looking at today’s market

In an ideal world, portfolio investing is all about comparing the returns available among the three liquid asset classes–stocks, bonds and cash–and choosing the mix that best suits one’s needs and risk preferences.

In the real world, the markets are sometimes gripped instead by almost overwhelming waves of greed or fear that blot out rational thought about potential future returns.  Once in a while, these strong emotions presage (where did that word come from?) a significant change in market direction.  Most often, however, they’re more like white noise.

In the white noise case, which I think this is an instance of, my experience is that people can sustain a feeling of utter panic for only a short time.  Three weeks?  …a month?  The best way I’ve found to gauge how far along we are in the process of exhausting this emotion is to look at charts (that is, sinking pretty low).  What I want to see is previous levels where previously selloffs have ended, where significant new buying has emerged.

I typically use the S&P 500.  Because this selloff has, to my mind, been mostly about the NASDAQ, I’ve looked at that, too.  Two observations:  as I’m writing this late Tuesday morning both indices are right at the level where selling stopped in June;  both are about 5% above the February lows.

My conclusion:  if this is a “normal” correction, it may have a little further to go, but it’s mostly over.  Personally, I own a lot of what has suffered the most damage, so I’m not doing anything.  Otherwise, I’d be selling stocks that have held up relatively well and buying interesting names that have been sold off a lot.

 

What’s the argument for this being a downturn of the second sort–a marker of a substantial change in market direction?  As far as the stock market goes, there are two, as I see it:

–Wall Street loves to see accelerating earnings.  A yearly pattern of +10%, +12%, +15% is better than +15%, +30%, +15%.  That’s despite the fact that the earnings level in the second case will be much higher in year three than in the first.

Why is this?  I really don’t know.  Maybe it’s that in the first case I can dream that future years will be even better.  In the second case, it looks like the stock in question has run into a brick wall that will stop/limit earnings advance.

What’s in question here is how Wall Street will react to the fact that 2018 earnings are receiving a large one-time boost from the reduction in the Federal corporate tax rate.  So next year almost every stock’s pattern in will look like case #2.

A human being will presumably look at pre-tax earnings to remove the one-time distortion.  But will an algorithm?

 

–Washington is going deeply into debt to reduce taxes for wealthy individuals and corporations, thereby revving the economy up.  It also sounds like it wants the Fed to maintain an emergency room-low level of interest rates, which will intensify the effect.  At the same time, it is acting to raise the price of petroleum and industrial metals, as well as everything imported from China–which will slow the economy down (at least for ordinary people).  It’s possible that Washington figures that the two impulses will cancel each other out.  On the other hand, it’s at least as likely, in my view, that both impulses create inflation fears that trigger a substantial decline in the dollar.  The resulting inflation could get 1970s-style ugly.

 

My sense is that the algorithm worry is too simple to be what’s behind the market decline, the economic worry too complicated.  If this is the seasonal selling I believe it to be, time is a factor as well as stock market levels.  To get the books to close in an orderly way, accountants would like portfolio managers not to trade next week.

Trump on trade

so far:

intellectual property…

One of Mr. Trump’s first actions as president was to withdraw the US from the Trans-Pacific Partnership, a consortium of world nations seeking, among other things, to halt Chinese theft of intellectual property.

…and metals

Trump has apparently since discovered that this is a serious issue but has decided that the US will go it alone in addressing it.  His approach of choice is to place tariffs on goods imported from China–steel and aluminum to start with–on the idea that the harm done to China by the tax will bring that country to the negotiating table.  In what seems to me to be his signature non-sequitur-ish move, Mr. Trump has also placed tariffs on imports of these metals from Canada and from the EU.

This action has prompted the imposition of retaliatory tariffs on imports from the US.

the effect of tariffs

–the industry being “protected’ by tariffs usually raises prices

–if it has inferior products, which is often the case, it also tends to slow its pace of innovation (think:  US pickup trucks, some of which still use engine technology from the 1940s)

–some producers will leave the market, meaning fewer choices for consumers;  certainly there will be fewer affordable choices

–overall economic growth slows.  The relatively small number of people in the protected industry benefit substantially, but the aggregate harm, spread out among the general population, outweighs this–usually by a lot

is there a plan?

If so, Mr. Trump has been unable/unwilling to explain it in a coherent way.  In a political sense, it seems to me that his focus is on rewarding participants in sunset industries who form the most solid part of his support–and gaining new potential voters through trade protection of new areas.

automobiles next?

Mr. Trump has proposed/threatened to place tariffs on automobile imports into the US.  This is a much bigger deal than what he has done to date.   How so?

–Yearly new car sales in the US exceed $500 billion in value, for one thing.  So tariffs that raise car prices stand to have important and widespread (negative) economic effects.

