taking out a fresh piece of paper

…or maybe “starting a new Word document,” or “taking a step back (to try to see the big picture)”.

My experience is that success in the stock market doesn’t necessarily come from knowing a lot of things–although a deep fund of general knowledge can’t hurt. Rather, it comes from knowing a few things much better and/or much earlier than most.

To my mind, stock market interest is now focused on two main topoics:

–the continuing rise in interest rates, and the associated topic–how high they need to get to rein in inflation. The yield on the 10-year has already risen from around 0.6% in mid-2020 to 4.2% last October. It’s now at 3.93% as I’m writing this. Let’s say that we end up at 4.2% again. One reason this yield is important is that it gives us a quick-and-dirty look at what the stock market PE (i.e.,1/earnings yield) should be. At 3.93%, the market PE should be 25.4x; at 4.2%, it should be 23.8x.

Slightly higher interest rates should imply somewhat slower spending, but the larger effect, I think, is that they also suggest about a 6% contraction in the market PE. Arguably, most or all of this will be offset by listed-company earnings growth. The timing of this offset is a matter of current debate

–the strength of earnings in 2023. I think there are two separate issues here. One is the strength of demand for goods and services in 2023. The second is what I suspect has been the very leisurely pace at which companies sold off excess stocks of stay-at-home goods last year–implying, I think, sales of this stuff in 2023 at lower prices. Why would a company act this way? …so executives would hit higher bonus levels. Why do I think this? …I’d be tempted to do the same and what I read as odd phrasings in earnings conference call transcripts.

My guess is that these topics have already been beaten to death by everyone except trading bots.

What I find more interesting:

–the FAANG companies that have dominated the US stock market over the past twenty years seem to me to be showing their advanced age. After all, growth stocks seem to me to last about five years before they have to reinvent themselves. Reinvention is difficult. Lots aren’t able to do this even once. But these companies have done so 2x or 3x …and, it seems to me, they’re all showing their age. Time to look for smaller, earlier-stage phenoms. In one sense, these are riskier than the behemoths because they’re less well-known, but the early 1970s show the high risk in hanging on to “one decision” stocks for too long

–banks are starting to put office building loans on credit watch, a result of changing work patterns post-pandemic. I’m not sure who benefits from this, but there must be someone. Suburban restaurant chains?

–a better than average, but not the best, human Go player beat a computer by making unusual moves that apparently distracted it. Are trading bots far behind?

the next couple of months

It seems to me the go-to view on Wall Street right now is that:

–peak pandemic-driven earnings came in the first half of last year

–therefore yoy earnings comparisons between now and the summer will be negative–probably by the largest amount in the current economic cycle, and

–as this occurs, stocks will go down one final time, to (hopefully) end the bear market

–during 2H23, earnings comparisons will begin to recover, driving stocks back up to where they started the year.

I have several thoughts:

–yes, during bear markets investors play their cards very close to the chest. They react to current (which is presumably going to be bad) news much more strongly than to the promise of better days in the second half and beyond. I think trading bots accentuate this tendency

–on the other hand, we’re in month 15 of the bear market and the forward PE on the S&P 500 (according to Ed Yardeni) has contracted from 22x to 18x for large cap, 14.5x for mid cap and 13.8x for small cap. In other words, a lot of time has passed and it seems to me a lot of bad news has already been factored into prices, especially for non-behemoths. As is typical of bear markets, though, there’s much more conceptual discussion focused on earnings progression than attention paid to valuation

–while timing the market makes for interesting conversation, it seems to me that the cliche we should be hanging onto is that every new cycle brings a change in market leadership. Back to the behemoths: if we consider the FAANGs (MAANGs?), they’ve been growing strongly for much, much longer than the five years or so the typical growth stock remains in the spotlight. That’s because they’ve progressively reinvented themselves. META, at least, seems to me to have run out of good new ideas, however–and investors have a better realization of how toxic the company’s products can be and how radically dependent they are on what Mark Zuckerberg wants to do.

In any event, I think it’s a more important issue for us to figure out which of the largest and best-known names, if any, we want to be holding when a new bull market begins. I think this is a potentially wiser use of time than trying to call the bottom …and take the all-or-nothing risk of selling with the intention of rebuying a lower prices

–some bear markets end with a whimper. The best preparation for a final selloff, if one occurs, seems to me to be to try to imagine how we’d upgrade the portfolio if one occurs. This might even be the inspiration for doing some housecleaning today.

an everyman approach to the stock market

I was going to start out by writing that the paradox of stock market investing is that on the one hand the market takes in just about everyone. On the other almost no active portfolio manager is able to perform better than an index fund. And those who do outperform in one year most times give everything back (and often more) the following year.

That’s not true, though. The securities world is one of the last bastions of corporate anti-woman sentiment and, with the possible exception of economics staffs, has a real anti-intellectual bias as well.

The real paradox is that even in the days when both brokerage firms and investment managers had large staffs of analysts virtually no one beat the market, even before subtracting fees. That continues to be the case today.

