analyzing the past week in stocks

a roller coaster ride

The past five or six days of stock market trading around the globe have been very unusual, to put it mildly.  To recap quickly, the S&P 500 (which will be my main focus here) peaked on July 31st at a value of 2114.  On Thursday August 21st, the index closed at 2026.  Then…

—on Friday the 21st, the S&P fell by 3.2%

–on Monday the 24th, the S&P opened down 5.2%–with major stocks falling by as much as 20%.  The index rallied back to breakeven before fading late in the day to close down 4%.

–on Tuesday the 25th, the index opened up slightly, added 2.5% to the initial print and then turned around to close 1.5% lower.

–on Wednesday, the index gained 4%+.

–on Thursday the S&P opened up slightly, rose steadily to gain a total of 2.5%, reversed course to lose almost all of that  …before reversing course again to end the day at +2.4%.

All this occurred on 2x -3x normal volume each day.

To add to the fun, the computers at Bank of NY-Mellon, which prices a good number of ETFs, failed over last weekend and still aren’t functioning normally.  So for days, traders of ETFs lost the NAV anchor on which to base their actions.  This may be a reason for my impression that bid-asked spreads for ETFs were wider than normal earlier this week.

As I’m writing this early Friday afternoon, the S&P is flattish.  Volume is about half – two-thirds of what it was earlier in the week.

why?

If the question is why a sharp decline now rather than, say, two weeks ago, there’s never a good answer.

If the question is what forces caused the big fall–and equally sharp rebound–that’s almost as difficult.  We might view this week as the panic-filled culmination of an equity slide that began on the first trading day of August and which is based, I think, mostly on extended valuation.  The decline in the oil price below $40 a barrel can’t have helped sentiment.  Nor would spirits have been perked up by the weakness of Chinese stocks as speculative excess continues to be washed out of that market.

Of course, battling computer trading algorithms could have been the driving force.  That would at least explain how quickly everything moved.

For my money, though, a technical correction in a pricey market is a good enough story.

 

A more important question for us as investors is whether the selling, however motivated, is over.  The optimistic part of me (which is virtually my entire body) says that the rebound from the opening lows on Monday is an important positive psychological sign.  However, I think volumes have to return to normal, time has to pass, and the market has to begin to drift upward before I’ll be completely convinced.

Let’s say, just for the sake of argument, that this week has seen the establishment of an important resistance level for the S&P.  Remember, I’m not yet willing to bet that this is the case.  But if it is, three considerations are important:

–the market often rises for a while, but then returns to visit the prior low before bouncing up again off it.  This action forms the so-called “double bottom,”–which technicians take as a very bullish sign

–in a major reversal of direction, market leadership often changes, meaning some star groups become clunkers going forward and some clunkers regain the market limelight.  Although I’d scarcely call this past week a major event, we should still look carefully for hints of leadership change

–we’re fast approaching the yearend selling season for mutual funds (most mutual funds have a fiscal year that ends on Halloween), which typically extends from mid-September to mid-October.  The prospect of such selling could keep a lid on stocks over the next weeks, and would be the vehicle for retesting Monday’s lows.

what to do?

That’s my topic for Monday.

 

 

thinking about China: deflating a stock market bubble

For most of the 30 years I’ve been watching China-related securities, the mainland stock markets have been an afterthought for virtually all foreign investors.  The same for the authorities in Beijing, as far as I can see.  They seem to have regarded the equity markets as a vehicle for funding moribund state-owned enterprises that no bureaucrat in his right mind would give money to.

The mainland markets have gradually morphed over the past decade into something more interesting, as smaller, more innovative firms elbowed their way in.  But the market remains very hard for foreigners to gain access to, and is arguably still not worth the trouble.  The real action remains in Hong Kong.

 

Last year, faced with a bubble in the domestic property market created by a flood of investment money with no place else to go, Beijing decided to redirect this flow of funds to the Shanghai and Shenzhen stock markets.

In solving one problem, however, Beijing created another.

The issue was partly that the mainland exchanges were going through the roof in US-internet-bubble fashion.  In addition, however, the rise was fueled in large part by borrowed money.  Worse, this consisted not only of official margin lending but also by huge amounts of sub rosa margin disguised as either uncollateralized borrowing or debt secured by businesses or property.  No one knew how large this total debt was–only that it was gigantic, and that inexperienced retail equity investors had leveraged themselves to the sky because they had taken government encouragement as a guarantee against losses.

