stock questions: #4

Q:  Am I (as a stock holder) supposed to be rooting for good economic news, or bad economic news?  It seems every time there is bad economic news stocks go down because everyone is worried about a recession.  But if there is good economic news, stocks often also go down as the market worries the Fed will have to keep jacking up interest rates to cool the economy and inflation.  Is there a goldilocks zone somewhere?

The short answer is that we should be rooting for good economic news. The deeper question is what’s good and what’s bad. It doesn’t help matters that the factors influencing the US economy at the moment are particularly complex.

The right way to start looking for answers, I think, is to understand what the economic aims of the country–and therefore of government economic policy–are in the US.

US economic goals, in theory anyway

The most important Federal economic goal is to achieve maximum sustainable GDP growth while keeping inflation under control. Early in my working career, “under control” was the dream of a steady 4% annual rise in prices. Most recently, the target has been set, by academic theory, at 2%. There’s serious discussion that the right number for today is 3%, the thought being that 2% is too close to zero and in particular that when the Fed has tried to boost inflation above (the too low) 1.8%-ish, where it had been for a half-decade or so, it wasn’t able to make prices budge. For what it’s worth, I’m in the 3% camp.

In advanced economies, inflation (i.e., steady, year-after-year increase in the price level) is ultimately wage inflation. The tool most often used to keep it in check is monetary policy.

(A long aside: This strategy is based on experience that shows Congress drags its feet so much that its help is often too late to do any good. You may remember that the Republican position during the 2008-09 financial crisis was that it would be better to have a repeat of the Great Depression (a decade of economic contraction, world GDP down by 15%, 20%+ unemployment in the US, widespread bankruptcies…) than bail out the banks for what seems to me to have been outright fraud in the home mortgage market. A gigantic fall in stock prices the following day changed their minds. Even so, the package that came out of Congress, while better than nothing, was maybe a third of what was needed to heal the domestic economy. Monetary policy and the passage of time did the heavy lifting, instead. No stomach in Washington for prosecution of the main offenders, either.)

The Fed raises rates to cool the economy down when it’s overheating (meaning growing fast enough to create inflation, and with no signs of slowing down) and lowers them to speed economic activity up when it stumbles. In my 40+ years of watching this process, the monetary authority always overshoots in both directions. It never intends to, but there are significant data lags in economic indicators and the Fed always wants to be sure.

where we are now

We’re in a post-pandemic, post-pandemic-denial, phase now where both the shockingly timely fiscal stimulus and the monetary stimulus from lowering interest rates to zero are being withdrawn. The fiscal stimulus is already in the rear view mirror; the “shock” of its absence, if that’s the right word, is being cushioned by the government payments in consumers’ hands but not yet spent.

The increase in interest rates back to “normal” is still under way. We can try to figure out what will happen from here in the way the Fed usually does–by looking at how much of the workforce is employed, what wage gains are and what the current level of interest rates is vs. our best guess at what a neutral rate is (neutral = not inflationary, but not causing the economy to slow). The last of these is arguably the most important.

the target rate

There’s no reason to buy a government bond if the interest rate doesn’t even cover the loss of purchasing power caused by inflation. Let’s say that investors expect inflation protection + a 1% real yield. Let’s also assume that supply chain disruptions are more or less straightened out by yearend (I’m not saying they will be, I’m saying suppose) and that commodities like oil and some semiconductors neither rise in price nor fall next year (I’m in the fall camp, but don’t want to bet the farm on this). If so, the 10-year Treasury note should be trading at a yield of: inflation + 1%. Let’s say: 2.5% – 3.0% + 1% = 3.5% – 4.0%.

The Fed has raised the Fed Funds rate from basically zero to 1.5 – 1.75%, moving the 10-year to 3.5% a few weeks ago. Another 0.75% hike appears to be on the cards for late this month.

If my back of the envelope calculation two paragraphs above is anywhere near to correct, we’re very close to where interest rates should be, at least for a plain vanilla economic cycle. It may be that the Fed will feel the need to cool the labor market down by raising rates a bit further. But my guess is that, if so, it will reverse course once it’s clear that the level of wage increases has stabilized.

