feeling for a bottom

feeling for the bottom

panic in the air

During bad markets like the present, company fundamentals tend to go out the window as predictors of short-term stock market performance.  What takes their place is varying shades of fear and reading charts.

As for fear, I’ve found in watching my own usually-optimistic behavior, that no matter how far down the market has fallen it isn’t approaching a bottom until I start to get scared–that maybe my innate cheeriness has finally ruined my career and the family finances.  For what it’s worth, I started getting these (irrational) feelings for the first time on Wednesday.  It could be that my last-minute rush to get my thesis project finished and submitted to SVA contributed a feeling of panic.  If not, my Wednesday experience is good news.

charts

My version of William Pitt is to say that charts (not patriotism) are the last refuge of scoundrels.  Nevertheless, when rationality flies out the door, charts are what’s left.

In the US, despite the chatter of TV actors, the important index is not the Dow but the S&P 500.  The important things to look for, in my view, are past bottoms and places where the index has been flattish for an extended period of time.  That’s not a lot to go on but that’s most of what there is.

In this case, the relevant figures I see are 2400, which was the bottom for the mysterious market drop at the end of 2018 and 2100, where the S&P spent much of 2015-16.

Two idiosyncracies of the US market:

–the index often breaks below a big support level–scaring the wits out of traders who see themselves sliding into a yawning abyss, in my view–before reversing itself.  The break below signals the bottom

–almost always the index recovers for several weeks before returning to, and bouncing up from, the initial bottom.  This didn’t happen in 2018, though.

the economy

My guess is that the worst of the coronavirus will be behind the US by June.  If that’s correct, then at some time in May (?) the stock market will begin to discount better times.

The biggest economic negative has come from the White House, where the incompetence of Mr. Trump was on full display, raising echoes of the disaster he created in Puerto Rico earlier in his term.  Not far behind is the recent revelation that Republican senators dumped their stock portfolios after coronavirus briefings, while still toeing the party line that there was nothing to worry about.  (My view is that Trump has done an enormous amount of long-term economic damage to the US in his presidency so far–hurting most deeply those who have trusted and supported him–but that we have yet to see the negative consequences.)  Somehow, Washington appears to have started to function again, however.

On the other hand, state and local officials have negated some of Trump’s “hoax” campaign by acting quickly and decisively.

From a purely stock market view, it seems to me that investors have switched out of panic mode and are beginning to sift through the rubble to sort winners from losers.  If I’m correct, it’s important for us as investors to pay attention to what the market is saying now–and ask ourselves how well this matches with our sense of what is happening.

 

 

 

 

dealing with market volatility

Beginning rant:  finance academics equate volatility with risk.  This has some intuitive plausibility.  Volatility is also easy to measure and you don’t have to know much about actual financial markets.  Using volatility as the principal measure of risk leads to odd conclusions, however.

For example: Portfolio A is either +/- 1% each week but is up by 8% each year; Portfolio B almost never changes and is up by 3% every twelve months.

Portfolio A will double in nine years; Portfolio B takes 24 years to double–by which time Portfolio A will be almost 4x the value of B.

People untrained in academic finance would opt for A.  Academics argue (with straight faces) that the results of A should be discounted because that portfolio fluctuates in value so much more than B.  Some of them might say that A is worse than B because of greater volatility, even though that would be cold comfort to an investor aiming to send a child to college or to retire (the two principal reasons for long-term savings).

more interesting stuff

–on the most basic level, if I’m saving to buy a car this year or for a vacation, that money should be in a bank account or money market fund, not in the stock market.  Same thing with next year’s tuition money

–the stock market is the intersection of the objective financial characteristics of publicly-traded companies with the hopes and fears of investors.  Most often, prices change because of human emotion rather than altered profit prospects.   What’s happening in markets now is unusual in two ways:  an external event, COVID-19, is causing unexpected and hard-to-predict declines in profit prospects for many publicly-traded companies; and the bizarrely incompetent response of the administration to the public health threat–little action + suppression of information (btw, vintage Trump, as we witnessed in Atlantic City)–is raising deep fears about the guy driving the bus we’re all on