Also, even if you spent the time and effort needed to locate an outperforming manager, there’s no guarantee that manager’s hot hand will continue or that the manager won’t be headhunted away or that they’ll get promoted to a higher-paying supervisory job. Then you’ve got to go through the whole process again.

Actually, there’s an obvious way we can do better than professionals …holding index funds. We also gain this way because the fees we’ll pay for services through a discount broker will be at most 10% of what we’d pay an active manager.

Nevertheless, even though few (none?) of us would think we can outshoot Steph Curry, get a hit against Edwin Diaz or block any NFL defensive lineman–and no one I know would try home knee surgery (one of our former neighbors, a software salesman, did elect to defend himself in criminal court, with predictably disastrous results), we all think we can hold our own against professional investors through our own active management.

In a limited sense, we can. Peter Lynch, for example, was an investor in Dunkin’ Donuts (now Dunkin’) during the early days of its national expansion. He learned about it from stopping for coffee on his way to work. A friend who’s a surgeon was always up-to-date on the latest medical research. And he knew from experience in his practice which drugs were effective and which were not. So he had an edge in evaluating drug companies and surgical equipment firms. Also, of course, in today’s world SEC filings for all publicly traded companies are readily available on the EDGAR site.

This brings up another issue. It’s crucial to know enough about financial accounting to be able to interpret the accounting statements.

To sum up: I think a reasonable strategy is to have most of one’s equity allocation in index funds, with one or two high-conviction ideas. These must be stocks where we have a reasonable basis for thinking we know more than the consensus and where we can monitor developments closely.

where we are now…(v)

The biggest financial meltdown of the past quarter century, prior to–and ex–the much bigger US housing market fiasco of 2007-09, was the popping of the internet bubble of 1999.

As I’m mentioning Henry Blodget below and thinking about Sam Bankman-Fried as another example of crookedness and excess, I’m realizing more clearly the strong parallels between then and now. The year 2000 ushered in not only recession but a two year rally in ultra-safe, bond-like sectors like Utilities and Staples (pretty much the only time in the past 30 years that such defensive sectors have been in the limelight), and the beginnings of the housing boom that would ultimately end up in epic levels of fraud. Maybe this is why today’s brokerage house strategists have been so strongly convinced, even now, that taking a defensive posture in anticipation of recession is the right thing to do.

the internet bubble of 1999


Alan Greenspan, then head of the Fed, had a penchant for running money policy a bit on the loose side, even though the stated intent of the monetary authority continued to be disinflationary. i.e., relatively restrictive. Two crises in 1997-988 reinforced this tendency to err on the side of too much stimulus:

–in 1997, international commercial banks mounted a sequence of attacks on the currencies of a number of emerging markets in Asia, Thailand being the first of a number of successes, to exploit their excessive dependence on dollar-denominated debt. This culminated in a massive, but unsuccessful, attempt in 1998 to break the peg between the HK$ and the US$. Sti8ll, the bank move destabilized commerce in Asia for more than a year

–Long Term Capital Management, founded in 1994, was a hedge fund. It focused exclusively on exploiting minute price differences between the US Treasury bond issues that were used in the pricing of bond derivatives, that is, “on the run” vs. Treasuries that were virtually identical except not used in derivative pricing, i.e., “off the run.” Although both kinds pay identical amounts in interest and return of principal, the former are more liquid and trade at higher prices in the aftermarket than the latter.

LTCM’s idea was to do what commercial banks routinely do, short on-the-run bonds and use the proceeds to buy off-the-run, earning small amounts on the spread between the two. Its twist: do so on a massive scale, using boatloads of short-term (i.e., lower interest rate) loans to scale up their positions. The operation was watched over by a celebrity bond manager, John Meriwether, with rockstar finance academics Myron Scholes and Robert Merton (the functional equivalent of celebrity influencers) on the board. What could go wrong?

Russia did. In 1998 the ruble collapsed and Russia defaulted on its sovereign debt, causing a flight to safety around the world. This created immense demand for on-the-run Treasuries. “Poof!,” unable to sell its illiquid holdings to cover its short positions, LTCM was bankrupt. But, as the old joke goes, borrow $1000 you can’t repay and you’re in trouble; borrow a billion dollars and the bank’s in trouble. Here, the Treasury was the one in trouble, given the multi-billion dollar overhang of illiquid Treasuries on the LTCM books and where buying interest had completely dried up. Washington ultimately arranged a bailout that played out over a couple of years.


–Y2K. A major worry here, which may seem silly now but which was a genuine worry back then, was whether computers of all types, from bank and government mainframes to PCs, would stop working on 1/1/2000. As I remember it, the issue was that most newer commercial programs were built on top of old code (think: banks) that, to save space (?), had internal calendars that only went up to 12/31/1999. So, arguably, they might all just shut down when 2000 dawned. That would mean no more working ATMs–or any personal or business access to money; no traffic lights; no air traffic control…

In the runup to 1/1/2000, lots of weird stuff happened by people preparing for the ensuing end to civilization. There was a speculative run on wooden plows, for example. Older US dollar coins, made from actual silver, sold for close to 10x face value.