 

As/when the market peaks and begins to decline, margin loans come due.  When speculators can’t add more money to margin accounts (as is inevitably the case), this triggers forced margin selling that feeds on itself and turns into an avalanche of downward pressure.  Once selling starts, it can be almost impossible to stop.  Of course, as soon as potential buyers realize what’s going on, they withdraw and wait for the market to hit bottom.

This precarious development in Shanghai/Shenzhen is not a unique phenomenon.  The same thing happened in 1985 in Singapore/Malaysia, in 1987 in Hong Kong, and in 1997-98 in many smaller Asian markets.  In hindsight, Beijing could possibly have averted the crisis by raising margin requirements and by cracking down on unofficial margin loans by financial institutions.  But it didn’t.

Beijing seems to me, however, to have followed the standard protocol for dealing with a mammoth overhang of margin selling and restoring order to the market, namely:

  1.  identifying and cutting off borrowing sources

2.  prohibiting short sellers from exacerbating the problem by speculative selling

3.  buying enough stock, either directly or indirectly, to reduce forced selling to a level that the market can handle unaided

4.  allowing the market, once functioning again, to clear by itself.

The way I look at it, we’re in #4 now.

One other comment:

in the US, the rise and fall of the stock market is regarded as the most powerful leading indicator of future economic performance.  I don’t think that what’s going on in Shanghai/Shenzhen stock trading has much macroeconomic significance.  Rather, the China stock market fall is an obstacle that every emerging market encounters on the way to stock market maturity.

 

 

 

 

 

 

 

 

 

 

thinking about China: economic growth and metals

In the late 1970s, Beijing decided that its central planning model of economic development wasn’t working because the domestic economy had become too complex.  It reluctantly shifted to the model Japan had used to recover from WWII–concentrating on export-oriented manufacturing, offering cheap labor in exchange for technology and industrial craft skill transfer.  China became an increasingly large user of natural resources (oil and metals) as it created industrial infrastructure, industrial plants and provided housing and other public services for its large population.

Maybe ten years ago China realized that it was soon going to run out of low-wage farm workers willing/able to switch to manufacturing in order to sustain the export-oriented model.  Associated pollution and other environmental problems were also becoming more acute.  So the natural resource intensive, export path to growth was nearing an end.

Five years or so ago, China, now out of cheap labor, began the shift to a consumer-oriented, domestic demand approach to GDP growth.  Government stimulus to offset the negative effects of the recent recession gave exporters one final surge of vitality.  Still, for years manual labor-intensive businesses have been leaving China for, say, Vietnam or Bangladesh.  Beijing has also been cracking down on relatively primitive steel and aluminum processing operations.

Politically and socially, as well as economically, this is a difficult transition to make, because rich and powerful forces of the status quo don’t want things to change.  Japan, Singapore and Hong Kong (multiple times) have made the shift; Malaysia, Thailand and much of South America have not.

One of the main characteristics of this period of change is a slowdown in demand for base metals and other industrial inputs.  For China, which had been the dominant customer for almost any base metal, the transition comes just as global mining companies have made (inexplicably, to my mind) huge additions to productive capacity.

The result of increasing supply at a time of flagging demand is easily predictable–lower prices.

Why write about this?

Many financial markets commentators have been pointing to low base metals prices as evidence of cyclical economic weakness in China.  That may ultimately turn out to be the case.  But it’s equally a sign of:  1) structural change in the Chinese economy, which would be a good thing, and 2) witless mining companies.  So it’s by no means a sure thing that bears on China are correct.

By the way, the last global collapse in base metals prices came in the early 1980s.  That followed a decade-long period of mine expansion that was based on the idea that the United States couldn’t grow economically without using copper, lead, zinc and iron in amounts that would increase in a straight line with GDP expansion.  In hindsight, what a mistake!  Although Peter Drucker had been writing about knowledge workers from the 1950s, no one put two and two together.  It took almost two decades for world growth to absorb the excess capacity that miners added back then.

 

what’s going on in stock markets?

technicals

From the intraday high of 2132 on July 20th, the S&P 500 has fallen by almost 12.5% to its intraday low of 1867 yesterday.

For fans of support and resistance, 1867 is within hailing distance of the 1820 intraday low for the index in mid-October 2014.  The closing lows at that October bottom were 1867 on both October 15th and 16th.

That all adds up to a severe correction by the experience of the past few years, but still one that might be called “garden variety.”

opposing signals

What’s unusual about this decline is that virtually the entire fall happened in a panic-filled two-day period–last Friday and yesterday.