–most professionals I’ve known try to avoid trading during down markets, realizing that what’s emotionally satisfying today will likely appear to be incredibly stupid in a few months.  For almost everyone, sticking with the plan is the right thing to do

–personally, I’ve found down markets to be excellent times for upgrading a portfolio.  That’s because clunkers that have badly lagged during an up phase tend to outperform when the market’s going down–this is a variation on “you can’t fall off the floor.”  Strong previous performers, on the other hand, tend to do relatively poorly (see my next point).  So it makes sense to switch.  Note:  this is much harder to do in practice than it seems.

–when all else fails, i.e., after the market has been going down for a while, even professionals revert to the charts–something no one wants to admit to.  Two things I look for:

support and resistance:  meaning prices at which lots of people have previously bought and sold.  Disney (DIS), for example, went sideways for a number of years at around $110 before spiking on news of its new streaming service.  Arguably people who sold DIS over that time would be willing to buy it back at around that level.  Strong previous performers have farther to fall to reach these levels

selling climax:  meaning a point where investors succumb to fear and dump out stocks without regard to price just to stop losing money.  Sometimes the same kind of thing happens when speculators on margin are unable to meet margin calls and are sold out.  In either case, the sign is a sharp drop on high volume.  I see a little bit of that going on today

 

more on Monday

 

discounting and the stock market cycle

stock market influences

earnings

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.

Jim Paulsen: lower lows, but not by much

Jim Paulsen, equity strategist for Wells Capital Management, an arm of Wells Fargo, gave an interview on CNBC yesterday.  It’s well worth listening to.

His main points:

–the stock market decline we’ve seen since November is all about adjustment to lower future earnings growth prospects.  This is being caused by the resumption of “normal” growth as the bounceback from deep recession is completed.  Another aspect of the return to normal is the economic drag from gradual end to extraordinary monetary stimulus, at least in the US.

In Mr. Paulsen’s view, the S&P 500 can trade at 16x trailing earnings in this new environment, not the 19x it was at two months ago.

–we may have seen the lows for the year last Wednesday at midday (1812 on the S&P 500).  More likely, the market will revisit those lows in the near future.  It will break below 1800 on the S&P, creating a fear-filled selling climax.

–assuming, as he does, that the S&P will end the year flat, i.e. around the 2044 where it closed 2015, a buyer at yesterday’s close would have a 9% return (11% dividends) from holding the index by yearend.  A buyer at 1800 would have a compelling 14% (16%) return.  11% might be enough to attract buyers; 16% surely will be.

–2017 will be a stronger year for earnings growth than 2015, implying that the market will rise further as/when it begins to discount next year’s earnings growth.

–the current selloff will trigger a market leadership change.  The new stars will likely be industrials, small-caps and foreign stocks.

what comes after a double bottom?

A double bottom marks a significant reversal in market direction.   There are two possibilities:

–after a bear market, meaning a nine-month to year+-long market decline caused by a recession.  (This is not the situation we’re in now.)  The market typically bottoms six months or so in advance of what government statistics will eventually say was the low point for the economy.  It does so partly on valuation, partly because the first anecdotal signs that the worst is over are beginning to be seen.

The market then begins its typical sawtooth pattern of upward movement, forming what technicians call a channel.  This is an upward sloping corridor whose ceiling is formed by progressive market highs and whose floor is similarly formed by progressive lows.  Initially, the slope can be quite steep.  Day to day, the market makes progress by bouncing along between floor and ceiling.

–after a correction, meaning a decline of, say, 5% to 10% in market value that occurs over several weeks and which, in effect, adjust market values back from stretched to the upside to levels where potential buyers see the potential for reasonable gains over a twelve month period.  (This is our current situation, in my view.)

