I’ve just updated my Keeping Score page for February and year-to-date. What a strange time!
When I looked at my Fidelity account this morning I saw two odd things: a simplified interface, and a message sent to everyone with a margin account (my wife and my joint account with Fidelity is a margin account, although we don’t trade on margin). The message was essentially a warning to be on the alert for potential margin calls.
I’ve never seen this before. A caveat: until I retired at the end of 2006 all the family money was in the mutual funds I was managing, in whatever vehicle my employer required. Still, I didn’t see this in 2008-09.
–Fidelity is anticipating/seeing volume increases that are testing the limits of its software (probably mostly an issue of private-company-esque aversion to spending on software infrastructure)
–more interesting, aggregate equity in the accounts of its margin customers must be dangerously (for the customers) low. Margin-driven selloffs are typically ugly–and very often mark a market bottom. Here’s why:
In its simplest form, a market participant establishes a margin portfolio by investing some of his own money and borrowing the rest from his broker. He pays interest on the margin loan (Fidelity charges 5% – 9%+, depending on the amount) but all of the gains/losses from the stocks go to him. The client does relinquish some control over the account to the broker. In particular, the broker has the right to liquidate some/all of the portfolio, and use the proceeds to repay the loan, if the portfolio value minus the loan value falls below specified levels.
Before liquidating, the broker tells the client what is going to happen and gives him a short period of time to put enough new money (securities or cash) into the account to get the equity above the minimum amount. This is a margin call.
If the client doesn’t meet the call, the broker begins to sell. The broker has only one aim–not to get the best price for the client but to convert securities to cash as fast as possible. Of course, potential buyers quickly figure out what’s going on and withdraw their bids. Carnage ensues.
That’s what Fidelity was saying we’re on the cusp of this morning.
There are some very shrewd and successful margin traders. Around the world, though, retail margin traders are regarded as the ultimate dumb money. That’s why seeing forced selling from these portfolios is typically seen as a very positive sign for stocks.
When a country is having economic problems–slow growth, outdated industrial base, weak educational system, balance of payments issues–there are generally speaking two ways to fix things:
–internal adjustment, meaning fixing the domestic problems through domestic government and private sector action, and
–external adjustment, meaning depreciating the currency.
The first approach is the fundamentally correct way. But it requires skill and demands a shakeup of the status quo. So it’s politically difficult.
Depreciating the currency, on the other hand, is a quick-fix, sugar-high kind of thing, of basically trying to shift the problem onto a country’s trading partners. The most common result, however, is a temporary growth spurt, a big loss of national wealth, and resurfacing of the old, unresolved problems a few years down the road–often with a bout of unwanted inflation. The main “pluses” of depreciation are that it’s politically easy, requires little skill and most people won’t understand who’s at fault for the ultimate unhappy ending.
the Great Depression of the 1930s;
the huge depreciation of the yen under PM Abe, which has impoverished the average Japanese citizen, made Japan a big tourist destination (because it’s so cheap) and pumped a little life into the old zaibatsu industrial conglomerates.
It’s understandable that Donald Trump is a fan. It’s not clear he has even a passing acquaintance with economic theory or history. And in a very real sense depreciation would be a reprise of the disaster he created in Atlantic City, where he freed himself of personal liabilities and paid himself millions but the people who trusted and supported him lost their shirts.
Elizabeth Warren, on the other hand, is harder to fathom. She appears to be intelligent, thoughtful and a careful planner. It’s difficult to believe that she doesn’t know what she’s supporting.
In an earlier post, I outlined what I saw then as differences between SARS in 2002 and the new COVID-19 in 2019.
–it appears China has mishandled COVID-19 in the same way it bungled SARS, surpressing information about the disease, allowing it to become more widespread than I might have hoped. Not a plus, nor a good look for Xi.
–if press reports are correct, the administration in Washington is ignoring the advice of the Center for Disease Control and approaching COVID-19 in the same (hare-brained) way it is dealing with the economy–potentially making a bad situation worse
I think COVID-19 will be in the rear view mirror by July–as SARS was in 2003–but the road to get there will be bumpier than I would have guessed.
–the way the stock market has reacted to the new coronavirus gives some insight, I think, into the differences between how AI discounts news vs. when human analysts were in charge.
when humans ruled
Pre-AI, analysts like me would look to past examples of similar situations–in this case, SARS.
Immediate points of difference: COVID-19 is not a unique occurrence–it’s the latest coronavirus from China but not the first so the fact of a new coronavirus should not be as shocking as the first was. COVID-19 carriers are contagious before they exhibit symptoms, so quarantine is more difficult–i.e., transmission is harder to stop. On the other hand, the death rate appears to be significantly lower than from SARS.
Two other factors: the first half of 2003 was the time of greatest medical risk; generally speaking, the stock market back then rose during that period (because the world was just entering recovery from the popping of the stock market internet bubble in early 2000; given that we’re in year 11 of recovery from the financial crisis, gains shouldn’t be anywhere top of the list of possibilities).
