Monthly Archives: March 2011

major changes in market direction (II): market bottoms

March 2, 2011 By in major changes in market direction, market bottoms Tags: , , , , , , , Leave a comment

looking at bear markets

What is the stock market?  It’s the place where the hopes and fears of investors meet with the objective, profit-making characteristics of companies, and express themselves in the prices of the publicly traded equities the companies issue.

characteristics of a bottom

time

Why is that important?  In a bear market, a key issue is time.

It’s true that, because people tend to extrapolate from recent experience, it takes time for investors to adjust to changing market conditions.  The initial bear market rally, prompted by the belief that the first leg down (of three) in a bear market is actually just a correction in an ongoing bull phase, bears witness to this.  But investors “get” the new market direction relatively quickly as the rally fades and stocks head back down.

In a bear market, the more important factor is that it takes time for companies to work off inventory, revise capital spending plans, figure out whether to halt projects already underway, and trim payroll.  With today’s sophisticated supply chain management software, the ripples of slowdown from the retail storefront that people spread very rapidly to suppliers.  This spreading call to adopt a defensive posture intensifies the slowdown.

Most important, though, it takes time for countercyclical measures by governments to be put into place and to start to work.  It takes time for economies to stabilize and begin to heal.

How long?

In the case of an inventory cycle recession, the process of stabilization probably takes a year.

As we’ve seen in the two recessions of the past decade, when structural factors are involved, the process may take two years.

The conclusion from this:  it makes no sense to start to look for a bottom until a substantial amount of time from the top has passed.

valuation

Because emotions run faster than changes in the corporate environment, stock values (after being pummeled) may stabilize and move sideways for a period of time during the later stages of a bear market.  The most important indicators, to my mind, with the lest important first, are:

1.  Economically sensitive, commodity-like cyclical stocks may trade at a discount to book value.  This essentially means that the companies are on sale for less than it would cost to build the plant and equipment they own, after repaying all debt.

2.  Companies sell for less than net working capital.  This is the same idea as #1, except that in this case the firm is selling for less than what you would get after running down inventories and collecting what trade creditors owe, and repaying all financial and trade obligations.  You get the plant and equipment, trademarks and brand names, distribution network…and everything else…for free.

3.  Some companies, usually weaker ones, trade at a discount to net cash on the balance sheet, meaning what’s left over in the bank after paying off all trade and financial obligations.  Stunning, but it happens.  Just check out March 2009–or November 2008.

4.  The dividend on stocks exceeds the coupon on the 10-year government bond.  This is a very unusual case, but something that occurred both in 2003 and 2009.  Typically, in my experience, the market to watch is the UK, a very income-oriented market.  When the FT 100 yields more than long gilts, the bell that we’re at the bottom is ringing loud and clear.

Strikingly, this phenomenon also occurred in the US in 2009–when Republican legislators in Washington inexplicably, and scarily, voted against rescue of the financial system.  They seemingly voted for a decade of the dust bowl, riding the rails, selling apples on street corners and 25% unemployment (in other words, the depression of the 1930s) as the best course for the economy.  Talk about cutting off your nose to spite your face–and frightening the wits out of investors.

an end to layoffs

I’m a great believer that the economic intelligence of the average citizen is very under-appreciated.  The first indications of slowdown come from the storefront; the first indications of corporate stabilization come company decisions to end layoffs.  This news spreads like wildfire through companies.  Salesmen sense a better tone with customers, line managers see more smiles–or at least fewer frowns–on the faces of top management.  These changes in corporate atmosphere—which I think any employee can sense in his own company–are also powerful indicators of a market bottom.  They’re part of the healing process.  They translate into a less defensive attitude on spending.  These changes, which you can see immediatle at work, take many months to be reflected in government statistics.

a selling climax

This is sometimes called a selling panic.  The idea is that investors finally lose the emotional control that they have been maintaining throughout the bear market and, gripped by fear, begin to sell large amounts of stock with no regard to price.  They do this either until they run out of things to sell or they become exhausted from the strong emotions they are experiencing.  In theory, you can’t work up this negative emotion again quickly.  And as you recover your senses you’re embarrassed and remorseful for having acted so stupidly and irrationally.  You also realize that you’ve participated in the final selloff and that the worst has passed.