Of course, this isn’t a plain-vanilla cycle. The pandemic, the war in Ukraine and the bizarre economic policies of the Trump administration all qualify in my mind as external shocks. More tomorrow.

stock questions: #3

 Q:  Is the stock market usually governed by the macro level economy, or the specific company?  I feel like if I look at my stock charts at a glance on any given day, they all pretty much go up and down at about the same proportion and around the same exact times, as the whole market moves up or down.  Today, Disney went up for a bit on news it’s Chinese Park would soon reopen, but then went down like everything else.  It seems like 90% of stock movement has been the macro conditions and maybe 10% information specific to any individual stock.  But wasn’t sure if that was normal, or just more due to all the recent instability and uncertainty.

One of my favorite analogies for portfolio management is that it’s like sailing a small boat across the Atlantic. If the weather is favorable, what counts is the sun deck, the food and how fast the boat can go. If a gigantic hurricane rolls in, however, none of the amenities matter that much. What really counts is being in a vessel that, however pedestrian, just won’t sink.

My weather report for today is that we’re past the worst, but are still in stormy seas.

We’re also in an unusually complex economic situation:

–we’re suffering from two big external stocks: the rise in the oil price stemming from the invasion of Ukraine, and the continuing supply chain issues stemming from the pandemic, and

–we’re in the process of withdrawing the extraordinary fiscal and monetary stimulus applied by the government to offset the negative effects of the pandemic. This itself has been complicated by two factors: Trump’s head-in-the-sand decision to pretend covid wasn’t happening and Biden’s fight-the-last-war decision to press for far more stimulus than economic experts recommended

–on a more longer-term conceptual level, the trend growth rate of GDP has been shrinking, due to a declining rate of workforce growth and lack of productivity gains.

The result of all this is that we have less clarity about the weather than usual.

What I think we can say:

–the stock market typically leads the economy by about six months, both on the way up and on the way down, which makes it historically the most accurate of leading economic indicators

–in a bull market, investors would already be starting to factor into today’s prices their expectations for earnings growth in 2023. I don’t see that happening.

–in a bear market, in contrast, investors continue to discount today’s news over and over again. That’s what you’re describing, and what I see, as well.

As to DIS, I don’t know the company well any more. It’s very difficult for any stock to move contrary to the current overall market mood. The specific issue I’d guess DIS has is to find a new source of growth to offset the continuing decline in ESPN. This itself isn’t new. The recent questioning of the prospects for Disney+ to be that new thing is.

four stock questions: #2

Q: Does a theme/sector ETF end up working against itself?  Like if you had SOXX (semiconductors) or JETS (airlines) would it be that some companies will emerge as the winners but it would be a net zero because you would also own the eventual losers?  or is it less of a zero sum game and more of a rising tide lifting all boats, where if demand for airline travel surges it could surge across the board and all companies could do well?

net zero?

Thinking over-simply, if despite cyclical ups and downs the trend is that the overall economy grows, and if the best and brightest (who will presumably grow the fastest) are the companies who list publicly, then we should have a trend of increasing earnings per share that drives the stock market higher over at least, say, a 5 -10 year period. Said a different way, although some businesses will fail, others will double or triple, or more, in size.

Imagine a 10-stock, equally-weighted sector portfolio. Let’s say eight of the stocks double in price over the decade, one triples and the tenth goes to zero. The overall portfolio is up by 20%, despite the zero. That’s because the loser can only be down by 100%, while the big winner is up by multiple times that. This is to say that under reasonable conditions the overall outcome will be better than zero.

In addition, sector indices don’t remain static. The index provider will most likely prune losers before they hit zero; the weighting of continuing winners (if any) will increase over time.

rising tide?

It is true that accelerating growth in a sector will help all the stocks in it. It’s not clear, though, that the best-run companies will be the best stock market performers. It’s at least equally likely that the sector road kill will be resuscitated and, although the lowest quality, will perform the best–because the change in expectations will be so dramatic.

the specific sector counts

Performance attribution analysis for my portfolios over my working career shows that about half my outperformance came from stock selection and half from sector selection. I mention this only to suggest that the sectors you choose to buy/avoid can make a big difference in your performance.

