major changes in market direction (III): market tops

market tops

Market tops are harder to define, and to recognize, than market bottoms–at least for me.  That’s partly because tops don’t all exhibit the set of common characteristics that bottoms do.

signs of a bottom…

Bottoms occur when stocks are priced at low enough levels that it’s hard to imagine a likely state of affairs that would justify where they’re trading at.  Clear signs of bottoms include:

–stocks trading a deep discount to book value, or

–the dividend yield on stocks higher than that on government bonds.

…don’t work in reverse for tops

The opposite indicators for book value or dividend yield don’t work at market tops.

Why not?

Book value doesn’t matter much for service companies, which are nowadays typically the bull market stars.  Accounting rules force service companies to charge expenditures on intangibles like R&D against current income, instead of putting them on the balance sheet and slowly writing them off. As a result, the concept of the balance sheet “book” value has limited relevance for them.  A software company trading at 4x book value is much different from a steel company trading at 4x book.

Also, the fact that long Treasury bonds were yielding 10% in mid-1987, a time when stocks were trading at 20x earnings and yielding, say, 2%, clearly warned of the crash to come in October.  But that was an unusual situation.  During my career, many bull markets (I’ve seen five of them in the US and a larger number overseas) have been driven by some overarching theme.  They’ve extended into an “emperor’s new clothes” kind of overvaluation and ended when the fantasy-like nature of valuations has been publicly exposed.  But the stock indices have rarely shown up as wildly expensive vs. bonds.

a list of bull markets

To illustrate this point, these are the bull market endings in the US that I’ve lived through as a professional investor:

1981 bull market driven by oil stocks as OPEC demanded higher prices for its output, and by fear of runaway inflation, which focused investors on tangible assets.  Bull market ended when spot crude prices peaked in late 1980 and began to fall.  Soon after, Volcker Fed began to raise rates aggressively, adding to downward pressure.

1987 bull market ends on valuation, with stocks at 20x expected earnings, an earnings yield of 5%; bonds were trading at half that level, a coupon yield of 10%.

1990 bull market ends as the US economy is beginning to overheat and the Fed signals rate rises; Saddam Hussein invades Kuwait, sending oil prices higher.

2000 really two themes, maybe two bull markets without a bear market in between.  The upturn in 1992 was sparked by the realization that the American industrial base had been modernized/revitalized during the junk bond era of the Eighties and was earning much more than almost anyone expected.  That phase was followed by the technology and Internet boom that lasted from 1996-early 2000.  The latter boom was intensified by Greenspan’s aggressive expansion of the money supply.  He did this to mitigate the effects of the Asian financial crisis and in fear of adverse Y2K effects that never materialized (thanks, Ed Yardeni!).  The bull market ended when new orders for internet-related hardware suddenly stopped coming in during late 1999.

2006 bull market fueled by housing bubble and belief that finance was the new area of US competitive advantage.  The bull market ended when homeowners began to default on mortgages they couldn’t afford to service.  The boom was subsequently shown (to my satisfaction, anyway) to have been based on massive systematic fraud by financial companies, abetted by widespread incompetence and neglect by government regulators.

what do they all have in common?

The obvious thing is that they all ended badly.  But the main point is that they don’t have the cookie-cutter identity of bear market bottoms. Instead, they have a kind of “family resemblance,” where some–but not all–of a set of several characteristics are evident.  Among the things to look for are:

time

Yes, as a bull market matures, the discounting mechanism begins to cause today’s stock prices to reflect possibilities that are farther and farther in the future.   This is in itself a warning sign.  But it still takes time for positive economic events to play themselves out and for storm clouds to appear on the horizon.  If a bull market is dominated by a theme, like oil or the internet, it also takes time for the theme to be recognized and played out to the extent that the major stocks are significantly overvalued.

A bull market typically lasts for well over two years.  The up market(s) of the Nineties lasted for seven.

waves of speculation

The earliest days of a bull market are typically marked by outperformance of large-cap names, as investors scramble to move big amounts of money back into stocks.  After this period, however, investor interest turns to small-caps.  This is particularly true in a thematically-driven market.

Interest then shifts in progressive waves from small-caps to mid-caps, then to large-caps and finally in a highly speculative way back to small caps.  These may be the same small caps the market was interested in earlier in the bull phase or they may be fresh IPOs.  But the new focus is typically on aspects of the businesses that are purely potential, that may never come to fruition or will not make money for years.

Technicians have historically remarked on this final phase, where market breadth narrows, as one of divergence between small-caps and large-caps, which are beginning to break down. But I think the highly speculative element is key.

Yes, this indicator appears to be the bell ringing kind that alerts us to the top of the market.  But, during the Greenspan era at least, this warning period has easily lasted a year or more.  So there has been a substantial risk to professional managers, even if they recognize the sign, if they become defensive too prematurely.

qualitative cracks in the thematic vision

A theme-driven bull market, like any good individual growth stock, has, in addition to its quantitative underpinnings, a qualitative “story” element behind it.  In my experience, threats to the theme always emerge first on the qualitative side.

