December is an odd month for stocks

Mark Twain on December

Mark Twain wrote in Pudd’nhead Wilson, “October:  this is one of the peculiarly dangerous months to speculate in stocks in.  The others are July, January, September, April, November, May, March, June, December, August and February.”

He was certainly right about October, although this is due less to Twain’s analytic skills and more to the US government allowing mutual funds to shift the end of their tax years from December to October in the late Eighties.  He’s also correct that each month has its own oddities.  But I think he’s wrong to stick December so close to the bottom of his list.

Why he underrates this month

Why?  Three reasons:

1.  First of all, almost all other taxable investors, like banks and insurance companies, end their tax years in December.  Prior to the rise of mutual funds,  year-end tax selling by this group of institutions was the key market mover to watch.  This action usually begins in December.  The same general rules apply as to mutual funds.  A taxable investor wants to match gains and losses so that they offset one another.  In order to do that, he has to sell both securities.

2.  Portfolio manager performance is normally judged on a January-to-December basis.  The manager’s results versus his benchmark index, as well perhaps as those versus his peers, determine whether he receives a bonus–and, if so, how much.  In a good year, bonuses can be many times a manager’s base salary.  Often, this situation affects the manager’s behavior in December.

A competent portfolio manager typically uses December to reorganize his portfolio to take advantage of what he thinks will happen in the coming year.  In particular, if the manager has had a very good year (so his bonus is secure) or a very bad year (so there’s no hope for a bonus), he has every incentive to make changes in December, even if he does this a bit prematurely and loses a bit of relative performance.  He’ll be certain to enter the new year with a forward-looking portfolio, rather than one filled up with last year’s ideas.

Only when the manager is on the cusp of some important performance or financial objective does it make sense for him to stand pat in the hope of squeezing out the last few basis points from what is likely a portfolio with aging market relevance.

3.  Retail investors also do their tax planning in December, matching sales of winners and sales of losers.  Many times, this occurs in the small-cap arena.  This selling forms much of the basis for the “January effect,” the strong outperformance of small caps to open the year, which is often just the bounce back of the previous year’s losers in the tax-selling derby.

My expectations…

I had expected this month to be strong in the beginning, followed by a gradual fade to the holidays (the last two weeks of the year is the only time a portfolio manager really has time to rest).  This may still turn out to be the case, but if the first quarter of the month is any indication, the ride will be a bit bumpier than I thought.

…aren’t that important

Although the daily ups and downs of the markets may be mesmerizing, remember that they’re not the important thing.  Our key task for this months is to put the finishing touches on a strategy for 2010.  More on this topic in later posts.

Growth vs. Value: how is this bull market stacking up?

A typical bull market progression

The first half of a typical bull market belongs to value investors, the second half to their growth counterparts.  The general idea behind this is that the outperforming stocks at any moment are those that are showing the strongest earnings growth.

Value stocks tend to be more sensitive to the rhythms of the overall economy than growth stocks.  So value tends to outperform during the part of the economic cycle when pent-up demand from a just-ended recession starts kicking in and the economy is expanding at a rapid clip.  As the cycle ages and the economy settles down to a slower, but still healthy, expansion rate, growth stocks, with their strong, but less economically-sensitive results, come to the fore.  Growth continues to outperform from this point through the end of the subsequent economic slowdown.

At first, the 2009 bull market looks like this..

On the surface, the 2009 bull market in the US seems to be following the traditional pattern.  With the index (I’m using the Russell 1000 as the benchmark–it’s big cap, like the S&P 500, but has wider coverage) up 62.8% from March 9 through November 30, value stocks (Russell 1000 Value index) are up 66.8%, while growth stocks (Russell 1000 Growth index) have risen 59.4%.

…but it really isn’t

When we look a little deeper, though, the usual pattern breaks down.  Instead of outperforming for a year or more, value stocks lose their relative acceleration after only two months.  They move more or less in line with growth stocks for the subsequent four months, after which they begin to lag.  The numbers are as follows:


Russell Value                +40.0% +19.1%              -.03%

Russell Growth              +30.0%         +17.9%              +4.0%

What does this mean?