Most important for this post, Y2K was a another reason for the Fed to keep money policy relatively accommodative

–internet infrastructure. There was a mad rush during 1999 to build fiber optic cable networks, including undersea connections between the US/EU and US/Asia

–cellphones and cellphone networks. Demand for cellphones and PDAs (personal digital assistants, like Blackberry) was very high, and expanding. This created shortages of semiconductors to power devices and the networks they used. FPGAs (field programmable gate arrays), big, expensive kludgy things, were particularly hot. They had nothing much going for them, other than you could erect a network with them today and install/correct network programming on the fly later on

–internet and internet commerce. AOL, the early internet leader, was being surpassed by browsers like Netscape that allowed direct access to the World Wide Web. This created potentially enormous demand for ecommerce websites. I remember going to the IPO roadshow for Amazon, for example. Management said virtually nothing about the company’s business. The entire pitch was: “look back to 1980, the dawn of the PC age. There were obscure little companies back then like Microsoft, Cisco and Oracle, trading for half-nothing that became tech giants. We’re at a similar juncture today. Who knows who the future winners will be, but buy a basket of potential beneficiaries. Include us in it.” To give this some context, MSFT was then trading at about 1000x its 1986 IPO price.

–dubious flame-fanning. The sell-side royalty of internet company analysis were Henry Blodget of Merrill and Mary Meeker of Morgan Stanley. Both wrote glowing reports about fledgling internet company IPOs that proved wildly optimistic. In his private mails, Blodget trashed some of them as total garbage. He settled subsequent SEC charges of securities fraud by agreeing to pay $4 million and accepting a lifetime ban from the securities business. Meeker left Wall Street to join venture capital firm Kleiner Perkins.

why the music stopped

Valuation was one important thing. I remember, for example, selling all my MSFT in late 1999. The company was trading at 65x earnings, despite growth slowing to about 5% and with Steve Ballmer taking over. (I bought it back 14 years later at 2/3 the price, just after Ballmer was ousted).

The global computer network didn’t collapse (I have no idea what happened to all those plows)

As with the 19th-century railroads, the mad rush to be the first with capacity resulted in much too much internet transmission infrastructure being created. Probably as important, rapid advancements in dense wave division multiplexing (sending hundreds of signals down a fiber optic strand rather than one) quickly made much of the cable laid in the late 1990s superfluous, and therefore worthless.

New chip fabs came on line, ending the shortage that had sent cellphone component prices sky-high

In other words, across the board, potential shortage turned into actual glut.

At the same time, Time Warner was agreeing to buy soon-to-be-senescent AOL for a ton of money, a bell-ringing warning of a market top.

where we are now…(iv)

external shocks

Speaking in the broadest possible terms, stock markets tend to be driven by the ups and downs of listed company profit growth. Profit growth, in turn, is a function both of the skill of company managements and demand for their products/services and of overall macroeconomic conditions + government maneuvering (through interest rate and public spending policies) to achieve maximum sustainable GDP growth.

Every once in a while, markets are subject to external shocks, meaning anything not in the previous paragraph, that can, for a while at least, have a substantial depressive influence on stock and/or bond prices.

The pandemic is a major recent example. The Russian invasion of Ukraine might be another, although its chief stock market-related impacts have been on oil and gas prices and on the EU economies that depend directly on Russian supplies.

The two other big systematic shocks in this century were the popping of the internet bubble in 2000 and the housing loan/bank insolvency crisis of 2007-08. My understanding is that both involved popular delusions plus a healthy dose of securities fraud.

–the housing loan crisis started out with the apparently innocent observation that people who owned their own homes live happier, healthier lives than those who don’t. So it became a government priority to encourage home ownership. That meant banks making mortgage loans. Rather than keeping the mortgages on their books, modern banks typically collect a processing fee and package loans in large bundles to sell to pension funds and other institutional investors. A popular variation on this theme became sorting bundles by the riskiness of its loans and maximizing the selling price by offering different risk tranches to insititutions with different risk tolerances.

Once all the “safe” mortgage loans had been made, banks began to make riskier loans. Then the after-action and press reports I’ve read say the banks began to pressure the rating agencies to give high ratings to low quality loans ,,,which they did. Then, ratings were given to a specified package of loans but in the product then offered to institutions the rated loans were replaced with inferior securities. Another source of trouble, somewhere along the line loan originators began to “improve” the financial qualifications of borrowers. And with all this extra demand, home prices began to rise, making loan to value ratios much iffier. Then borrowers began to default. Then the US banks realized that even after unloading the most toxic junk on EU banks, they retained enough exposure that they were effectively bankrupt. Yes, they had some insurance coverage, but the issuer was as insolvent as they were.

More bad stuff: companies in, say, China that shipped goods to California relied on letters of credit issued by US banks stating that the customer had money on deposit and the shipper would be paid once the goods reached the US. But what good was that if the bank went under during transit. So world trade came to a screeching halt. Also, tech-ish companies still smarting from not having laid off more workers sooner after Y2K started massive layoffs.

This was the worst economic time since the Great Depression.

tomorrow: Y2K, the other market pothole