discounting and the stock market cycle

stock market influences


To a substantial degree, stock prices are driven by the earnings performance of the companies whose securities are publicly traded.  But profit levels and potential profit gains aren’t the only factor.  Stock prices are also influenced by investor perceptions of the risk of owning stocks, by alternating emotions of fear and greed, that is, that are best expressed quantitatively in the relationship between the interest yield on government bonds and the earnings yield (1/PE) on stocks.

discounting:  fear vs. greed

Stock prices typically anticipate or “discount” future earnings.  But how far investors are willing to look forward is also a business cycle function of the alternating emotions of fear and greed.

Putting this relationship in its simplest form:

–at market bottoms investors are typically unwilling to discount in current prices any future good news.  As confidence builds, investors are progressively willing to factor in more and more of the expected future.

–in what I would call a normal market, toward the middle of each calendar year investors begin to discount expectations for earnings in the following year.

–at speculative tops, investors are routinely driving stock prices higher by discounting earnings from two or three years hence.  This, even though there’s no evidence that even professional analysts have much of a clue about how earnings will play out that far in the future.

(extreme) examples

Look back to the dark days of 2008-09.  During the financial crisis, S&P 500 earnings fell by 28% from their 2007 level.  The S&P 500 index, however, plunged by a tiny bit less than 50% from its July 2007 high to its March 2009 low.

In 2013, on the other hand, we can see the reverse phenomenon.   S&P 500 earnings rose by 5% that year.  The index itself soared by 30%, however.  What happened?   Stock market investors–after a four-year (!!) period of extreme caution and an almost exclusive focus on bonds–began to factor the possibility of future earnings gains into stock prices once again.  This was, I think, the market finally returning to normal–something that begins to happens within twelve months of the bottom in a garden-variety recession.

Where are we now in the fear/greed cycle?

More tomorrow.

more trouble for active managers

When I started in the investment business in the late 1970s, fees of all types were, by today’s standards, almost incomprehensibly high.  Upfront sales charges for mutual funds, for example, were as high as 8.5% of the money placed in them.  And commissions paid even by institutional investors for trades could exceed 1% of the principal.

Competition from discount brokers like Fidelity offering no-load funds addressed the first issue.  The tripling of stocks in the 1980s fixed the second.  Managers reasoned that the brokers they were dealing with were neither providing better information nor handling trades with more finesse in 1989 than in 1980, yet the absolute amount of money paid to them for trading had tripled.  So buy-side institutions stopped paying a percentage and instead put caps on the absolute amount they would pay for a trade or for access to brokerage research.

All the while, however, management fees as a percentage of assets remained untouched.


That appears about to change, however.  The impetus comes from Europe, where fees are unusually high and where active management results have been, as I read them, unusually poor.

The argument is the same one active managers used in the 1980s in the US.  Stock markets have tripled from their 2009 lows and are up by 50% from their 2007 highs.  All this while investors have been getting the same weak relative performance, only now they’re paying 1.5x- 3x what they used to–simply because the markets have risen.

So let’s pay managers a fixed amount for the dubious services they provide rather than rewarding them for the fact that over time GDP has a tendency to rise, taking corporate profits–and thereby markets–with it.

The European proposal to decouple manager pay from asset size comes on the heels of one to force managers to make public the amount of customer money they use to purchase third-party research by allowing higher-than-normal trading commissions.  Most likely, customer outrage will put an end to this widespread practice.

Both changes will doubtless quickly migrate to the US, once they’re adopted elsewhere.




oil inventories: rising or falling?

The most commonly used industry statistics say “rising.”

However, an article in last Thursday’s Financial Times says the opposite.

The difference?

The FT’s assertion is that official statistics emphasize what’s happening in the US, because data there are plentiful.  And in the US, thanks to the resurgence of shale oil production, inventories are indeed rising.  On the other hand, the FT reports that it has data from a startup that tracks by satellite oil tanker movements around the world, which seem to demonstrate that the international flow of oil by tanker is down by at least 16% year on year during 1Q17.