My interpretation

Of course, it’s always risky to draw conclusions from relatively limited amounts of data (on the other hand, this is what stock investors always do–when the total picture is in, the market has long since discounted it).  To me, though, the truncated period of outperformance of value stocks suggests that the market is much more aware than bears would give credit for that this is a very unusual and weak recovery.  Instead of the 5%-7% real economic growth that marks the early quarters of bounceback from a typical inventory cycle recession–and characterized by consumers and businesses rushing to satisfy pent-up demand, the early shunning of value suggests the market has much lower expectations.

It’s also interesting–maybe even correct–to note that about the time that companies were getting a firm sense of what the September quarter would look like, Wall Street started to rotate toward less economically sensitive growth issues.

The message I get from the numbers–one which applies only to the US and must be subject to constant potential revision–is that the market thinks that stocks in general will not go rushing higher from here for some time.  The sectoral rotation in search of laggards that seems to be starting in the market suggests the same thing.  The apparent focus on the stronger, faster-growing market components does too.

This would imply that, although the overall market may provide a stable base for investors to stand on (in other words, the bottom won’t drop out of the market), good individual stock selection will provide the key to investment success next year–or at least until the overall economy regains a lot more of its “normal” strength.

This is not bad news.  In fact, it would be pretty good, if true, considering the horrible beating the US economy has taken from the financial crisis.  The positive message would be that there’s a chance to make good money next year by being in the right stocks.

It’s where stocks are going that counts, not where they’ve been (l)

It’s not where they’ve been…

It’s easy for anyone, including professional investors, to become paralyzed into inaction by sharp recent price rises, either of the market as a whole or of individual stocks.  Every once in a while, at market tops (in other words, about once every four years), this is the correct stance.  Most of the time, though, it’s not.

Our current situation is a case in point.  The S&P 500 is up 60% from the lows in March.  It’s up 18%, year to date.  Economically sensitive stocks have doubled or tripled off the lows.  Highly financially leveraged firms that seemed on the brink of disaster last winter can be up 5x, or even 10x, from the absolute bottom.  But unless you can somehow go back in time and transact at those prices, the have limited relevance to our investment situation today.

You may regret not having bought, or be patting yourself on the back for having had the courage to act.   Neither emotional state of mind will necessarily help you in your role as an investor, which is to make money from this point on.

(I think it would be instructive, however, to go back and review what pundits were saying about the market at any time from April or May on.  I’m confident that at every point you would find commentators saying the market had gone “too far, too fast,” and was “due for a pullback.”  Their advice?  “Wait for a correction.”  This is what the consensus always says in the early stages of a bull market.  And it’s always wrong.  If you want more information on this topic, look at my posts from March and April.)

The only relevant investment question is “What comes next?”

…it’s where they’re going that counts.

The stock market is a futures market.  The most important questions are always:

what are future profits likely to be–either for the market as a whole, or for sectors or individual stocks you may be looking at?

how much of that is reflected in today’s stock price?

what doesn’t the consensus not yet understand, or what is it not yet looking at?

Where are we now?

I read a research report recently whose summary was, in effect, we’re six months from the bottom and two years from the top.  This conclusion is a variation on the typical four-year inventory/interest rate/election cycle that has been a rough and ready timing tool at least since the Second World War.  The idea is that the stock market goes up for 2 1/2 years, more or less, and then down for 1 1/2.

I don’t whether the precise timing will hold in this cycle, but I do think the spirit of the remark is correct.

We’re way past the panic of March, when investors were convinced (by stunning congressional ineptitude, in my opinion) that Washington lacked the skills to fix the financial crisis.  We now are beginning to get confirmation from other economic indicators of what stocks (a powerful leading indicator themselves) have been telling us for a while–that the recession has just about run its course and that corporate profits are about to rise substantially.

What we haven’t yet begun to do is to make meaningful estimates of what corporate profits are likely to be for 2010 and beyond.  In a way, I think investors as a whole are stuck in the error of looking backward rather than forward.  Perhaps taken aback by the magnitude of the stock market decline, the consensus seems to be unable to imagine the good things that can happen next year and the year after that.  Remember, the S&P would need to rise almost another 50% to reach the last high-water market of 2007.