Obvious investment areas to avoid would be operations physically located in China or with large sales to/in China; anything travel- or vacation-related, like airlines, hotels, cruise ships, amusement parks, tourist destinations.
It’s harder for me to think of areas that would prosper during a time like this, mostly because I’m not a big fan of healthcare stocks. Arguably anything operating totally outside China and not dependent on inputs from China; highly-automated capital-intensive operations rather than labor-intensive, Public utility-like stocks.
Portfolio reorientation–becoming defensive and raising cash–would have started in early February.
the AI world
What I find interesting is that the thought process/behavior I just described only started happening, as far as I can see, about a week ago. That’s when news headlines began to emphasize that COVID-19 was spreading to areas outside China. Put another way, the selloff came maybe three weeks later than it would were traditional investment professionals running the show. In the in-between time, speculative tech stocks shot up like rockets. The ensuing selloff has hit those high-fliers at least as badly as stocks that are directly affected.
–violent, December 2018-like selloff
–recent outperformers targeted, whether fundamentals affected or not.
what to do
Better said, what I’m doing.
The two questions about every market selloff are: how long and how far down. On the first front, it seems likely that COVID-19 will be a continuing topic of concern through the first half. The second is harder to gauge. There was a one-month selloff in December 2018 that came out of nowhere and pushed stocks down by about 10%. Today’s situation is probably worse, but that’s purely a guess.
I’ve found that even professional investors tend to not want to confront the ugliness of falling markets, and tend to do nothing. However, in a downdraft stocks that have been clunkers don’t go down as much as former outperformers. Nothing esoteric here. It’s simply because they haven’t gone up in the first place.
A market like the one we’re in now almost always gives us the chance to get rid of clunkers and reposition into long-term winners at a more favorable relative price than we could in an up market. My experience is that this is what we all should be doing now. As I wrote above, my hunch is that we don’t need to be in a big hurry, but there’s no reason (especially in a zero commission world) not to get started.
bull market = strong economy?
Does stock market strength always mean a booming economy?
The short answer is no.
Mexico in the 1980s
The best illustration I can think of is Mexico in the 1980s. That economy was a disaster, which played out first of all in the currency markets, where the peso lost 98% of its value vs. the US$ during that decade. Despite this, in US$ terms the Mexican stock market was hands down the best in the world over the period, far outpacing the S&P 500.
…a domestic form of capital flight is the short story.
An incompetent and corrupt government in Mexico was spending much more than it was taking in in taxes but was loathe to raise interest rates to defend the peso. Fearing currency depreciation triggered by excessive debt, citizens began transferring massive amounts of money abroad, converting their pesos mostly into US$ and either buying property or depositing in a bank. This added to downward pressure on the peso. In September 1982 the government instituted capital controls to stem the outflow–basically making it illegal for citizens to convert their pesos into other currencies (Texas, which had been a big beneficiary of the money flow into the US, will remember the negative effect stemming it had).
With that door closed, Mexican savers turned to the national stock market as a way to preserve their wealth. They avoided domestic-oriented companies that had revenues in pesos. They especially shunned any with costs in dollars. They focused instead on gold and silver mines or locally-listed industrial companies that had substantial earnings and assets outside Mexico. The ideal situation was a multinational firm with revenues in dollars and costs in pesos.
today in the US
To be clear, I don’t think we’re anything close to 1980s Mexico. But it trying to explain to myself what’s behind the huge divergence in performance between companies wedded to the US economy (bad) and multinational tech (good) I keep coming back to the Mexico experience. Why?
I don’t see the US economic situation as especially rosy. Evidently, the stock market doesn’t either. In tone, administration economic policy looks to me like a reprise of Donald Trump’s disastrous foray into Atlantic City gambling–where he made money personally but where the supporters who financed and trusted him lost their shirts.
What catches my eye:
–tariff and immigration actions are suppressing current growth and discouraging US and foreign firms from building new plant and equipment here
–strong support of fossil fuels plus the roadblocks the administration is trying to create against renewables will likely make domestic companies non-starters in a post-carbon world outside the US. Look at what similar “protection” did to Detroit’s business in the 1980s.
–threats to deny Chinese companies access to US financial markets and/or the US banking system are accelerating Beijing’s plans to create a digital renminbi alternative to the dollar
–the administration’s denial of access to US-made computer components by Chinese companies will spur creation of a competing business in China–the same way the tariff wars have already opened the door to Brazil in the soybean market, permanently damaging US farmers
–not a permanent issue but one that implies lack of planning: isn’t it weird to create large tax-cut stimulus but then until it wears off to launch a trade war that will cause contraction?
Then there are Trump’s intangibles–his white racism, his sadism, his constant 1984-ish prevarication, his disdain for honest civil servants, his orange face paint, the simulacrum he appears to inhabit much of the time, the influence of Vladimir Putin… None of these can be positives, either for stocks or for the country, even though it may not be clear how to quantify them. (A saving grace may be that the EU can’t seem to get its act together and both China and the UK appear to be governed by Trump clones.)
Two of them:
1.If you were thinking all this, how would you invest your money?