Tankers move about 40% of the 90+million barrels of crude brought to the surface globally each day.  So the startup’s data implies that worldwide shipments are down by about 6 million daily barrels.  In other words, supply is now running about 4 million daily barrels below demand–but we can’t see that because the shortfall is mostly occurring in Asia, where publicly available data are poor.

If the startup information is correct, I see two investment implications (neither of which I’m ready to bet the farm on, though developments will be interesting to watch):

–the global crude oil supply/demand situation is slowly tightening, contrary to consensus beliefs, and

–in a world where few, if any, experienced oil industry securities analysts are working for brokers, and where instead algorithms parsing public data are becoming the norm, it may take a long time for the market to realize that tightening is going on.

It will be potentially important to monitor:  (1) whether what the FT is reporting proves to be correct; (2) if so, how long a lag there will be from FT publication last week to market awareness; and (3) whether the market reaction will be ho-hum or a powerful upward movement in oil stocks.  If this is indeed a non-consensus view, and I think it is< then the latter is more likely, I think, than the former.

This situation may shed some light not only on the oil market but also on how the discounting mechanism may be changing on Wall Street.




trading (iii): start with a paper portfolio

practice first

As I mentioned last week, your initial plan may be very simple, no more than “I intend to beat the S&P 500 index by selecting sectors with superior profit growth potential,” or “I intend to beat the S&P 500 by selecting individual stocks that are deeply undervalued as measured by the price/cash flow ratio.”

The next step is to create a paper portfolio to test out your ideas.

The paper portfolio is just what the name implies:  you create a portfolio on paper of the names you would want to buy (or sell, if that’s what you think you’ll be good at), watch what happens and keep score.

Based on the results, you refine your ideas.

using real money…

…in small amounts.  That’s the next step.

My experience is that if a paper portfolio is like going to the batting cages to practice your swing, using real money is like playing in a game with a live pitcher and fielders.  Your concentration is sharper, because the stakes are higher.  Sometimes, people who have no trouble performing with a paper portfolio encounter difficulties with a real-money portfolio.  That typically passes with time.

On the other hand, unless you’re convinced that you’re not taking your paper portfolio seriously enough, real-money trading won’t go well if your paper portfolio has consistently underperformed.

trading (ii)

have a game plan

In the beginning, when you’re feeling your way, a plan will likely be relatively simple.  Still, it should contain at least three elements:

–what you intend to do

–why wht you’re doing will enable you to make money, and

–how you are going to measure your performance.

the process

In all likelihood, a trading process will include a healthy dose of technical analysis, which in its saner elements is an effort to read the short-term emotional mood of the market.

Take the case of Tesla (TSLA), where investors seem to alternate between bouts of severe depression and wild enthusiasm.  The plan may consist simply of buying TSLA at, say, $200-, when spirits are flagging, and selling at $250+, when owners are dancing in the streets.

Or it could be that you’ve held Amazon (AMZN) for years.  You observe that the stock is travelling in an upward-sloping channel that’s now bounded on the low side at, say, $750 and on the high side at $850.  You might decide you can trade around a core position by selling some of what you own above $850 and buying below $750.

the source of profits

Ultimately you have to believe that something you do gives you an edge over the average investor. Maybe you are very familiar with the price action of a certain stock because you’ve owned it for a long time.  Maybe your work gives you insight into the publicly traded companies in a given industry or geographical area.  Maybe you think that rising trading volume always precedes rising/falling price and you use screens to identify stocks where this is happening.

measuring performance

There’s a very strong tendency among even professional investors to remember successes vividly but brush losses under the rug.  Because of this, it’s essential to measure how you’re doing, both in absolute terms and relative to the performance of a benchmark index on at least a monthly basis.

