One of the deep, dark secrets of active equity portfolio management, is that almost no professional manager does better than an index fund. That’s even before subtracting the fees clients pay for this “service.”

As it turns out, I had a twenty year stretch as a global equity pm, during which I generally outperformed my index (with the occasional clunker year). But I was an outlier. And I never managed more than a couple of billion dollars, which meant I had lots of flexibility in what I could hold than managers of mega-portfolios. I also spent less of my time interacting with the people who hired me, because there were fewer of them.

Who outperforms, then? If professional managers in the aggregate are (mild) losers to the S&P 500 year after year, someone else must do better. But who? My belief is that it’s individual investors like you and me. But this is a story for another day.

The point I want to make today is that owning an index fund isn’t a bad thing. In fact, odds are that you’ll beat most professionals, and pay lower fees, doing so.

It seems to me that a superior strategy is to hold, say, 80% of your equity savings in index funds or ETFs and the rest in a few individual stocks or sector ETFs that there’s some reason to believe you know more about than the average holder. This involves work. Thinking about your companies and their competitors, reading the SEC filings and company press releases, studying the relevant industry, using the products, if you can… If you do this with one or two, or a few, stocks, chances are you’ll do better than the typical pm–who probably doesn’t do much of this. If you find this boring, on the other hand, stick with index products.

I think the first half of 2023 will be an especially problematic time for world stock markets. If this is right, it’s an argument for ticking closer than normal to an index.

It’s not that I expect anything like the series of earthshaking events that dominated 2022–Trump’s attempt to overthrow the US government, the invasion of Ukraine, the dual China problems of an imploding property sector and rampant covid, the sharp rise in interest rates in most of the world as covid-related economic stimulus began to be reversed.

The big issue I see is exemplified by Morgan Stanley’s view that the S&P 500 could decline another 25% in the first half as disappointing corporate results from 2022 are announced–mostly during 1Q23.

Two aspects to this conclusion, as I see things:

–the pandemic ended pretty much all at once during the first half of 2022. This caught most publicly-traded companies by surprise. They had been loading up on raw materials and finished goods they could grab, double- and triple-ordering and being willing to pay very high prices, on the idea that the pandemic would continue for a much longer time. Think: used cars, for example, or mid-range large screen TVs.

What do companies do in a case like this? They say as little as possible initially, and hope to be able to sell as much as possible of the (now hugely bloated) excess inventories. But they can’t do this forever. Typically, at the end of the reporting year–December, or January for most retailers–they’ll come clean (or clean-ish) and write their inventories down to fair market value (there are limits to what they can do, but this is a minor point). Morgan Stanley appears to think that this + weak holiday sales mean the coming reporting season will be particularly ugly.

–in the world I grew up in as an investor 20-30 years ago, armies of securities analysts working for investment managers and for brokers would have been hard at work trying to figure out the magnitude of the bad news. And stocks would begin to decline–far in advance of company announcements–as analysts’ results became known.

Some of this is certainly happening now. Look at Carvana (CVNA), now trading at 1.5%!!! of its mid-2021 high. …or KMX (CarMax) at 42% of its high. Morgan Stanley, however, seems to think that the main market downdraft is still to come. Trading bots, trained to react to earnings results, will drive the market down sharply as full-year 2022 results are announced in late winter.

In my experience, a bull market ends up factoring into current prices more than all the good news that the coming year could possibly bring, and a bear market will discount the same bad news over and over again. We’ll know the bear market is over when companies announce bad news and the stocks don’t go down.

Personally, I think we’re very close to this final bear market stage, if we’re not there already. But I’m certainly not willing to bet that I’m correct. What I’m actually doing now is combing through what I hold, to weed out the names I think are the weakest.

More next week. Happy New Year!!

Babysitting grandchildren is lots of fun. But it took a lot longer than I’d expected.

Where I left off was:

–consensus expectations for 2023 appear to assume that 2022 losers will continue to lose and that 2022 winners will continue to win. This may turn out to be the case. The contra-argument is that at some point valuation starts to kick in. This can happen in one of two ways:

—-current market darlings may end up being priced for perfection, or for perfection +. That is, everything good that could plausibly happen for the company, and maybe also things that are next to impossible, are already factored into the price.

We’ve seen this movie before, with the stay-at-home stocks in 2021.

—-on the other end of the valuation spectrum, out of favor stocks can be beaten down to the point where they’re trading below tangible book value. That is, they could be bought and liquidated for considerably more than the stock price. In today’s world, companies can also have intangible assets–intellectual property, brand names, distribution networks…–that can have great value but which are not reflected on the balance sheet. One of my favorite examples is Microsoft, which went sideways/down for 14 years after the internet bubble of 1999-2000, but which exploded upward once skilled management was installed.

One caveat with this traditional “value” view is the dual share structure in many NASDAQ names (think” META) that can cement past-its-sell-by-date management in place.

