Quantifying Price Dislocation and A 54% Return for a Basic Material Stock

 “Study the past if you would define the Future” – Confucius

We often talk in our Weekly Market Call about the power of using history as an objective gauge for the future.  Specifically, taking a snapshot of today’s environment and then finding similar environments historically to see what has typically happened next.  We’ve verified the predictive nature and market impact of this approach in recent notes, but it seems we should help our readers better understand why there is any value to incorporating this information.  Why should you care?  One very simple application is to quantify when price dislocations are occurring and how to profit from them, and we’ve identified a current example below with a 54% projected return over the next six months.

To start, let’s quickly define price dislocations as times where the price is divorced from the fundamentals.  This is often driven by an event, whether it’s security specific, a macro event or otherwise.  Let’s also agree that this is a subjective view, depending on the type of investor, their approach, their time horizons and their position in the security.  This spread of intentions and views is what makes markets, and also where the value of EidoSearch comes into play by quantifying reaction to these environments.

To illustrate the point of price dislocation, you need not look further than 2008 and 2009.  Our data and projections were even more predictive during that period than during “normal” market conditions.  Why?  Because those markets were less about security or market level fundamentals and more about investor behavior (fear).  A good example of price dislocation at the security level is with Intercept Pharmaceuticals.  In January of this year, ICPT shot up almost 400 points in just two days.  The company passed a clinical trial phase early in the process, and with flying colors, and the stock went through the roof.  Have we seen this type of reaction historically?  How did investors react to those similar environments?

Per the charts below you’ll see that the EidoSearch projection on January 14^th, based on similar instances of this pattern in healthcare stocks historically (red line is the typical outcome), was for a short term bump but then a drop from the current price and that it would languish.  The chart to the right shows the actual return profile from after that event through to Friday’s close.

Projection for Intercept (ICPT) on January 14, 2014              Current 1 year chart for Intercept (ICPT) through

We have not only quantified when there are price dislocations occurring with security prices at current, but like in the instance with Intercept above, provide a powerful GAUGE for how investors will respond to these situations based on their responses historically.  Being able to find these similar historical environments with tremendous statistical accuracy and speed is part of what makes us unique.  Putting this information in the hands of a fundamental investor provides a powerful data point for them to apply in their mosaic.

These price dislocations don’t just happen in the worst or best market conditions, or in the extremes once every few months, but they happen every day in varying degrees to hundreds of securities.  On a go forward basis, proactively alerting these outliers to an investor based on their custom universe of securities can help trigger new opportunities, better manage existing positions and improve overall profitability.  To boil it down even further, EidoSearch essentially extends the price chart in an objective, statistically significant and predictive manner without bias.  Why shouldn’t this be considered as a gauge for every most investment decisions?

So, enough beating of the drum.  For this week’s Market Call we set out to screen for some securities that appeared to have the most significant price dislocations based upon how investors have reacted historically.  That is, find a current price trend where investors have consistently traded the stock up or down historically because they see it as mis-priced.  As usual, we found a bunch, but thought one of the more compelling was for a Brazilian Steel Maker called Gerdau (GGB).  Looking at the 53 most similar instances of their current 6 month price trend in Basic Materials historically, the average return in the next 6 months is 54.7%.

Current 6 month price trend in Gerdau (GGB) through Friday’s close price

Chart of the 6 month forward returns of each of the 53 most similar instances of the current 6 month price trend in Gerdau (GGB)

Replicating the Market Call in EidoSearch (Clients Only)

• Go to New Search tab, select Equities, type in GGB for Gerbau and hit View button or Enter
• Select the 6 month tab at the top of the chart, and then hit Search at the bottom of the chart
• Click on Return Chart to get the projection above, as well as the table of historical instances and other underlying analytics