Unlike the case with 1980s Mexico, there’s no foreign stock market destination that’s clearly better. China through Hong Kong would be my first thought, except that Xi Jinping’s heavy-handed attempt to violate the 1984 handover treaty has deeply damaged the SAR. So we’re probably limited to US-traded equities.
What to buy?
–that are structural change beneficiaries
–whose main attraction is intellectual property, the rights to which are held outside the US,
–with minimum physical plant and equipment owned inside the US, and
–building new operating infrastructure outside the US, say, across the border in Canada.
As I see it, this is pretty much what’s going on.
2.What happens if Mr. Trump is not reelected?
A lot depends on who may take his place. But it could well mean that we return to a more “normal” economy, where the population increases, so too economic growth, corporate investment in the US resumes, domestic bricks-and-mortar firms do better–and some of the air comes out of the software companies’ stocks.
At first glance, the performance of the S&P 500 would seem to say yes–the S&P 500 is up by 47% since the first trading day of January 2017. That’s substantially better than Europe or Japan has done over the same time period. On the other hand, the US–which caused the global financial crisis–was first out of the blocks in repairing ailing banks.
Look a little closer, however, and the evidence from the S&P is not so clear. There are a number of factors involved:
–about half the earnings of the S&P come from outside the US
–major domestic industries like housing or autos have little representation in the S&P
–tech companies, which don’t employ a ton of people and many of which don’t need offices or showrooms, make up about a quarter of the index.
The Russell 2000, an index made up of mid-sized, mostly domestic firms, is–I think–a much better indicator of how things are going for the average American.
looking at US stocks
Russell 2000 = US-based, US-serving firms flat
S&P 500 = half US/half foreign earnings +3%
S&P 500 software = half US/half foreign earnings, no US plants needed +13%
Russell 2000 +8%
S&P 500 +22%
S&P 500 software +32%
Russell 2000 +23%
S&P 500 +47%
S&P 500 software +75%
What’s going on?
To state the obvious, investors are much more interested in betting on forces of structural change than on the administration’s efforts to pump life into traditional industries. It may also be that the market thinks, as I do, that the MAGA plan (if that’s the right word) will end up being a lot like Mr. Trump’s foray into Atlantic City gambling–where he profited personally but knew surprisingly little, with the result that the people who supported and trusted him lost almost everything.
What’s been running through my mind recently, though, is the resemblance between this US market and the Mexican bolsa in the 1980s.
SARS emerged in China in November 2002. Local authorities, later removed from office in disgrace, initially failed to sound an alarm about the new disease, apparently thinking reporting it would reflect badly on them and hoping it would just go away if ignored.
The world first became aware of SARS as a public health threat in February 2003. The disease was declared under control in July 2003. By that time there had been 8000+ reported cases and about 800 deaths. The overwhelming majority of the fatalities were in China. The elderly and the very young were the age groups hardest hit.
the new virus
As of yesterday, there had been 2700+ cases of the new coronavirus reported and 80+ deaths.
There are four differences I see between the SARS epidemic and this year’s outbreak:
–faster reporting and more aggressive quarantining today (the disease is passed through contact with an infected person’s bodily fluids. There’s no medicine that works against it, so isolating victims is the only “cure”)
–symptoms emerge on average about ten days after infection, pretty much the same as with SARS. But unlike the case with SARS, where carriers only became infectious after they showed symptoms, carriers of the new virus appear to be infectious from day one, long before they become visibly ill
–China is a much larger part of the world economy today than it was back then. While the US has grown by 80% (using conventional GDP) since 2003, China is 12x the size it was then. So the slowdown in global economic activity that will result from quarantine measures in China today will be greater than it was for SARS. If SARS is a good indicator–and it’s the only one we have, so it is in a sense our best guide–the current outbreak will be well past the worst by mid-year
–SARS happened just as the world was beginning to recover from the recession caused by the internet bubble collapse of early 2000. The new virus comes during year 11 of recovery from the downturn caused by the near-collapse of the US banking system from losses that piled up during years of wildly speculative lending and securities trading. In other words, SARS happened when profits were beginning to boom and stocks really wanted to go up; in contrast, this virus is happening when profits are plateauing and stocks want to go sideways mostly because interest rates are crazy low.
During the SARS outbreak business travel came to a screeching halt because people feared becoming sick/being quarantined in a foreign country. If it’s correct that the new virus can be passed on even before the carrier shows symptoms, the risk in using public transport is substantially greater. So too the possibility that one’s home country will temporarily bar returnees from virus-infected areas.
Securities markets in China are currently closed for the New Year holiday. It isn’t clear that they will reopen on schedule. In the meantime, China-related selling pressure will likely be redirected to markets like New York. Alibaba (BABA) shares (which I hold), for example, are down about 6% in pre-market trading. At some point, assuming as I do that the SARS analogy will be a good indicator, there’ll be a buying opportunity. For me, it’s not today, although if I weren’t a BABA holder I’d probably buy a little.
It will be interesting to see how AI handles trading today.