where we are now…(iii)

“big picture” thoughts

cyclical ups and downs

If I’m not just projecting a US perspective on the rest of the world (because what I’m a out to describe is the way the US economy works), national governments in general have a goal of achieving maximum sustainable GDP growth. This may not be the highest level objective, but it’s among the top few.

The fiscal and monetary tools that governments have to achieve this are relatively blunt. And their effect comes with a lag, a bigger one for legislation than for changes in interest rates. (The conventional wisdom during my working career was that fiscal policy aimed at supporting growth comes into play so late that it causes more harm than good.) The result has been economies that don’t just keep on chugging along at a moderate pace, but instead expand to the point of overheating and then contract for a short while before starting to expand again.

Stock markets, in the pre-AI trading era anyway, have tended to follow a cycle of lengthy rise (2 1/2 years?), shorter contraction (1 – 1 1/2 years) and then a new expansion. For a long time in the US, this cycle was always about four years and was known as the election cycle, because incumbent presidents pressured the Federal Reserve into lower interest rates excessively so the economy would be booming on election day. The first year of a new term would likely be recessionary as the new administration cleaned up the economic mess the only had manufactured.

Since Paul Volcker, “yes” to the cycle, “no” to the four years (there have been longer up cycles) as the Federal Reserve became more independent. Trump, however, attempted to return to the bad old days, exerting enormous pressure on the Fed to lower rates in the runup to the 2020 election.

shocks to the system

These come in two forms:

external shocks, like changes in the oil price, or the pandemic, and

extraordinary popular delusions, like the Internet bubble of 1999, the 2006-07 housing bubble or the zero-interest-rate-driven stock market bubble during the pandemic.

All of these involve a period of extreme optimism, followed by one of extreme pessimism as the dream of unlimited riches comes to an end. The period of substantial overvaluation is followed by one of substantial undervaluation–and an eventual picking up the pieces either as the undervaluation becomes apparent or economic activity picks up again.

where we are now…(ii)

My first post in this series: interest rate movements will continue to have a major business-cycle-related influence on both stocks and bonds, but the gigantic tailwind for stocks created by the 40-year decline in rates from 20%+ to zero (and below that in the EU) is behind us.

using stock/index price charts

There’s a whole pseudo-science of chart reading, dealing with individual stocks as well as indices, in all the world stock markets I know of. The book everyone in the US or Europe ends up relying on is Technical Analysis of Stock Trends, by Edwards and Magee, published in (I think) the late 1930s. My skimming through the book at the other end of the link above suggests its the guts of the one I read in the late 1970s, but I can’t say what changes, if any, have been made to the original.

Why to investors use charts? Several reasons:

–in some markets, particularly in emerging economies, financial statements are either highly unreliable or non-existent. So charts are all the typical investor has

–charts can have value in describing the relative bullishness/bearishness of the market, especially around emotional extremes–at tops and bottoms

–in some cases, unusual trading activity can be evidence of either a corporate action (e.g., a developing takeover fight) or as-yet undisclosed problems in a company. So the trading is a signal to do some investigation

–in markets, again mostly smaller ones, where syndicates of wealthy market players operate “pump and dump
schemes, unusual trading activity can indicate this as well

–technical analysis is faster/easier to learn than fundamental (economic + accounting) analysis and it uses weird, cool words to describe things

One further caution:

In the mid-1980s I was hired by a small mutual fund organization to fix its broken global fund. During my first week, I discovered–as had the brokers he routinely dealt with–my predecessor thought his main source of value-added was his ability to “read” price charts. His “strategy” seems to have been to find companies whose stock had recently dropped like a stone–i.e., had a decline that was so sharp and so deep that all possible bad news must already have been discounted in the price. So, he thought, he would buy and wait for good things to happen (since all the bad had already occurred).

As the first step in an overall analysis, seeking out extreme emotional reactions and possible bouncebacks isn’t a bad idea. It’s not for me. But it’s what deep value investors do.

In this case, however, the manager appeared to just buy ugly-looking charts.

Once the sell side understood what he did, brokers began to give him what he wanted. They expanded the Y axes of charts they sent him and contracted the X so that even a slow wasting away looked like a trainwreck. He never noticed, though.

where we are now, and, more or less, how we got here (i)

I got a lengthy email from a friend in the EU about a week ago with general questions about the stock market. I thought I’d answer some of them here.