This doesn’t always happen.  The big bear market of 1981-82 ended with a whimper, with no final selloff.

In contrast, during four weeks in November 2008, for example, the S&P dropped by 25%. Shockingly–to me, anyway–this huge November selloff wasn’t the bottom.  Thanks to Washington, another selloff of the same magnitude occurred in February-March 2009. That was the first time in 30 years of investing that I’d seen that. I wish I hadn’t.

revisit March 2009–you’ll be surprised

Pick any stock and look back to its price in early March 2009.  You probably won’t believe how cheap it was.  And, yes, the dividend yield on US stocks was higher than the long Treasury, there were stocks selling at a discount to net cash and corporations were beginning to work out that they had fired too many people.  All the signs of a major bottom were there.  Of course, except for possible rehiring, all the other signs were there in November 2008.


 

major changes in market direction (I): general

March 1, 2011 By in Current Market Thoughts, major changes in market direction, Recent Market Action, Strategy Tags: , , , , , , Leave a comment

I’ve been writing for the past couple of days about minor, counter-trend moves in stock prices.  I figure I might as well continue on this topic by writing about the characteristics, as far as I know them, of major changes in market directions–market tops and market bottoms.

This will be the first of three posts and will cover general stuff.  Market bottoms will come next.   Market tops, for me a far more difficult topic, I’ll try on Thursday.

general

shape

Stock market indices have long been considered good leading signals for the direction of the overall economy of a country.  In the US, for example, it’s one of the more reliable of the set of indicators economists use to chart economic progress.  The cliché is that the market leads the real economy by about six months.

While that may be true in on average, I’d add one refinement:

the market’s discounting mechanism, that is, what future events the market is willing to factor into today’s stock prices, varies with the business cycle.  In a bear market, investor optimism contracts sharply, to the point that at the bottom investors are only willing to pay for the here-and-now–and will sometimes even demand a discount price to book value; they won’t pay for what they consider a risky future at all.  On the other hand, in the later states of a bull market, investors are happy to pay for earnings two or more years in the future, even though there’s no evidence that professional securities analysts can project earnings accurately one year ahead.

time

As a practical rule of thumb, the classic inventory-adjustment business cycle is a four-year phenomenon.  During a boom, the money authority sees that a country’s entire industrial capacity is being utilized, more capacity is in the works, the labor pool is almost completely empty and firms are beginning to poach employees from each other by offering higher compensation packages.  In other words, the economy is starting to overheat.

The central bank responds by raising short-term interest rates.  That slows the economy markedly and a mild recession ensues.  At some point, probably about eighteen months later, the monetary authority concludes the economy has cooled down enough that rising unemployment is a bigger danger than inflation.  It reverses course and begins to lower rates.  This starts the upcycle again.

In this simple world, where there are no external shocks and no egregious policy and regulatory blunders (don’t we wish!), the rhythm of the economy is:  two and a half years of up, followed by one and a half years of down.  The rhythm of the stock market is close to the same.

Three practical rules derive from this picture:

1.  two years into a bull market, start to look for signs that the end of the good times may be near,

2. after one year of down market, start getting ready to buy, and

3.  look to the monetary authority for confirmation of a change in trend.  Under normal circumstances, however, industrial capacity utilization and the unemployment rate will lead central bank action.  So look at them first.

the “real” world of the past fifteen years

You’re probably thinking that this simple timing rule wouldn’t have done a lot of good during the collapse of the speculative internet market of the late Nineties or the popping of the housing bubble a few years ago.  That’s absolutely right.  However, the mistakes of the Greenspan Fed have had  common effects on stocks.

In addition to intensifying the ups and downs, they’ve also stretched the market cycle time frame to 3+ years of up and  about 2 years of down, but they haven’t altered the basic shape.  And (let’s hope) the present Fed has learned from the havoc the “maistro” has wreaked.  So it’s possible that once economic recovery in the developed world gains strength, we’ll revert to the older, more benign pattern.

Be that as it may, I think we can draw one important conclusion.   Market history suggests that right now, with the world about to enter year three of uptrending stock prices, we’re only reaching the earliest stages of having to think about how and when the current bull market will end.