As an example of this, in the US market over the past ten years, sector performance has been as follows:

IT +17.0% per year on average

Healthcare +13.1%

Consumer discretionary +12.5%

S&P 500 +10.9%

Financials +10.4%

Industrials +9.0%

Staples +7.7%

Materials +7.4%

Utilities +6.2%

Real estate +5.5%

Communication services +4.4%

Energy +0.5%.

These are sectors, not industries, but I think the point is still valid–selecting the right area to be in is at least as important as intra-industry/sector price action.

four stock market questions: the first one

I got an email recently from a reader (and relative) that I thought I’d answer through posts. Here is the first one:

Q: Does an ETF have to go up or down in general proportion to the underlying stocks that make it up?  Like if ARKK was made up of just 10 stocks, and one day all 10 went down 5% each, would ARKK itself drop 5% in aggregate?  Or could people decide they liked ARKK as a long term investment and buy it and ARKK goes up 5% despite each and every stock that makes it up dropping 5% the same day?

A: An ETF is like a mutual fund in that both are special purpose corporations (details). One key difference is that mutual funds handle recordkeeping and sales/redemptions themselves and deduct prospectus-specified administrative charges from overall fund assets for doing so. Mutual funds sell/redeem once daily, after the US market close, and at net asset value. So the question of transactions away from NAV never comes up.

In contrast, brokers that an ETF designates as authorized agents keep the fund’s records of trades. They also make a market in the shares, buying and selling them during normal market hours, just like they do for individual stocks, and taking a bid-asked spread as compensation.

An aside: the major stock exchanges update prices of US-traded stocks every 15 seconds; brokers use these feeds to calculate the NAV of any ETF precisely (a practical impossibility for you and me). So we can’t know exactly how our buy/sell price differs from NAV at the time we transact. This is a big edge for the broker. But in a normal market, the broker markup will likely be less than 0.5% of NAV.

In the real world, brokerage house traders routinely keep open positions, both long and short, that they plan to close at a more profitable point later on. Let’s assume, though, that the trader’s goal is not to have any risk on his books and to close positions as fast as possible.

Let’s look at the case of common stock XYZ trading at $10 right now.

In the simplest case, one client wants to sell 100 shares of XYZ and at the same time a second customer wants to buy the same number. The trader simultaneously agrees to pay the seller $9.95/sh and charge the buyer $10.05/sh, and pocket the $.10/sh spread. The trade will settle in two days.

If the sells are 300 shares and the buys 100, the broker will execute the buy/sell of the first 100 shares in line and lower the price he is willing to pay for the rest to, say $9.80 or $9.75. This process both draws in new buyers and encourages price-sensitive sellers to withdraw their orders.

If, in contrast, the buys are 300 and the sells 100, the broker will act in analogous fashion by raising the price he is willing to pay for the rest.

In either case, the right-now hopes and fears of the market can move XYZ up and down, without apparent regard for any intrinsic value of the underlying company.

An ETF is different, however. The underlying assets are themselves publicly traded stocks, whose asset value the broker calculates every 15 seconds. Also, the agreement between ETF and authorized agent allows the agent to both exchange ETF share for the underlying assets and to exchange packages of the underlying assets for ETF shares.

So if the ETF begins to trade above NAV, the broker will sell the ETF short in the market, buy the underlying assets, convert them into new ETF shares and use them to close out the original short. If the ETF is trading below NAV, the broker buys the ETF, shorts the underlying stocks and converts the ETF into stocks to close the short.

In simpler terms, if the ETF is trading at $100 and NAV is $105, the broker buys the ETF (spending $100) while shorting the underlying stocks (taking in $105), and then exchanges the ETF share for the underlying stocks and closes the trade. This arbitrage is simple, can be done automatically, is virtually costless–and nets $5.

If the ETF is trading at $105 and the NAV is $100, the opposite happens. Short the ETF, buy the stocks, present them to the ETF for a new ETF share, close out the short. Net $5.

So, although in theory the situation you describe could happen–the ETF trading at a substantial premium to NAV–it’s highly unlikely, both because the ETF can create new shares to meet stepped-up demand and because the arbitrage opportunity, were a premium to develop, is so lucrative.

One possible exception: at the bottom of the market during the 2008–09 financial crisis, shares of ETFs containing only foreign stocks closed one day at discounts of as much as 12% to NAV. The main reason, I think, is that foreign markets weren’t open at that time of day for arbitrage to happen.