My checklist:

valuations: I’ve thought that since mid-2021 the US stock market began gradually discounting the interest rate increases that the Fed finally began to implement this week.

My experience is that nothing is ever 100% factored into prices until it actually occurs. But the 10-year Treasury note is already at a yield of 2.19%, or about 50bp higher than its peak yield last year. If we assume the 10-year yield ends up at 3% by yearend, we’ve already gone (as is usually the case) a considerable way toward the final goal before any Fed action. Traditional norms suggest a 3% 10-year is compatible with a PE, based on 2022 earnings, higher than 30x for the S&P. Based on consensus earnings expectations, the S&P is currently trading at less than 20x.

This apparently favorable valuation has not come from the S&P falling that much. Instead, it’s more a function of relatively high expectations for real earnings growth this year, with a pinch of inflation tossed in.

One way (i.e., my way) of looking at market action over the past year is that the main story has been a massive rotation away from tech names into defensives that has accelerated over the past four or five months. Within tech, which even in its beaten down state is over a third of the market, there has been a similarly stark rotation away from smaller-cap and speculative names into industry giants like Alphabet, Amazon and Microsoft.

As I wrote yesterday, the aggregate numbers for performance from last year’s high through last week are:

S&P -11.2%

NASDAQ -20.0%

ARKK -53.8%.

Arguably, we’ve experienced a bear market in NASDAQ over the past four months and we may not get another 10% drop in the S&P. This is doubly so because the economy has been growing strongly throughout 2021 and is expected to continue to expand at a better-then-average pace this year.

Earlier-state tech, exemplified by the ARK funds, has been more than cut in half.

Arguably, the rich valuations are now in defensives. My guess is we’ll look back in a year and realize valuations today, maybe except for mining, are better than reasonable.

possible negatives: To my mind there are two big ones potentially in the wings. One is the possibility that Russia’s invasion of Ukraine spirals into something much bigger, as the potemkin village nature of Russia’s conventional army is exposed. I think this possibility will be a continuing PE depressant until there’s a clear resolution.

The second is that the Trump wing of the Republican party somehow gains ground. At the moment, given its pro-Russia, anti-Ukraine leanings, that’s hard to see. But my view is that, taking off my hat as a human being and donning my investor cap, Trump did so much economic damage to the US during his term (think: his NJ casinos) that his political stock rising would be accompanied by PE contraction on Wall Street.

bargain hunting: I’m not sure I see any. But I think the ARK-ish stocks that have been crushed since November will be the place to look.

capitulation: I don’t think we’ll be sure for at least a short while. I know I was, let’s say, rather disturbed earlier this week. I wasn’t October 1987 disturbed, or early 2009 disturbed, by any means. But I started to feel that maybe I’d misdiagnosed the current situation, and that things are actually much worse than I’d been thinking. To my way of thinking, that’s in a perverse way a good sign. If I’m feeling a bit shaky, what must investors who don’t have all my scars be feeling? Hopefully, panicking. Not that I wish anyone ill, but down markets often signal the end with a sharp selloff that participants almost immediately begin to regret. I don’t see that in the charts, but maybe there’s been enough AI violence along the way that we’ve had a bunch of mini-capitulations, with no energy left for a final drop. The next few days will tell a lot, I think.

To summarize: good valuation, possible wimpy capitulation, bargain hunting still up in the air (an accidental pun–I ended up buying some HOOD in the airport yesterday morning), but Russia still a wild card. Not much like the market action in 2000 or 2008. On the other hand, the charts look a lot, I think, like early 2020, when covid victims were being stacked up in refrigerator trucks. Back then, it was the US-centric Russell 2000 that collapsed–and stayed down until November–while stay-at-home stocks and multinationals rallied. To push the analogy, maybe the SPACs and the negative-cash-flow tech stocks play the role of the Russell 2000 this time around, while the rest of the market advances.

the traditional market

Historically, the US stock market has been the best leading indicator of the the US economy, signally both expansions and contractions by about six months in advance of their appearance in official government data. I don’t think there’s a generally accepted rationale behind this phenomenon.