This is also the best way to identify your strengths and, more importantly, the mistakes you are prone to.  Everyone has something in this second category.  Simply no longer doing stuff that you always lose money on can give a big boost to performance.  I know this sounds silly, but I can’t think of a single professional I’ve known over the years who hasn’t had to deal with eliminating a chronic bad investment habit.

More on Monday.


so you want to be a day trader

why trading?

As human beings, we’re all very complex.  Sometimes(often, in my case) we do things for reasons we don’t clearly understand.  We can be influenced in ways we’re not fully conscious of by our families, our friends, our neighbors, our heritage   …as well as by daily bombardment by media of all types.

Sounds silly, but:

–Early in my career as an analyst, I remember calling the CFO of an oil and gas exploration firm to ask him, in polite terms, why anyone would buy the tax shelter programs he was selling through investment advisers, since my reading of the prospectuses seemed to show that virtually all the benefits went to the promoter.  His reply was that buyers were not particularly sophisticated financially.  They typically bought the programs as a way to signal to others that they were wealthy enough to have a “tax problem.”

–Some people are attracted to the riskiest stocks simply because they’re risky rather than because they might offer superior returns.  Buying them is in effect a substitute for going on a thrill ride at the amusement park.

In my experience, successful investors and successful traders have one thing in common.  They are clear about their purpose   …which is to make money.  They’re not working to feed their egos, make friends, or enhance their standing in the minds of others, although these positive things might be nice as side effects.  It’s all about making a return.

This is not to say one shouldn’t have scruples.  As an active manager, I avoided tobacco stocks, for example, because I believe this is a morally bankrupt business.

There’s also no way to know whether you can make money buy buying and selling financial instruments–whatever your holding period–unless you try.

Nevertheless, if you are going to be successful, the bottom line must be that you intend to make a profit.


More tomorrow.
























January and the Trump rally

The first couple of weeks in January are usually bad ones for stocks.  Taxable investors typically start their annual portfolio revamping by selling their losers near yearend but they tend to nurse their winners into the following tax year.  From the first trading day in January on, they aggressively prune or jettison profitable positions they no longer think will outperform.

As a result, stocks usually go down in early January.

(An aside:  December losers, especially small caps selling for below $5 a share, tend to bounce back sharply from late-year lows in January.  This is called the “January effect.”  I don’t think it will play an important role this year.)

Not so, so far in 2017.  Instead, the upward movement in the S&P 500 triggered by the surprise election of Donald Trump as president has continued.

Two key differences between today and the last two months of 2016:

–the US$ has, at least for the moment, stopped rising, and

–the market seems to be rotating away from putative Trump administration beneficiaries into left-behind sectors like IT and REITs.

What does this mean?

I think it says that the initial rally on the anticipation of possible pluses from an end to dysfunction in Washington–corporate tax reform, infrastructure spending, and a more normal monetary policy–is getting long in the tooth.  Yes, economic growth appears to be accelerating and consumer confidence is rising.  But potential winners from a Trump administration have advanced by, let’s say, 20% since the election, while more defensive issues have fallen.

Investors are shifting from being driven by concept to being motivated by valuation.  They think, correctly in my view, that the leaders are looking a bit pricey and laggards are looking like relative bargains.  So they’re moving from the first group to the second.

What happens next?

Absent new information, or new inflows of money to equity managers, the market is likely to stall and then sag a little.   The most important factor here is the consensus expectation that the S&P 500 is likely to rise by about 5% for the year as a whole–which would imply there’s severely limited upside, at least until we get further concrete information about the economy or about Congress.

My guess is that the next major move is up.  If so, it will be triggered either by surprisingly good economic data or by bold action to stimulate the economy from Congress.  We should be watching carefully for either.

In the meantime, we can deepen our analysis of Trump beneficiaries, especially, I think, in the Energy sector.  My sense is, day traders aside, there’s no reason to sell (of course, I’m bullish by disposition, so this is my default position).