I’ve just updated my Keeping Score page for September, 3Q17 and year-to-date. IT continues its remarkable run. Utilities et al continue to falter.
The Wall Street Journal has an interesting article today on the birth of the ETF–and the index fund, for that matter.
Two factors stand out to me as being missing from the account, however:
–when the S&P 500 peaked in August 1987, it was trading at 20x earnings. This compared very unfavorably with the then 10% yield on the long Treasury bond. A 10% Treasury yield would imply a PE multiple on the S&P of 10x–meaning either that bonds were dirt cheap or that the stock market was wildly overvalued vs. the bond market.
–a new product, called at the time portfolio insurance, a form of dynamic hedging, had very recently been created and sold to institutional investors by entrepreneurs steeped in academic efficient markets theory. Roughly speaking, the “insurance” consisted in the intention to stabilize equity portfolio values by overlaying a program of buying and selling futures against the physical stock. Buy futures as/if the market rises; sell futures as/if the market falls.
One of the key assumptions of the insurers was that willing/eager counterparties for their futures transactions could be found at all times and at theoretically predictable prices. On the Friday before Black Monday–itself a down day–the insurers’ model required them to sell a large number of futures contracts. Few buyers were available, though. Those who were willing to transact were bidding far below the theoretical contract value. Whoops.
On Monday morning, the insurers, who appear to have had negligible actual market experience, capitulated and began selling futures contracts at whatever price they could get. This put downward pressure both on futures and on the physical market. At the same time, pension funds, noting the large gap between the price of futures and the (much higher) price of the underlying stocks, began to buy futures. But to counterbalance the added risk to their portfolios, they sold correspondingly large amounts of stocks. A mess.
Arguably, we would shrug off at least part of this today as just being crazy hedge funds or algorithmic traders. Back in 1987, however, equity portfolio managers had never before seen derivatives exerting such a powerful influence on the physical market. It was VERY scary.
conclusions for today
Stocks and bonds are nowhere near as out of whack with one another as they were back in 1987. The nearest we have today to a comparable issue is what happens as worldwide excess liquidity is drained by central banks from money markets.
The trigger for the Black Monday collapse came from an area that was little understood, even by those involved in it–activity that had severe negative unexpected consequences. The investors who did the best after the crash, I think, were those who understood the most quickly what had happened.
Collateral damage: one of the most important results of Black Monday, I think, was the loss of confidence in traditional investment advisers working for the big brokerage houses that it created. This was, I think, partly because of individuals’ market losses, but partly, too, to the generally horrible executions received when they sold stocks in the aftermath. This was the start of a significant acceleration of the shift to discount brokers and to mutual fund products.
I’ve been reading a lot of commentary recently that maintains stocks are generally expensive. Sometimes the commentators even recommend selling, although in true Wall Street strategist style, they’re not very specific about how much to sell or how deep they think the downside risk is.
The standard argument is that if you compare the PE ratio of the S&P today with its past, the current number, just about 25x, is unusually high.
What I haven’t see anyone do, however, is consider the price of stocks against the price of alternative liquid investments–cash and bonds. That would tell you what to do with the money if you sell stocks. It would also tell you that bonds are much more expensive than stocks.
The yield on the 10-year Treasury is currently 2.23%. That’s the equivalent of a PE of about 44x. The return on cash is worse. Cash, however, protects principal from capital loss, except in the most dire circumstances–ones where you’re thinking you should have bought canned goods and a cabin in the woods..
In addition, I think the most likely course for interest rates in the US is for them to rise. When this has happened in the past, bond prices have fallen while stocks have gone basically sideways. There’s no guarantee this will happen with stocks again. But rising rates are always bad news for bonds.
What is surprising to me about current market movements is that stocks continue to be so strong during a time of typical seasonal weakness.
It has to do with taxes on mutual funds and ETFs, whose tax years normally end in October.
That wasn’t always true. Up until the late 1980s, the tax year for mutual funds typically ended on December 31st. That, however, gave the funds no time to close their books and send out the required taxable distributions (basically, all of the income plus realized gains) to shareholders before the end of the calendar year. Often, preliminary distributions were made in December and supplementary ones in January. This was expensive …and the late distributions meant that part of the money owed to the IRS was pushed into the next tax year.