Generally speaking, the same upward channel forms.  But the slope may be very shallow.  In fact, until new, positive, economic information emerges, there may not be much of a slope at all, so that stocks move more sideways than up.  Nevertheless, in the case that the channel is almost completely horizontal, periodic successful testing of the bottom established at the end of the correction reinforces the idea that downside risk is limited.

technical analysis: double bottom

Regular readers will know that I’m not a particular fan of technical analysis, at least as a primary tool in determining the investment attractiveness of the equity market or of individual stocks.  A hundred years ago–maybe even sixty years ago–it was the tool, because there was nothing else.  Before the SEC, company financials were a joke, and they weren’t easily available in a timely manner.  Watching the trading patterns of the “smart money” was arguably the best an average person could do.

Nowadays, the SEC’s Edgar site has all US-traded companies’ filings available for free the instant they’re made.  Most companies also have extensive libraries of their own available on their sites.  Firms now webcast their earnings conference calls for all to hear.  If you don’t feel like listening, transcripts are available for free soon afterward from Seeking Alpha.  

So it isn’t so much that technical analysis is bad per se.  It’s just that like the horse-drawn cart it’s been replaced by fundamental information that’s quantum leaps better.

support/resistance

Still, there are some aspects to technical analysis that I find useful.  One is support/resistance.  This is the idea that price levels where there has been significant past trading volume, preferably over an extended period, will act as floors to support stocks as they fall, as well as ceilings to impede their advance.  Both holding at and breaking through these levels are often significant events.  In particular…

double bottom

When the market has been declining for an extended period of time, or has dropped particularly sharply (the “magic” numbers technicians use are typically losses of 1/3, 1/2 or 2/3 of the prior advance), it often stabilizes for no apparent reason and begins a significant upward bounce (+10%?).

The fact that prices are now going up isn’t enough by itself to establish they have reached an important low.  In almost all cases (March 2009 was, on the surface at least, a significant exception–see below), stocks begin falling again within a few weeks and find themselves approaching the previous low.  If the market touches–or almost touches–the previous low but begins to rebound again (in the US, the market may briefly trade lower than the previous low–we’re daredevils, after all), this is often a strong sign that resistance is forming at the old low.  This revisiting of the low is the necessary second part of the double bottom.

There can be a triple bottom, too.  More often, in my experience, the market begins a new, upward pattern of higher highs and higher lows after the second bottom.

Fundamental conditions must also be in place for this bottoming to happen.  Stocks have to be cheap; investor pessimism must be high; the downtrend must be protracted enough for at least some investors to think that conditions won’t get worse.

In essence, what the double bottom tells us is that intense negative emotion that has been driving prices sharply (often irrationally) lower has begun to play itself out.

current examples

Double bottoms happen with individual stocks and stock groups, too.

Look at the Macau casinos traded in Hong Kong.  Some, like Galaxy Entertainment, have lost half their value over the past ten months.  But the group appears to have bottomed in late September-early October.   The stocks bounced off their lows, returned near them several weeks later and appear since then to have established a new upward pattern.

I haven’t looked carefully at energy stocks–but the oils are a group where I’d be looking for similar behavior.

the March 2009 case

The S&P 500 appeared to me to be bottoming in early 2009.  As is usual during recessions, government programs were being put in place to stop the economic bleeding.  Anticipating this, investors had pretty much stopped selling.  However, in late March investors were horrified to hear that Congress failed to pass the proposed bank bailout bill/  Some (Republican) Representatives were even saying they would prefer a rerun of the Great Depression to a bank bailout.  The S&P fell more than 7% on the news, but recovered all its losses when the bill was passed the following day.  If we erase those two trading days, early 2009 exhibits a “normal” bottoming process.

 

 

what if this is a bear market…and not just a wicked correction?

standard definitions

Commentators often use sound-bite definitions for economic and stock market phenomena.  For example,

–a recession is two successive quarters of year-on-year GDP decline.

–a correction is a short, counter-trend, fall in stocks of 5%-10%.

–a bear market is a fall in stock prices of 20% or more.