–For another, automobile manufacturing supply chains are complex:  many US-brand vehicles are substantially made outside the US; many foreign-brand vehicles are made mostly domestically.

–In addition, US car makers are all multi-nationals, so they face the risk that any politically-created gains domestically would be offset (or more than offset) by penalties in large growth markets like China.  Toyota has already announced that it is putting proposed expansion of its US production, intended for export to China, on hold.  It will send cars from Japan instead.  [Q: Who is the largest exporter of US-made cars to China?  A:  BMW  –illustrating the potential for unintended effects with automotive tariffs.]

 

More significant for the long term, the world is in a gradual transition toward electric vehicles.  They will likely prove to be especially important in China, the world’s largest car market, which has already prioritized electric vehicles as a way of dealing with its serious air pollution problem.

This is an area where the US is now a world leader.  Trade retaliation that would slow domestic development of electric vehicles, or which would prevent export of US-made electric cars to China, could be particularly damaging.

This has already happened once to the US auto industry during the heavily protected 1980s.  The enhanced profitability that quotas on imported vehicles created back then induced an atmosphere of complacency.  The relative market position of the Big Three deteriorated a lot.  During that decade alone, GM lost a quarter of its market share, mostly to foreign brands.  Just as bad, the Big Three continued to damage their own brand image by offering a parade of high-cost, low-reliability vehicles.  GM has been the poster child for this.  It controlled almost half the US car market in 1980; its current market share is about a third of that.

In sum, I think Mr. Trump is playing with fire with his tariff policy.  I’m not sure whether he understands just how much long-term damage he may inadvertently do.

stock market implications

One of the quirks of the US stock market is that autos and housing are key industries for the economy but neither has significant representation in the S&P 500–or any other general domestic index, for that matter.

Tariffs applied so far will have little direct negative impact on S&P 500 earnings, although eventually consumer spending will slow a bit.  So far, fears about the direction in which Mr. Trump may be taking the country–and the failure of Congress to act as a counterweight–have expressed themselves in two ways.  They are:

–currency weakness and

–an emphasis on IT sector in the S&P 500.  Within IT, the favorites have been those with the greatest international reach, and those that provide services rather than physical products.  My guess is that if auto tariffs are put in place, this trend will intensify.  Industrial stocks + specific areas of retaliation will, I think, join the areas to be avoided.

 

Of course, intended or not (I think “not”), this drag on growth would be coming after a supercharging of domestic growth through an unfunded tax cut.   This arguably means that the eventual train wreck being orchestrated by Mr. Trump will be too far down the line to be discounted in stock prices right away.

 

 

~$70 a barrel crude (ii)

Two factors are moving the Energy sector higher.  The obvious one is the higher oil price during a normally seasonally weak time.  In addition, though, the market is actively looking for alternatives to IT.  It isn’t that the bright long-term future for this sector has dimmed.  It’s that near-term valuations for IT have risen to the point that Wall Street wants to see more concrete evidence of high growth–in the form of superior future earnings reports–before it’s willing to bid the stocks significantly higher.  With IT shunted to the sidelines for now, the market is not being a picky as it might be otherwise about alternatives such as Energy and Consumer discretionary.

The fancy term for what’s going on now is “counter-trend rally.”  It can go on for months.

 

As to the oils,

–a higher crude oil price is clearly a positive for the exploration and proudction companies that produce the stuff.  In particular, all but the least adept shale oil drillers must now be making money.  This is where investment activity will be centered, I think.

 

–refiners and marketers, who have benefitted from lower costs are now facing higher prices.  So they’re net losers.  Long/short investors will be reversing their positions to now be short refiners and long e&p.

 

–the biggest multinational integrateds are a puzzle.  On the one hand, they traditionally make most of their money from finding and producing crude.  On the other, they’ve spent very heavily over the past decade on mega-projects that depend for their viability on $100+ oil.  This has been a horrible mistake.  Shale oil output will likely keep crude well short of $100 for a very long time.

Yes, the big multinationals have all taken significant writeoffs on these ill-starred projects.  But, in theory at least, writeoffs aren’t supposed to create future profits.  They can only eliminate capital costs that there’s no chance of recovering.  As these projects come online, they’ll likely produce strong positive cash flow (recovery of upfront costs already on the balance sheet) but little profit.

The question in my mind is how the market will value this cash flow.  As I see it–value investors might argue otherwise–most stock market participants buy earnings, not cash generation.  Small companies in this situation would likely be acquired by larger rivals.  But the firms I’m talking about–ExxonMobil, Shell, BP…–are probably too big for that.  Will they turn themselves into quasi-bonds by paying out most of this cash in dividends?  I have no idea.