For example, the late Seventies oil-driven market assumed that demand for oil was insatiable.  At the time academic economists were coming out with theories claiming a special nature for oil–that it had a “backward-bending” nature which made demand increase as prices rose.  Yes, that sounds crazy now, but academic journals were publishing articles about this new “discovery.”  At some point, though, people elected to conserve–to turn down the thermostat, take public transportation and buy heavier clothes–rather than pay sky-high oil prices.

Similarly, as the internet boom matured, companies began to find ways to make existing data transmission lines carry more capacity (rapid development of deep wave division multiplexing) so that they didn’t have to spend so much on new lines.

These qualitative indicators of impending trouble are always there.  They tell you nothing about exact timing, but they do serve as a warning to be on your guard.

stumbling blocks to recognition

Bull markets only come along once or twice a decade.  That’s not very often.  In addition, the Greenspan monetary philosophy encouraged the creation of speculative bubbles, making it harder to figure when, or at what levels, stocks should be peaking.  (A Heideggerian might say that we refuse to recognize patterns that develop only over long periods because they remind us of our mortality (sorry!).)

But there are also more practical stumbling blocks.  In particular,

–research reports from brokerage houses are relentlessly positive.  Neither brokers nor analysts make money by telling clients to sell.  In fact, they may lose business by doing so if they anger company managements or large holders of a stock they express a negative opinion about.

–the reliance of institutional clients on third-party consultants to select and evaluate managers has had two relevant results– ever higher specialization of portfolio managers, and the prohibition of “style drift,” or movement away from the areas the manager knows best.  So today’s institutional manager may not pay much attention to relative sector valuation.  It may make no sense for him to hunt for undervalued parts of the market outside what has worked for him in the past, because he won’t be allowed by his clients to invest in them.

–he won’t be permitted to raise cash either, because of the strong institutional emphasis is on relative performance rather than absolute.  In consequence, if a manager doesn’t see anything but overvaluation in the areas he has been hired to invest in, his only choice is to give back the money.  That made Warren Buffett’s reputation a half-century ago, but not many people have been willing to follow his lead.  Why?  …they forfeit management fees, and they have no guarantee they’ll ever get the money back.

The result of all these factors is to create a situation where a professional portfolio manager tends not to pay enough attention to, or to underestimate, how frothy the market may be at a given moment.

tops can last a long time

Rarely, bull markets have a “melt-up,” a buying panic that’s the same kind of definitive signal of the top that a selling panic, or meltdown, is of the bottom.  More often, though, a bull market top lasts through months of basically sideways action.  It’s as if you have a great seat at the movies and the film is terrific, but you smell a whiff of smoke.  You know someone will eventually yell “Fire!’ and all hell will break loose.  But in the meantime, it’s such a good movie and you have such a great seat that you decide not to leave.

for us as individuals

Three comments:

1.  We have none of the restrictions, or the blinders, of institutional investors.  We can afford to give up some of the upside to protect our downside.  We can leave the theater.

2.  There’s a temptation to focus solely on the overvalued sector and to argue that while doom impends there, the rest of the market is safe.  That’s almost always a mistake.  When the bull market ends, everything goes down.  The decline in overvalued stocks tends to drag everything else down with them.  Occasionally, as was the case with very defensive stocks during the collapse of the internet bubble, some sectors may show absolute gains.  In most cases, however, their performance is relatively good but bad in absolute terms.

3.  Up until the past decade, post-WWII bull markets in the US have typically lasted about 2 1/2 years.  Bear markets have lasted around 1 1/2.  Together, the two make up the typical inventory adjustment or “electoral” market cycle.

Arguably, then, the bull is beginning to live on borrowed time when an up market enters year three.  Similarly, a bear market is starting to be on its last legs when the decline enters year two.  A reasonable strategy would be to begin to look hard for signs of reversal once those mileposts have been achieved.

Neither rule of thumb would have done much good so far in the 21st century.  The bust that followed the internet bubble dragged on from April 2000 until March 2003.  The housing-driven bull market that followed lasted four years, until mid-2007.

It’s possible, however, that with Mr. Greenspan out of the picture and with “bond vigilantes” on higher alert that the older patterns may reemerge.

(Note:  I’m editing and updating this in March 2012, in response to a reader’s comment.  The bull market that began in March 2009 endured a sharp correction of about 20% last summer.  That was right on the old schedule.  However, prices have since rebounded and are retouching the old highs.   And the intrusion into financial markets by governments in the developed world–with the EU and Japan joining the cheap money party–is greater today than it has been over the past several years.  So the timing of the 2011 correction may have only been coincidence.  Personally, I think we may continue to be winging it for a while–at least until the shape of post-election fiscal policy in the US becomes clearer.)


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