Who knows whether we’ll reach the 2007 market highs in the US in the current cycle.  On the one hand, it’s hard to imagine the financial stocks, which were such a big part of the market then, playing the same role this time around.  In fact, the previous cycle leaders are most often non-factors for a long while from that point.  On the other, technological and communication innovation is blazing along at a torrid pace.  And, of course, the steep decline we’ve had in the dollar (more to come, I think) make the old highs a less daunting target in local currency terms.

In any event, the economic environment is likely to be supportive for stocks for the next two years or so. I can imagine two main scenarios.  You can probably imagine more (post them as comments, if you like).  Mine are:

1.  plain vanilla The overall market rises 10% per year in 2010 and 2011, which would have the S&P 500 a bit above 1300 by the end of the period.  Overweighting of economically sensitive sectors makes a few percentage points of outperformance possible.  Returns would be much better than those on bonds or cash.

2. late Seventies redux The overall market meanders in a trendless way, making little progress over the next two years.  This general result disguises powerful underlying sectoral movements, both positive and negative, that more or less cancel each other out in the market aggregate.  My guess would be that tech, materials, energy, entertainment all outperform substantially.  Staples utilities, financials are all left behind.  Eventually consumer discretionary joins the positive column.  The net result is that substantial outperformance is possible.  (The key statistic of the second half of the Seventies, in my opinion, is that the smallest 100 by market capitalization of the S&P 500 outperformed the index by at least 25 percentage points each year.)

The Next Economic Boom

The Magnus article

I’ve been a big fan of George Magnus, an economist who consults for UBS and contributes to the Financial Times, for a long time. He was one of the first to warn that the financial crisis we are now dealing with would be far worse than the consensus thinks.  Last Friday, in an article in the FT, he argues that “the current consensus about secular stagnation… (could:  read will)…be wrong again.”  He makes three main points:

1.  generally speaking, the main forces creating economic growth are:

–growing labor force

–lowering barriers to the movement of goods and capital

–the interplay of capital investment with technological change.

2.  Over the past thirty years or so, the drivers of economic expansion have been:

–increased female participation in the workforce, especially in the advanced economies of the West

–worldwide trend toward lower interest rates–causing, however, increasing financial leverage

–worldwide efforts to lower barriers to the movement of goods and capital

–technological change, including:  personal computers, enterprise networking hardware and software, and the internet.

Its conclusions Continue reading

Shaping a Portfolio–Highly Volatile Companies: Cyclicals, Leveraged, “Near-Death Experiences”

Cyclicality, Leverage, “Near Death”

The three kinds of companies have two things in common:  their earnings can swing wildly, and their stocks even more so.  They can be like playing with fire, so they’re not for everyone.  In fact, they’re not for most people, even though they usually lead the performance of a bull market in its first year or more.  So you might want to stop reading here.  Or you might keep on going just so you’ll know something more about how these stocks work, even if you won’t own them.

Cyclical companies are ones whose sales follow the business cycle up and down, like homebuilders, technology firms, metals miners or car companies.  Sometimes investors will try to distinguish firms that deal in pure commodities, like lumber or basic chemicals, from those with other sources of value-added by calling the former “deep” cyclicals.

There is also a kind of cyclicality within an industry.  Sometimes, the market leader has such a strong reputation for quality and service that the other market entrants end up being “overflow” producers–that is, they get orders only when the leader has run out of capacity and can’t supply new requests–despite having adequate quality and comparable prices.  Even though the industry as a whole may not be particularly cyclical, it can turns out to be a roller coaster ride for the second-tier firms.

“Leveraged” companies are ones who have structured themselves in a way that small changes in sales, positive or negative, create large changes in profits.  The leveraging comes in two forms, financial and operating.

Financial leverage means debt, either bank borrowings or bonds.

Operating leverage means high fixed costs (fixed costs are those that have to be paid, whether there’s any output or not; variable costs are those directly linked with the production of a specific item).