–the consensus view is that the major indices, like S&P and NASDAQ, will exit 2023 at roughly the same value they enter the year. This has happened nine times in the past 75 years, so it is possible. I think it’s much more likely, though, that the indices will be either up or down by 10% or so. I also think that , given the pummeling stocks have had over the past year+, the +10% is more likely. It strikes me, though, that strategists feel that in the current uncertain climate if they’re too conservative, clients will soon forget; if they’re too aggressive, they risk losing their jobs.

–it seems to me the major “cosmic” issues we have to deal with as investors are, in descending order of importance:

—-the ultimate landing place for the 10-year Treasury, because the long bond yield will determine the PE for stocks

—-the extent of the excess inventories accumulated by companies during the pandemic and as yet not disposed of–we know from TGT and WMT that six months ago they had a ton of stuff no one wanted any more, and the two are cream of the crop in inventory control. writeoffs? weaker-than-expected 1Q23 earnings?

—-the robustness of Europe, in the face of the higher cost of energy and the area’s general messedup-edness. Two aspects: maybe a quarter of the S&P 500 earnings come from Europe; and strength there would likely cause bond managers to shift away from US Treasuries, weakening the dollar

—-shifting economic dynamics in Asia, as Xi continues to reestablish Mao-ish Communist Party control over that country given up during Deng’s “socialism with Chinese characteristics” rule.

more tomorrow (I hope)

This is typically the quietest week of the year. I’d intended to write about how I intend to approach 2023 starting today (basically we’ve all got to find something we think will be significant for the stock market next year and, in the ideal case, that’s not well-recognized. But I decided to write instead about Elon Musk’s seemingly continuous sales of TSLA stock.

The general situation is well-known. Musk agreed to buy Twitter a while ago, pretty much sight unseen, at a price that appeared, even at that time, to be wildly high, and using debt financing whose servicing costs would likely absorb all the cash flow Twitter would be likely to generate.

It seems to me that Musk has done a lot of reputational damage to himself, and by implication to TSLA, both by the apparently very unfavorable deal he agreed to and by what seem to be reckless operating decisions since talking control.

Today’s question: why has Musk continued to raise money?

I think the issue is the $13 billion in face value of bank debt Twitter took on as part of the Musk purchase. That debt is still on the banks’ balance sheets. They’d planned to sell on to debt investors but the wheels started to come off Twitter before they could do so at par.

This debt is potentially a big problem for Musk. If Twitter is not able to make interest payments, the debt holders will sooner or later be able to force Twitter into bankruptcy. In bankruptcy, current equity would be cancelled and existing debt would be redeemed in exchange for the equity of a successor company. In other words, control of Twitter would pass from Musk and his co-investors to the creditors.

Suppose the banks are warming up to sell to third parties who would have no compunctions about throwing Twitter into bankruptcy. If so, it would be important to Musk to bid for enough of the debt that he would emerge from the ensuing bankruptcy still in control rather than out on the sidewalk.

Happy Holidays!!!

positioning for 2023

Looking at the US stock market from it’s top a year or so ago, the S&P 500 has declined by 20% from its late-2021 highs; NASDAQ is down by almost 40%; and the speculative ARK fund ARKK, is off by very close to 80%.

The S&P 500 Value index is off by only about 8%; the corresponding Growth index is down by 30%.

For the S&P as a whole, we’ve been experiencing what might be called a garden-variety bear market. For the S&P Value it’s been more like a walk in the park. For the worst of the other markers, however, declines have been more reminiscent of 1973-74 and 2007-09, the worst stock market performances since the Great Depression of the 1930s.

The big question is, as it always is, what comes next.

What I find most striking about the, admittedly limited, brokerage house strategy I’ve been reading is that the consensus seems to be that the stocks that haven’t fallen much will continue to outperform and that the current crash-and-burners will continue to implode. Maybe so, but this strikes me as odd.

I’ve just been called to babysitting, so I’ll pick this up on Monday. For now, I’ll just say that the way I think we should deal with this question is to craft a portfolio whose success/failure doesn’t hinge on this single, to me clear-as-mud, issue.

Stock market opinion seems to me to be divided between those who think that potentially weak 1Q23 earnings–no matter how well flagged by companies or securities analysts in advance–will cause serious new downward pressure on stock prices in the new year. Others, perhaps more traditional (i.e., more like me), think that some combination of investors reacting today to expected earnings declines plus the beating stocks have taken in 2022–meaning lower valuations–will mitigate the damage. This is a topic for next week.

We, however, have got to get to 2023 first.

I find current market action to be very unusual for December. As I see it, former pandemic stars that have been weak all year are breaking down again to lower lows …and on relatively low volume. Put a different way, sellers are highly motivated and buyers are few and far between. My interpretation is that individual investors have waited until the last possible moment before selling stocks they have steep losses on to establish losses for tax purposes. Un fortunately for these sellers, most potential institutional buyers have closed up shop for the year. So sellers have to transact at lower prices that they might if most professionals weren’t on vacation.

It will be interesting to see whether the new year brings a rebound in the names being pummeled this week or whether we still have to wait for a bottom in these stocks to be established. I’m in the rebound camp, but I’m always too optimistic.