An important part of investing is the ability to identify and exploit market trends, which I understand as being persistent movements of an individual security, a sector or an index in the same direction over a considerable period of time. Significant recent trends have ranged from the twenty-year+ disinflationary trend that started in the early Eighties, to the rise of mobile communications networks and devices in the early Nineties, to the plain-vanilla inventory cycle that usually consists, in the US at least, of about 30 months of rising markets followed by 18 months or so of falling ones.
Counter-trend movements are normal
Trends are never one-directional. Instead, they are punctuated by periodic counter-trend movements. Seen over periods of, say, six months or a year, the interplay of trend and counter-trend movements are what gives markets their characteristic pattern sawtooth pattern of advance and decline.
As I see it, counter-trend movements are of two types, which I’ll call relative and absolute.
A relative counter-trend movement presupposes that we have both trend-leading (or trend-establishing) elements of a market and non-trend elements. When a new trend establishes itself, the trend-leading elements typically power ahead in the direction of the trend and significantly outdistance the non-trend elements. An example might be the behavior of cyclical stocks vs. defensive stocks since the market turn in early March.
At some point, no matter what the longer-term merits of the trend-leading elements are vs. the non-trend elements, short-term relative valuations become stretched. When this situation prevails, shorter-term-thinking arbitrageurs enter the market. They sell the leading elements and use the money to buy the lagging elements, and do this until they think shorter-term relative valuations are more in line with one another. During this period, non-trend stocks take over market leadership and the “real” trend stocks lag behind. In a flat overall market, the non-trend stocks go up and the trend-leading stocks go down, until arbitrageurs are satisfied that a new balance has been reached.
Another way of putting this is that initially stocks that stand, conceptually at least, to be beneficiaries of some longer-term economic trend move first. That is, concept beats valuation. After a period of outperformance, relative valuations become stretched enough that the market wants to narrow the valuation differences. During this period, valuation beats concept.
At some point–the “magic” technical numbers seem to be when the trend leaders have reversed 1/3 or 1/2 of their lead–the primary trend resumes.
The second kind of counter-trend movement is an absolute one. Here the issue is not the question of the relative value of trend-establishing and non-trend elements. Instead, it’s the issue of how much anticipated future earnings growth to build into today’s stock prices. In the early stages of any trend, the trend-leading elements virtually always advance much farther than the current situation implies they should. They are, then, beginning to discount what the future development of the trend will imply for prices. The “future” may be one year in advance, or two years or even more. At some point, however, further price movement demands that the holder be paying today for assumed performance that he considers to be “too far” in the future.
How far is “too far”? In my experience, the market refuses to look more than a few months ahead during a down market–that is, it refuses to imagine that future events can be much different from what they are today. In an up market, investors will easily pay today for economic performance that they think will occur a year out. But the US market almost always balks at paying for the future more than 18 months ahead.
When the price of a trend-leading element already has expressed in it all it is likely to accomplish within the discounting horizon of the market, it either stops moving or reverses direction. In my experience again, stocks normally either move up or move down. They rarely just stand still.
The trend resumes when one of two things happens: either new information emerges to show that the market has underestimated what the trend will bring in profits within the discount horizon; or time passes, shifting the boundary of the discount horizon forward.
Why is this important?
It’s important to realize that the financial markets, and the stock markets in particular, do not move in the direction of even the strongest long-term trend every day. Periodic counter-trend movements are normal and healthy for the markets. So you shouldn’t let yourself be shaken out of a trend-leading position by the normal short-term saw-toothed movement of securities.
Counter-trend movements can also provide an opportunity to shift your portfolio more heavily toward the trend, by selling non-trend elements while they are rising and buying trend-leading elements while they are falling. Note: there’s never any reason to make your portfolio an all or nothing bet on a single theme. If you already have an appropriate position size based on your risk tolerance, just do nothing during one of these counter-trend episodes. Monitor, but don’t increase risk.
Where are we now?
World stock markets have exhibited their normal sawtoothed pattern while rising sharply from early March through the beginning of June. They have been moving generally sideways since, with some tendency to rotate toward defensive stocks, which have lagged almost continuously since March. What I’ve found notable over this period is how little tendency there has been toward a relative value counter-trend rotation.
On the S&P 500, the sideways movement has bounced between 890 and 950, as investors wait for more data to confirm the fact of economic stabilization and to give some outline to what eventual recovery will look like. In other words, we have reached the point of a possible absolute counter-trend rally. The market has decided that trend-leading stocks can’t go up without further good news and is trying to decide whether they should go sideways or down.
As I mentioned above, markets rarely like to stand still. As short-term traders become more convinced that the market has hit a (temporary) wall to upward progress, they will take the only bet open to them–that the market will go down.
At this point, I don’t see anything that fundamentally reverses the economic recovery trend. A counter-trend movement has already created corrections in many trend-leading stocks. This is normal. The only open question, I think, is whether the counter-trend movement is content with sideways movement or whether it will take the S&P down into the mid or low 800s.