases. While one could certainly view the “outsiders” who are not specialists jumping into a sector to be unwashed and uneducated, sometimes what those investors have is a fresh perspective. Dry bulk observers note the large slate of new ships to be delivered this year, the forecast by the freight derivatives market that rates will stay low for a long time, stress in lenders who are the main providers of financing to ship owners, and a slowdown in cargoes entering the market. All of this is perfectly true. However, I think it would be wise to be aware of developments in the broader economy. The equity market has rebounded, junk bond spreads have been narrowing, the ECB has showered liquidity on European banks (many of whom are shipping lenders), Chinese inflation has been falling (which gives leadership there room to increase stimulus), and scrapping of older ships has been growing by leaps and bounds. No doubt there are other positive developments I have failed to notice.

I will freely admit that I do not know why shipping equities have diverged from day rates. However, I think that every analyst should remember to be humble and be aware that it is quite possible you are missing something important when the market sends you a signal like this.

As always, do your own due diligence, be careful, and do not rely on anything you read here as investment advice. You can lose money on this stuff.


  1. Perhaps a value investor would declare EGLE fully valued, and stay away until another value opportunity presents itself.

    I remember buying EGLE in 2006, and getting out 18 months later in July 07 because it just couldn't possibly go any higher. It's hard to see how this divergence is different.

    1. I think that this sector is both fundamentally volatile and of small size. That means that moves to both the upside and the downside tend to be exaggerated.

      The dry bulk industry is interesting, but I mostly chose it to illustrate a common problem analysts face.