The stock market (I mean any stock market, but I’m mostly thinking about the US) is the arena where the hopes and fears of investors interact with the objective characteristics of publicly listed companies to figure out what those companies are worth.

There’s really no “pure” demand for equities; there’s a demand on the part of investors for liquid securities–ones that can most times be bought and sold at a fair-ish price almost instantly.

There are three types of these liquid securities: cash, bonds and stocks. The price of each has an influence on the prices of the others, with the biggest determinant being the level of interest rates (currency relationships can count as well, with the value of the US dollar being the most important). The main standard for interest rates is the interest yield available on the 10-year Treasury note, which is 3.53% as of last Friday.

If we pretend that a stock is a funny kind of bond, with our portion of company earnings, or earnings yield (1/PE), as the equivalent of the interest yield on a government bond, then we have a rough and ready way of gauging what the general level of stock prices should be so that they’re reasonable substitutes for bonds. This rubric says that a 10-year note at 3.53% is the equivalent of a stock market PE of 28x earnings.

If we think the highest the yield we imagine the 10-year could reasonably get to is 5%, then the market PE should be something like 20x this year’s expected earnings.

There are obvious practical problems with this equivalence, over and above its having been invented by finance academics. There’s no government guarantee in the case of stocks, for example, that we’ll get our money back after 10 years. Nor is there a promise by company management to pay out any portion of earnings as quarterly/yearly dividend payments.

One key fact, though is that in late 1981, the yield on the 10-year approached 16%, with the Fed Funds rate breaking higher than 20% for a short period that year.

For the 40-some following years, fixed income has been in a relatively steady downtrend–putting wind into the sails of common stocks–until bottoming at effectively zero during the pandemic. In the EU, for what it’s worth, the bottom was below zero.

That gigantic tailwind is now in the rear view mirror. So, it seems to me, it’s very dangerous to extrapolate from that extremely long period of good news on the interest rate front to what now lies before us–in both stocks and bonds.

Intel (INTC) this morning

I woke up this morning to see a flood of news reports about across-the-board salary cuts for senior people at INTC (this is a stock I think I know something about but haven’t had a position in for years). I looked for a press release on the company website. Nothing. It looks like engineers groused to reporters, who then called INTC to verify before releasing their articles. My guess is that the company just didn’t want to address the issue during its earnings call on January 26th.

The stock is up slightly in a flattish market as I’m writing this, implying that this is either old news or Wall Street doesn’t think it’s important.

I went back to the earnings call transcript, whose jargon had caused me to quit halfway through, and read it to the end. Lots about expense control and the extra-large customer chip inventories that will take the first half to work through, nothing specific about salary cuts.

There was something that I’d missed that popped out to me the second time through, though. INTC has suddenly worked out that assets whose value it had been expensing in its financial reporting over a five-year useful life (i.e., 20% of the purchase price a year) actually should be depreciated over eight years (or 12.5% per year). This has nothing to do with the actual flows of cash in and out of the company or the tax it pays to the IRS. It’s all about optics in reports to shareholders.

In 2023, for example, INTC spends $25 billion on new capital assets. If all of that were subject to the old rubric, the company would have written off 20%, or $5 billion, as an expense on the income statement. Under the new company rules, INTC would expense $3.1 billion instead. Same IRS results, same cash in/out of the company, but pre-tax income would be almost $2 billion higher.

I have mixed feelings about this. In the before times, when I was learning the analyst trade, this would be a sure sign of management weakness. Given that trading bots may not read the fine print on accounting conventions and instead react to the eps figure without a thought to earnings quality, maybe this is a prudent protective measure. Could also be there’s some obscure financing covenant that requires a minimum level of eps.

One other thing: INTC says it aspires to cut another $7 billion out of operating expenses over the next year or so. Given that the company pays about $6 billion a year in dividends, that goal could be achieved almost immediately. The company has gone out of its way to say it will maintain a dividend, however. But the wording of this promise is, I think, carefully crafted. INTC isn’t saying it will maintain a dividend at the current level, as I read it–only that it will pay something.