Two thoughts:

—–why fool around with the multinationals when the shale oil companies are clear winners?

—–as/when the integrateds start to show relative strength, we have to begin to consider that the party may be over.  So watch them.

a rainy Friday in August in New York

August is the month when many senior portfolio managers are away from the office on vacation.  So big decisions on portfolio structure tend not to be made.

Friday is the day of the week when short-term traders’ thoughts turn to flattening their books so they won’t carry risk over the weekend.

It’s raining, which sparks thoughts in traders of sleeping in or leaving work early.

Add all that up, and the heavy betting should be that US stocks will likely move sideways in the morning and fade off toward the close.

That means this is a good day to stand on the sidelines and size up the tone of the market.

 

In pre-market trading, tech is up and bricks-and-mortar retailing (on the earnings miss by Foot Locker) is down.  …nothing new about this.  At some point there will doubtless be a fierce counter-trend rally.  But the negative earnings surprises are still provoking severe selloffs.  So I don’t think today is the day.

Pundits are speculating about the damaging effects on his political agenda of Mr. Trump’s apparent defense of neo-Nazis in Charlottesville.  …but the Trump trade has been MIA since January, with the US a laggard among world stock markets during Mr. Trump’s time in office so far.  Yes, there may be residual hope for corporate tax reform from the administration, which this latest demonstration of the president’s ineptness as a executive could arguably undermine.  My guess is, however, that he is already well understood.

Two questions for today:

–will the market perform more strongly than the season and the weather are suggesting? This would be evidence that there’s still an untapped reservoir of bullishness waiting for somewhat better prices to express itself.

–should we be buying in the afternoon if it’s weaker than I expect?  My answer is No.  I think there is a lot of untapped bullishness, but we’re in a slowly rising channel whose present ceiling is less than 2500 on the S&P 500.   That’s not enough upside for me.  I’m also content to wait for any incipient bearishness to play itself out further.

It will be interesting to see how today plays out.

 

last Friday’s US stock movement

Last Friday the S&P 500 opened at 2436, rose to 2446, fell to 2416 and rallied at the end of the day to close little changed at 2432.  Volume was maybe 10% higher than normal.  Sounds ho-hum.

Look at Financials, Energy or Technology and the story isn’t one of a sleepy summer-like Friday.  It’s violent sector rotation instead.

According to Google Finance, the Energy sector was up by +1.4% for the day and Financials by +0.8%.  Technology fell by -2.7%.

But that understates what happened beneath the calm surface.

Oil exploration and production stocks, which have been in free fall recently, rallied by 4% or more.  Large internet-related names fell by an equal amount.  Market darling Invidia (NVDA) rose by 4% in early Friday trading, then reversed course to fall by 15%, and rallied late in the day to close “only” down by 7%+.  That came on 5x recent daily volume.

What’s going on?

Well, to state the obvious, Friday’s stock market action in the US runs counter to recent trends.  To my mind, the aggressive buying and selling are both based on relative valuation rather than any sudden change in the fundamental prospects for any of the companies whose stocks are gyrating around.  It’s an assertion by the market that no matter how grim the outlook for oil, the stocks are too cheap–and no matter how rosy the future for tech, the stocks are too expensive.

This is part and parcel of equity investing.  There’s always someone, usually with a long investment horizon, who is willing to bet against the current trend, on grounds that current price movements are being driven by too much emotion and not enough by dollars and cents.

what’s unusual

What’s unusual about last Friday, to my mind, is how sharp the division between winning and losing sub-sectors has been and how aggressively stocks have been both sold and bought.

For what it’s worth, I also think it’s odd that this should happen on a Friday. Human buyers/sellers of this size tend, in my experience, to worry about whether they can execute their plans in one day, preferring not to let the competition mull the situation over on the weekend.  But that’s a minor point.  (One could equally argue that if the buyers/sells were looking for maximum surprise, Friday would be the ideal day to act.)

If this is indeed a counter-trend rally, meaning that after a period of valuation adjustment the prior trend will reassert itself (which is what I think), the most important investment question is how long–and how severe–the pro-energy, anti-tech rotation will be.

My experience is that it’s never just one day and that a counter-trend movement can run for a month.  On the other hand, this doesn’t look like the typical work of traditional human portfolio managers.  It looks to me more like trading done by computers.  If that’s correct, I’d imagine the buying/selling will cut deep and be over relatively quickly.  But that’s just a guess.  And I know my tendency in situations like this is to act too soon.

For myself, I’ve been thinking for some time that US oil exploration companies have been battered down too much.  As for tech, I still think it will be the most important sector for this year.  So I’m happy to use this weakness to rearrange my overall holdings, nibbling at the fallen tech names and offloading a couple of REITS I own that I think are fully valued.