The virtues of these definitions are that they’re brief and unambiguous.  On the other side of the coin, brief and unambiguous doesn’t represent real life that well.

adding complexity, but also relevance

There’s a time aspect to corrections and bear markets.

A correction typically lasts a few weeks.  That’s because it’s normally a valuation issue–that “animal spirits” have pushed stock prices higher than near-term earnings can comfortably support.  Short-term traders sell, but intend to repurchase in short order, hopefully at somewhat lower prices.

Bear markets, on the other hand, come in two types.  Both anticipate–and ultimately reflect–widespread economic weakness that will last for a year or so.  The garden variety is a consequence of governments’ countercyclical fiscal and money actions when economies are about to overheat (too bad Mr. Greenspan forgot about this part of his job).

The really deep ones come from one-time shocks to the system.  In the past, these have been “external shocks,” like huge oil price rises.  The most recent is the self-inflicted wound of the financial meltdown.  As we experienced in 2007-2009, these ones are deeper and longer.

for the record…

…I don’t think we’re in a bear market–at least not in the world outside the EU (where stocks have already lost over a third of their value since May).

I think we’re in an unusual situation of correction in world markets, complicated by the EU situation.  In brief, the EU hoped to get away with not rebuilding its banks’ strength after the losses they took in the financial crisis, but hiding them instead.  They figured they could free-ride on the economic coattails of China and the US instead and use worldwide growth to mend.

Then the Greek crisis came.  And, instead of addressing the fact their gamble had failed, EU governments have spent the last year with their heads in the sand, letting the problem get worse.

why bring this up now?

EU stocks have lost over a third of their value since May.  US stocks are down by almost 20% (the “magic” bear market line).  Metals prices are crashing.  Stocks have been extremely volatile.

Monday morning I saw a lot of crazy stuff when I turned my computer Monday morning.

–European markets were down 5% intraday.

–Hong Kong-traded Ping An Insurance (I own it–ouch!) had lost another 8%+.  It was down by 25% in three days on rumors that HSBC was about to sell a portion of its holding (so what, I say).

–AAPL lost $10 in early trading in a rising US market on a report out of Taiwan that orders for iPad components from Hon Hai for the December quarter were lower than expected.  It turns out the orders, if they are indeed being lost at Hon Hai, are most likely going to a new iPad factory that’s opening in Brazil in December. It could equally be that AAPL is preparing for iPad3, which would be a bullish sign, I think.  But, noooo. Traders took the most bearish interpretation.

The world isn’t 5% better one week, 6% worse the next, and 7% better the week after that.  Economic processes don’t change that fast.  Human emotions do, however.  And the extremes of emotion we’re seeing now typically signal significant turning points in market behavior.  Hence the title of this post.

what to do

My best guess is that we continue to move sideways in markets ex the EU until European governments address their banking crisis.  They markets probably rally.  But that may not be for a while, so don’t bank on that.

I think the best strategy is to use days of crazy selling as a chance to buy stocks that are being irrationally sold down.  Be very picky, though.  Look for high quality names where you’re very confident about the fundamentals.  And don’t bet the farm on a single stock.

On September 6-9, for example, I bought INTC, because I saw it was trading at under $20 a share, or less than 9x earnings, and with a dividend yield of 4.3%.  As/when it reaches $24, I have to decide whether I keep it.

if it’s a bear market, then what?

Then markets are not turning up again until maybe next summer.  And, if past form holds true, we’ll see at least one more downdraft in stock prices–maybe another 10% from here, more in economically sensitive stocks and in emerging markets securities (even though the emerging economies themselves may be fine).  That will come as government statistics and company reports show economic activity dipping into negative territory.  Yes, world stock markets may have begun discounting this possibility.  But, ex the EU, they’re barely begun to, in my view.

As much as it cuts against the grain of my growth stock temperament, it seems to me it’s worthwhile thinking about asset allocation and how you’d act if a more ursine mood begins to make itself evident on Wall Street.  My portfolio is betting against this, but it never hurts to think about what happens if you’re wrong.