The explanation I’ve arrived at over the years is that if you work inside any corporation, particularly an economically sensitive one, the in-house grapevine is an exceptionally accurate way to get a feel for how business is doing. Things like: …no raises, no bonuses this year …the food in the cafeteria is worse than usual …cutbacks on business travel …layoffs are on the way or …bonuses will be really good …personnel is paying $1000 for hiring recommendations that pan out …the company picnic is back, and it’s in a hotel, not the conference room.

Retail companies like Walmart or Target are also treasure troves of information. Are customers buying low-end $10 jeans, mid-range $20 jeans or money-to-burn, brand-name $40 denim? Manufacturers’ order books are information gold, as well.

Whatever the transmission mechanism, it’s important for us as investors to realize that anecdotal evidence of the economic gears changing is in the air long before there’s official evidence either from corporate results being announced or data being collected and summarized by Washington.

(Note: two opposing forces have affected the lead time between stock market and economy. On one hand, the speed of information flows continues to rise at a rapid rate. On the other, during my working career, armies of very highly-paid securities analysts vied with one another to find, and act on, key data ahead of the pack. Not only that, their years of experience covering a given set of companies allowed them to appreciate the significance of new data a lot faster than neophytes. Virtually every one of these living libraries was laid off, however, during the financial crisis of 2008-09. More on this–and what I perceive as the new way later.)

So the real question behind why the stock market leads the economy, I think, is what makes investors shift from playing defense to playing offense and vice versa.

the shift is a judgment call

My observation of professional investors is that, even though the best continually reinvent themselves as they adjust to economic change and development, no one I’ve ever been aware of has been able to call both market tops and market bottoms. Myself, all of the performance evidence is that I’m much better at up markets than down and that I can call bottoms much better than tops. This last is what I want to write about.

From the market high in mid-November 2021 through last Friday, the S&P 500 has fallen by 11.2%, NASDAQ by 20.0% and ARKK by a mind-boggling 53.8%.

My checklist:

1. Has the market fallen enough, i.e., are valuations reasonable or better, given expected profit growth and interest rates?
2. Are any big new economic negatives looming or have the final shoes already dropped?
3. Are there any signs that value-style investors are picking through the rubble of the worst-hit sectors/stocks?
4. Has there been a cathartic event, a panic-driven selloff where holders sell without regard to price? Two indicators of this: very high volume, unusually sharp price declines, all coming after months of uncertainty.

more tomorrow

I’m not a fan of the Dow Jones Industrials index(or any of the other Dow indices, for that matter). It was a brilliant step forward when it was invented a century ago. But it was created in the pre-computer world . This is a problem in two respects:

–although it has changed radically since being acquired by Standard and Poors, it is still to a great degree a rear view mirror look into the world economy. Its bones are in the pre-WWII era, when–much like a market in an emerging country–stocks were mostly for the wealthy and mature businesses, steady earnings and dividends were the order of the day. If the S&P and NASDAQ give a look into 2022, the Dow is a picture of, say, 1990

–member stocks are weighted by the price of a share of stock, not the total market value of the company. So if it were in the Dow, Amazon, at around $2800 a share would have 10x the weight of Microsoft, trading at about $280, even though MSFT is about 50% larger then AMZN. The only virtue of the way the Dow is calculated that I can see is that the index is easy to figure out with pencil and paper. Essential in 1896, weird today.

Generally speaking, the main usefulness of the Dow for me is the clear signal it sends that the user knows next to nothing about stocks.