So the rules were changed in the Eighties. Mutual funds were strongly encouraged to end their tax years in October, and virtually every existing fund made the change. New ones followed suit. That gave funds two months to get their accounts in order and send out distributions to shareholders before their customers’ tax year ends.
getting ready to distribute
How do funds–and now ETFs–prepare for yearend distributions?
Although it doesn’t make much economic sense, shareholders like to receive distributions. They appear to view them as like dividends on stocks, a sign of good management. They don’t, on the other hand, like distributions that are eitherminiscule or are larger than, say, 5% of the assets.
When September rolls around, management firms begin to look closely at the level of net gains/losses realized so far in the year (the best firms monitor this all the time). In my experience, the early September figure is rarely at the desired target of 3% or so. If the number is too high, funds will scour the portfolio to find stocks with losses to sell. If the number is too low, funds will look for stocks with large gains that can be realized.
In either case, this means selling.
Some years, the selling begins right after Labor Day. In others, it’s the middle of the month. The one constant, however, is that the selling dries up in mid-October. That’s because the funds’ accountants will ask that, if possible, managers not trade in the last week or so of the year. They point out that their job is simpler–and their fees smaller–if they do not have to carry unsettled trades into the new tax year. Although the manager’s job is to make money for clients, not make the accountants happy, my experience is that there’s at least some institutional pressure to abide by their wishes.
Most often, the September-October selling pressure sets the market up for a bounceback rally in November-December.
I was reading an article from Fortune magazine about the AMZN takeover of WFM. Although it echoed much of what the rest of the press is saying, I was struck by it–mostly because my expectations for Fortune are higher than for financial reporting in general.
Three ideas in the article stuck out in particular:
–that AMZN’s goal with WFM is to compete head-to-head in groceries with Wal-Mart (WMT)
—the implication that because the margins of grocery chains are low they have a poor business model
–that the price cuts made by AMZN on Monday are small, therefore they make no difference.
–ten campers, including yourself, are being chased by a bear. If the goal is purely personal survival, you don’t need to outrun the bear. You only need to outrun one of the other nine.
Put a different way, the goal of, say, Zara or Suit Supply is not to compete head-to-head on price with WMT. that would be suicide. Instead, those firms intend to provide differentiated clothing to a more focused audience. Yes, it’s still clothing, but it’s different clothing. Initially, at least, that’s AMZN’s goal with WFM. It wants to expand WFM’s appeal to a smaller, younger, more affluent audience, not steal traffic from WMT.
–the key to profitability in a distribution business is to turn inventory over rapidly, taking a small markup on each transaction. This is surprisingly badly understood by most professional investors, as well as virtually all the financial press–and by WFM, as well. This is one reason that as an investor I love distribution companies.
Low markups defend against competition and create customer loyalty; continual effort to keep the growth in inventory under the growth in sales creates positive operating leverage.
WFM appears to me to have chosen do pretty much the opposite–to take large markups on each transaction, a “strategy” that has stunted sales growth. Inventory turns are higher for WFM than for other grocers, although I suspect that this is a function of differences in product mix. In any event, something else (or, more likely, a bunch of other something elses) in WFM’s organizational structure is all messed up. The income statement shows that its very fat gross margins are frittered away almost completely by high overhead expenses.
If I were AMZN, I’d figure I’d attack what I think is the abundant low-hanging fruit in operating inefficiency and lower food selling prices as I made gains there
–it’s very easy to lower prices. It’s extremely hard to raise them again–a key reason that couponing is a favorite supermarket strategy. So it would be crazy for a merchant to lower prices across the board on day one. $.49 a pound bananas, displayed prominently by the store entrance, is aimed at setting customer expectations about pricing throughout the store. It’s a symbol, a promise …at this point, nothing more.
Every investment company has to make public filings with the SEC that disclose its quarter-end investment positions. Comparing the changes between filings allows anyone to see the investment moves of high-level professionals, even though this comes with a lag.
Recently, the press has picked up on the results of two investments made by Warren Buffett/BRK during the financial crisis. He provided finance to Bank of America (BAC) and to General Electric (GE), two companies whose operations were under great stress because of recession. As he has done in other instances, Buffett demanded, and received, a long-running option to convert what were essentially commercial loans into the companies’ common stock at 2008 prices, in the case of GE, and 2011 prices, in the case of BAC.