High fixed costs can result for a number or reasons:

1.  it’s the nature of the business, like a semiconductor factory,  a cement plant or a hotel;

2.  the company’s plant and equipment is no longer state of the art and costs more to run than newer assets;

3.  the plant and equipment isn’t configured in the best way.

Companies can mitigate the effect of leverage by entering into long-term arrangements, either formal contracts or informal agreements, that guarantee customers will always buy a certain portion of their output, though usually in return for a price concession.  Japanese blast furnace steel mills, for example, have traditionally done this with their automotive customers.  In most cases, I think, the industry leader does some form of this.

On the other hand, a company can choose to figuratively revel in its leverage and operate mostly/exclusively in the non-contract or “spot” market.  It argues that the higher prices in good times more than offset the lower prices in bad.  UMC, the Taiwanese semiconductor foundry, is a case in point.  Twenty years ago, most gold mining companies operated this way, as well, but they also made sure they had no debt.

I think of “near death” companies as ones that depend on the kindness of strangers, and which are destined to go into bankruptcy in a world ruled by justice rather than mercy (or, what amounts to the same thing, government support for “strategic” industries).  Computer memory chip makers would be a good example.  PALM (a family member owns shares), pre its rescue by Bono, might be another.  Too much leverage, management ineptitude, too much cyclicality are usually the causes of these companies’ problems.

When To Buy Them–and How Much

How much?  In large amounts, never, in my opinion (a value investor would probably be more enthusiastic, though).

For most people, never may still be the right answer.  For those with a relatively high risk tolerance, small amounts, among the top-tier companies, is probably best.

When to buy? These stocks are often the best performers during the first year or so of a new bull market.  Their performance is typically in inverse order to their riskiness/cyclicality. Why? As you will be able to see from any historical record, these stocks as a group are pummelled in a down market, with the most highly leveraged doing by far the worst.  The stocks are usually trading a steep discounts to asset value, with the second-tier companies at the lowest valuations.  As the cycle turns, however, these “worst” companies (more precisely, those who don’t go into bankruptcy first) get disproportionately large sales gains (the industry leader runs out of capacity, so buyers have to turn to the same #2 and #3 they shunned a few months before) and the threat of bankruptcy recedes.  So these stocks benefit not only from sharply increasing earnings, but also from a perceived decrease in risk.

Professionals typically buy the stocks of these volatile companies when they conclude that conditions can’t get any worse and sell them when they conclude that things can’t get any better.  In effect, this means they buy when there are no earnings and no backlog of new orders and sell when the company is raking money in and the future looks great.

To me, it looks like now is the time.

Where Would I Look?

First, let me say I’m only beginning to do the research anyone would need before actually buying one of these, but I think three areas (the “usual suspects,” for me) are potentially interesting:  hotels like HOT, MAR or IHG and casinos (I own WYNN already); semiconductor fountries, especially TSMC ; and industrial machinery companies like CAT or DE.

Usually I get worried about a stock symbol that spells a word–this isn’t a joke–because I think it shows top management is spending more time trying to be cute than running the business.  But CAT is the start of the company’s name, and the management that picked HOT isn’t there any more.  I do have unresolved/unresearched worries about both, though:  CAT’s financing operation and HOT’s timeshares.

If you’re sticking to a plan of index funds + sector funds + individual stocks, you may decide that the cyclical area is too much trouble to deal with directly and find a sector fund to get exposure here instead.

What the Risk-Averse–That’s Almost Everyone– Should Avoid

“Risk averse” doesn’t mean conservative.  It means expecting to be paid for taking risk and not embracing risk as an end in itself.  Anyway, even the deepest value investors I’ve known would say to avoid industries in secular decline.  That would certainly include airlines and newspapers.  I’m sure you can come up with more.

I was listening to CNBC the other day and heard a reporter say a certain group of equity-oriented hedge funds had lost money over the past six weeks or so because they were long (i.e., they owned) high-quality companies and were short (i.e. had borrowed and sold, effectively betting the stock would underperform) low-quality companies.  He didn’t know, but you should, if you’ve read this far, that the hedge funds in question were betting the market would continue to go down.  Why?  because low-quality, leveraged, cyclical companies outperform in the early stages of an up market.