Prior to S&P taking control of Dow Jones and trying (very successfully) to make the Dow behave more like the S&P 500, the Dow did have a practical use. If the Dow began to outperform the S&P, you’d know a market advance was getting long in the tooth. (In many cases, and among the various currents swirling around trading at any given time, there’s a progression during a bull market from the smallest, purest beneficiaries of economic strength that progressively widens out to include more and more partial beneficiaries. The Dow beginning to outperform the S&P, the most stodgy moving better than the rest, was a signal that the final stones were being turned.).

That didn’t happen last year as the market began to turn away from the stay-at-home darlings of 2020. Since 2022 began, however, the Dow has begun to outperform the S&P as the market decline deepens. Ytd, the Dow is down by 9.5%, the S&P by 12.5%, NASDAQ by 19.5%.

In other words, the biggest and most conservative stocks have been outperforming the rest over the past 2 1/2 months, for the first time in at least five years. Maybe the “new” Dow has become a signal of the market bottoming rather than topping. If so, we should study the Dow vs. S&P relationship carefully for signs of relative strength by the latter. If nothing else, it gives us something to do while we wait for the current storm to pass.

statistics

Worldwide oil demand is likely to be about 100 million daily barrels in 2022.

The biggest users of oil are:

–the US, 20 million daily barrels;

–Europe, 15 million barrels;

–China, 14 million;

–India, 5 million.

The biggest producers:

–US, 12 million daily barrels

–Russia, 11 million

–Saudi Arabia, 10 million

–all of OPEC, 28 million

–Europe, 3 million.

Notes on usage:

Europe’s population is 2.2x the size of the US, but the US uses a third more oil, meaning we have 3x the European usage per capita.

Russia exports about 7 million barrels of oil daily. Just under 2 million goes to Europe, its biggest customer, less than 500,000 (pre-embargo) to the US.

The US has asked Saudi Arabia and the UAE to increase their production to offset the barrels no longer being bought from Russia. Both have refused, which makes sense from their domestic economic perspective.

what I’m thinking, in no particular order:

Demand for oil is relatively inflexible. Small changes in supply, even changes as small as 1%-2%, are enough to create dramatic swings up or down in price.

As I see it, what is going on in the oil market today is panicky anticipation of future supply shortfalls, not a reaction to shortages that are occurring now.

Why does the US use so much more oil than the rest of the world? It comes down to politics. The big oil companies incorporated in the US have powerful political influence and have enormous long-term investment in oil reserves, whose output they hope to sell years and years from now. They are also far behind European rivals in reshaping themselves into energy companies–meaning in developing renewables. Detroit automakers are technological laggards, as well–in their case in development of fuel-efficient gasoline engines. As very large employers and with workers who have generally been Democratic-voting union members, they have been protected by Washington from competition from superior offerings built by foreign auto majors for almost a half-century, long before the ecological damage being done by engine emissions was well understood. The most recent example of this protection came less than two years ago, when the Trump administration advocated rolling back minimum mileage requirements for cars, a short-term benefit for both the oil companies and the automakers but one that would have left the US even farther behind the rest of the world.

If Russia sold no oil outside its borders, the world would need to make up 7 million barrels, either through production elsewhere or conservation. Because oil demand is relatively inflexible, it’s hard to tell what a 7% shortfall in supply would do to price, other than it would rocket it higher. The price has already doubled from the early December lows to a high of $120 just a day or two ago on speculation about what might occur. And this is coming at what is seasonally the weakest for demand. This part of the picture doesn’t look good.

What has happened in past boycotts elsewhere, though, is that the oil majors, who buy from a lot of producing countries, simply swap the boycotted oil for some other variety and send unboycotted oil to the boycotting country. Or the boycotted oil is processed elsewhere and arrives in the boycotting country as products rather than crude. Or the oil is “accidentally” mislabeled and sold as unboycotted output. So whatever the final tally of quantities boycotted will turn out to be, it will likely considerably overstate the actual loss of supply of oil to end users. And we already know that large users of Russian crude like the EU aren’t going along with the US boycott, preferring in the EU case to use less Russian natural gas. If I had to make up a number, I’d guess that Russian oil exports fall by 2 million barrels a day, which would be bad but manageable.