BRK and GE, BAC
BRK has recently cashed out of its position in GE completely and has converted the BAC preferred stock it bought into common. Back of the envelope, here’s how Mr. Buffett made out:
–BRK lent GE $3 billion and received a total of $4 billion back, including the sale of all the stock bought through warrant exercise; a gain of 33.3% over nine years, during which time the S&P 500 gained 250%+.
–BRK lent BAC $5 billion. It has received about $2 billion in dividend payments and has a gain of about $11 billion on the BAC stock it now owns. That’s a gain of 260% over six years, during which time the S&P 500 gained about 110%.
Together: BRK lost $6.5 billion by its investment in GE vs. holding an S&P 500 index fund; it has gained $8 billion vs the index so far on holding BAC.
A more interesting question: did BRK do well or badly?
On GE, the answer is clear. The investment did very poorly.
On BAC, the answer is also clear. The investment gave BRK more downside protection, and higher income, than the common during a time when BAC was in hot water. And it came just before BAC began its long run of outperformance against the S&P 500. So this was a home run.
Regular readers will know that my overall view on Mr. Buffett is that he persists in using a manual typewriter in a Word (or Google docs) world. You have to hand it to him on BAC. But GE’s salad days were long gone when he put BRK’s money into it.
Personally, I’m not a big Donald Trump fan.
In this post, however, I’m taking off my hat as a human being and putting on my hat as a portfolio manager to give my thoughts on how the Trump economic agenda may affect stocks over the coming months.
How I read events so far:
–the S&P 500 rose by 10% from the surprise Trump presidential victory through yearend. Leading sectors were Materials, Industrials and Energy. The three were all potential beneficiaries of the Trump platform–infrastructure spending, developing domestic energy sources and promoting domestic manufacturing
–the dollar rose by about 7% against the euro. This came from a combination of hope for accelerating economic growth, and belief that greater fiscal stimulus would allow the Fed to raise short-term interest rates at a faster-than-consensus pace
–promise to reform corporate taxes, to reduce the top tax rate from the present 35% to perhaps 20%, while eliminating loopholes. Why? The rate is unusually high in world terms and a key reason for US corporations shifting operations abroad. My back-of-the-envelope calculation is that tax reform could boost the profits of the S&P 500 by around 10%. I think it’s reasonable to assume that a large portion of this potential gain was being baked into stock prices prior to the inauguration
–stock gains, sector rotation. the S&P 500 has risen by a further 10% since January 1st. However, the 4Q16 leaders have ceased outperforming. The big winners have been IT, Healthcare and Consumer Discretionary–all beneficiaries of an expanding, but not red-hot economy, and the first two with substantial non-dollar exposure
–dollar weakness. the euro went basically sideways/slightly up from early January until April. Since then, the euro has reversed course, gaining 10% vs the US$. It’s now about 8% higher than it was the day before the election. The yen is a more complicated story, because Bank of Japan policy is to weaken the currency against trading partners’. The dollar has also strengthened against the yen during 4Q16 and has weakened since. The yen is now about 6% weaker against the dollar than it was in early November.
The poor performance of infrastructure spending beneficiaries since January suggests to me that there’s little expectation on Wall Street today that Mr. Trump will deliver on his promises in this area any time soon. So not a worry.
The weakness in the dollar has two aspects:
—–it acts as an economic and stock market stimulus. For a euro-oriented investor, for example, the S&P 500 has barely moved this year. In other words, to some degree this year’s stock market rise is being triggered by the currency decline
—–it’s also a function of lowered expectations for interest rate rises in the near future.
Both indicate, I think, a tempering of 4Q16 economic expectations for the US. The fact that the dollar has basically given up its post-election gains argues that this isn’t a worry either.
Substantial tax reform would likely mean a 10% boost to S&P 500 earnings–and therefore arguably a 10% rise in stock prices. A good chunk of this potential positive was factored into stock prices, I think, in late 2016 – early 2017. The worry that Mr. Trump will not deliver on taxes may have already put a ceiling on stocks around where they are now. If concrete evidence of Washington dysfunction around the tax topic emerges, that might easily clip 5% off the current S&P 500 level.