So this all gives us two opposing market signals.  On the one hand, in the normal two-steps-forward-one-step-backward rhythm of stock markets, we’ve finally made a significant backward step over a suitably long period of time.  One might conclude that we’re done with that phase and are ready for the next up move.

On the other hand, the past two trading days have been fear-filled.  On Friday, the S&P was down by 3%+ and closed on its lows.  Yes, it was a Friday, so brokerage houses flattened their books going into the weekend (translation:  dumped inventory into the market near the close).  Even so, closing on the lows sends shivers down traders’ spines.  Then the market opened on Monday down by about 6%, another stomach acid inducer.  Pundits rushed in to “explain” the goings on to retail investors as a sign that the Chinese economy (the largest, or second-largest, depending on how you count, economy in the world) was imploding–with dire consequences for the rest of the globe.  That increased the fear quotient.

My point here is that emotions are much more powerful that we usually recognize–and they linger.  Maybe the market had been fearful for close to a month and purged that fear over the past two trading days.  But I don’t have the sense that anyone was afraid before fireworks erupted on Friday.  That’s my main hesitation about saying Monday represents a selling climax that clears the way for upward progress.

China not the cause

I think that China is the trigger for what’s happening in markets now, not the cause.

I’m torn between two viewpoints on China as an economy.  I think the hedge funds proclaiming that the selloff in oil and metals is due to economic weakness in China that Beijing is covering up–and that we are due for a protracted bout of global economic weakness–are completely wrong.  On the other hand, either they or their brethren spouted similar nonsense about hyperinflation being induced by Fed action five years or so ago.  Everyone now knows that was totally wrong–yet this craziness struck a responsive chord and influenced stock trading for an extended period of time.

My conclusion:  this isn’t a time to bet heavily on whether the market is going up or down (it almost never is).

trading up

During periods like this, most investors, even professionals, tend to go on vacation.  They just don’t look at the daily ups and downs of prices.  For anyone who can stand the rocking of the boat, however, there’s useful portfolio work that can be done to upgrade holdings.

–clunkers that have never gone up usually don’t go down a lot in general market declines.   Strong stocks that have gone up a lot typically get pummeled.  So this is a great time to ditch the former and use the money to buy the latter.

–we’re in a time of significant structural economic change.  I think the prophets of doom are mistaking that for cyclical economic weakness.  Losers in a time like this are typically large and well-known; potential winners are typically smaller and more obscure.  For most of us, the appropriate switch is from old-line, status-quo stocks into ETFs that are focused on Millennials.

 

stock options and stock buybacks

I first became aware of the crucial relationship between stock option grants and stock buybacks in the late 1990s.

I was on a research trip to San Francisco, where I had dinner with the new CEO, a turnaround specialist, of a chip design and manufacturing company with a checkered history.

In the course of our conversation, he said that one of his objectives was to ensure he retained top talent.  He went on to mention, as if it were a matter of course, that he would do so by having his firm issue enough stock options to transfer ownership of 6% of the company each year to workers (I’m pretty sure 6% was the number, but it could have been 8%).

I was shocked.

My first thought was that after eight years (six years, if the 8% is correct), there’d potentially be 50% more shares out.  This would massively dilute the ownership interest of any shares I might buy for clients.

My second was that I would have to evaluate the potential for massive positive earnings surprises that would make the stock skyrocket if the turnaround were successful, against the steady erosion of my ownership interest through stock option issuance.  (I decided to bet on skyrocket, which ended up being the right thing to do).

My third was that eventually suppliers of equity capital like me would have to question whether the kind of ownership shift this CEO was presenting as normal tilted rewards too far in the direction of management.

 

After this experience, I began to look much more carefully at the share option schemes of companies that might potentially be in one of my portfolios.  I noticed that in many cases companies had stock buyback programs–pitched as a “return to shareholders” of profits, sort of like dividends–that almost exactly offset the dilution from the issuance of new stock to employees.

This isn’t the case for all companies, but my observation is that it is for many.  I don’t think this is a coincidence.

Part of the rational for buybacks, it seems to me, is simply to prevent dilution of earnings per share, which would arguably help no one.  But at the same time, for the casual observer who looks only at share count and at earnings vs. eps, it obscures how big the corporate stock option issuance plan is.  I don’t think this is an accident, either.  Yes, the information is all in the SEC filings, but the reality is that even many investment professionals don’t read them.

That’s what I find problematic about stock buybacks–that I feel they’re misleadingly described as a shareholder benefit, while their purpose is to play down the level of key employee compensation.

 

 

Follow

Get every new post delivered to your Inbox.

Join 371 other followers