If Russia could sell no oil/refined products abroad, it would have to store output somewhere and/or slow down the flow of crude to the surface. The latter risks doing long-term damage to the underground fields themselves. Given that foreign oilfield services companies aren’t likely do further business with Russia, such damage may be difficult to reverse. My guess is that this would be the most devastating consequence for Russia of the US boycott.

It appears the US + Canada can almost immediately make up for the boycotted Russian oil from North American sources. Just as OPEC–ex Venezuela, apparently–is unwilling to boost production to offset the boycott’s effect on consuming nations, many consuming nations are reluctant to participate in the oil boycott. The EU, for example, prefers to reduce its natural gas purchases instead. This suggests that the supply shortfall may be far less–at least initially–than the financial markets now suspect.

Will fracking in the US come to the rescue? From an oil major perspective, maybe. However, according to the Economist, small- and mid-sized frackers in the US lost their financial backers a mind-boggling $300 billion during their latest drilling frenzy (shades of 1982, when the same kind of crazy lending to overleveraged wildcatters also happened–this time junk bond funds). So they’re having a hard time raising the money they need to resume drilling.

Why no help from OPEC? To my mind, the simplest explanation has nothing to do with Russia. It’s that the Saudis need $80 a barrel oil to balance their government books. They’re swimming in money today. Why mess with a good thing?

The greatest fear of the domestic oil industry is (correctly) that the oil price reaches a level–let’s pluck $150 a barrel out of the air–that leads to a wholesale, strongly positive reevaluation of renewables. The switch away from oil starts in earnest. EVs become a 2025 thing, not 2035. The US starts to conserve in earnest. Suddenly, there’s a glut of oil and much, much lower prices.

Some commentators are saying that the current situation will turn into a replay of the high-inflation, low-growth era of the US in the 1970s because of the oil price spike. Maybe this will turn out to be true, but I don’t understand how.

During the 1970s, the oil price went up by more than 10x. Rising inflation was cemented into the US economy by wage contracts that called for inflation-beating yearly increases. Washington encouraged profligate use of oil by keeping domestic price below world market levels. It compelled the continuing purchase of gas-guzzlers by severely limiting the import of fuel-efficient alternatives. Presidents before Gerald Ford tended to arm-twist the Fed into lowering rates in election years to make their reelection easier, adding to the inflation problem (The Volcker era ended that. Trump tried in vain to revive the ’70s rate-manipulation practice). My point is the 1970s oil shock was much greater than today’s, there was a lot more wrong with the economy back then and the Fed has learned a lot since then.

The rhythms of growth and value investing are different.

In a somewhat too simple sense, growth investors have greater certainty about when market-moving information will reach the public–during the next quarterly earnings announcement–than about what that information will be. Growth investors believe, sometimes with great conviction, that earnings for XYZ will be up at least 20%, buy maybe a lot more (vs. consensus expectations of, say, 12%), but they know for sure when the actuals will be announced.

On the other hand, value investors (good ones, at least) have a firm conviction, buttressed by careful analysis of company and industry fundamentals, that a firm whose stock they hold is deeply undervalued by the market. That undervaluation is based on the company’s rich collection of assets, on which it is currently earning only a paltry return. They think this hundred dollar bill lying on the sidewalk will ultimately be picked up and put to use. They know what will happen, but they have no idea when.

Three consequences:

–value investors have a different mindset, and a much longer investment time horizon, than growth investors

–value portfolios tend to have maybe twice the number of positions as their growth counterparts, to give a greater chance that something will perform in a given year

–value investors tend to fall into two camps: dyed-in-the-wool asset value enthusiasts and value with a catalyst investors. Both use the value methodology but the latter want to see some impetus for positive change in a company before buying. They understand they’ll miss the absolute bottom, but they have greater certainty that they won’t be tossed to the curb before their ideas bear fruit.