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 have no idea why the seasonal mutual fund-induced S&P 500 selloff hasn’t happened (so far, at least) this year. Could be this is just an instance of the adage that the market tends to make the greatest fools out of the largest number of people–namely, me. But even the best portfolio managers are wrong at least 40% of the time. Not a profession for people who desperately need to be right about everything.
By the way, another curiosity about the annual mutual fund dividend is that holders strongly desire to have a dividend, even though this means paying income tax on it–but almost no one actually receives the payout. Virtually everyone elects to have the dividend automatically reinvested in the fund. In my experience, only holders of 2% -3% of shares actually take the money. So there’s no need for the portfolio manager to raise cash.
This means the annual selloff is an occasion to do portfolio housecleaning plus optics for shareholders.
I heard an interesting radio interview of a prominent fixed income strategist the other day. He said that the reason gradual money tightening by the Fed in the US has made no impact on the bond market is that central bankers in the EU and Japan are still creating new money like there’s no tomorrow. That liquidity is offsetting what the US is doing so far to drain the punch bowl. By next spring, however, both the EU and Japan will be at least no longer manufacturing new liquidity and may be joining the US in tapering down the excess money stimulus. Once that’s occurring, we’ll see a bond bear market. At the very least, I think, that would put a cap on stock market gains. Until then, however…
September S&P 500 performance:
–I’ll post details for one month, the third quarter and year-to-date later in the week
–the biggest winners for September were: Energy +9.8%, Finance +5.1%, IT +4.5%. Losers: Staples -1.1%, Real Estate -1.9%, Utilities -3.0%. S&P 500 +1.9%.
ytd: IT +24.4%; S&P +12.5%; Energy -8.6%.
The general outline of the Trump administration’s proposed revision of the corporate and individual income tax systems was announced yesterday.
The possible elimination of the deductability from federally taxable income of individuals’ state and local tax payments could have profound–and not highly predictable–long-term economic effects. But from a right-now stock market point of view, I think the most important items are corporate:
–lowering the top tax bracket from 35% to 20% and
–decreasing the tax on repatriated foreign cash.
the tax rate
My appallingly simple back-of-the-envelope (but not necessarily incorrect) calculation says the first could boost the US profits of publicly listed companies by almost 25%. Figuring that domestic operations account for half of reported S&P 500 profits, that would mean an immediate contraction of the PE on S&P 500 earnings of 12% or so.
I think this has been baked in the stock market cake for a long time. If I’m correct, passage of this provision into law won’t make stock prices go up by much. Failure to do so will make them go down–maybe by a lot.
I wrote about this a while ago. I think the post is still relevant, so read it if you have time. The basic idea is that the government tried this about a decade ago. Although $300 billion or so was repatriated back then, there was no noticeable increase in overall domestic corporate investment. Companies used domestically available cash already earmarked for capex for other purposes and spent the repatriated dollars on capex instead.
This was, but shouldn’t have been, a shock to Washington. Really, …if you had a choice between building a plant in a country that took away $.10 in tax for every dollar in pre-tax profit you made vs. in a country that took $.35 away, which would you choose? (The listed company answer: the place where favorable tax treatment makes your return on investment 38% higher.) Privately held firms act differently, but that’s a whole other story.
The combination of repatriation + a lower corporate tax rate could have two positive economic and stock market effects. Companies should be much more willing to put this idle cash to work into domestic capital investment. There could also be a wave of merger and acquisition activity financed by this returning money.
I think we may be at a watershed moment in terms of the acceptability of the corporate behavior of tech/internet-related companies.
Up until now, it has been enough for investors that Silicon Valley produce increasing profits. Institutionalized poor behavior on the part of the firms’ managements–whether that be violation of some employees’ civil rights or less-than-ethical treatment of customers or shareholders–has made little difference to their stocks’ performance.
Uber is perhaps the poster child for this phenomenon, which has also been, aptly, I think, characterized as “fratboy” behavior. But now Uber appears to be losing its license to operate in London, which holds 5% of the worldwide active users of the taxi service, because of its not being a “fit and proper” operator.
The case of Facebook (FB) is just as interesting. Founder Mark Zuckerberg announced plans last year to give a large amount of his stock in FB to a charitable trust that he and his wife would run. In order to preserve his majority control of FB despite divesting a large chunk of his shares, he proposed that each A share, the ones with super voting power that insiders like him hold, be “split” into one A + two C shares, the ones with no voting rights. Zuckerberg could then give away the C shares, representing about 2/3 of his wealth, without any decrease in his 53% voting control of FB.
The board of FB appointed one of its members, Marc Andreessen, a developer of the Mosaic and Netscape browsers, to represent third-party shareholders in this matter–to ensure that this restructuring would be fair to them.
Institutional investors sued. During discovery, they found among other things, emails between Andreessen and Zuckerberg in which, far from defending third-party holders, Andreessen appears to be coaching Zuckerberg on how to present his proposal to the board in the most favorable light for him.
Today, FB announced it’s dropping the restructuring plan.
If I’m correct about a fundamental change in investor sentiment, what does this mean for us as investors?
At the very least, I think it means that the business-is-what-you-can-get-away-with attitude (borrowing from Andy Warhol) of many tech companies will be penalized with a discount valuation. It may also prevent some early stage firms from being able to list–preventing employees from cashing in on what they’ve built. On tech/internet’s notorious anti-woman bias, I’m not sure. After all, the investment business isn’t that far ahead of tech in eliminating this form of prejudice.
Toys R Us (TRU) is no longer a publicly traded company. After a very rocky period of being buffeted by Wal-Mart, Target, and with Amazon beginning to pile on, TRU was taken private in 2005.
Its fortunes haven’t improved while in private equity hands. In addition, as private equity projects usually do, TRU acquired a huge amount of debt, as well. In a situation like this, suppliers are typically very antsy about the possibility of a bankruptcy filing. That’s because trade creditors have little standing in bankruptcy court; they usually can’t get either their merchandise back or payment on any receivables due.
When a reent press report appeared that TRU was considering Chapter 11, suppliers apparently refused to send any more merchandise to TRU on credit, demanding payment in full upfront instead. The company didn’t have the cash available to pay for enough merchandise to fill its stores in advance of the all-important holiday season. So it filed for Chapter 11 bankruptcy.
None of this is particularly strange. Years ago, one of my interns did a study that showed that even in the early 1990s TRU was losing market share to WMT and TGT, and was making due mostly by taking share from mom and pop toy stores. Then the last mom and pops closed their doors and TRU’s real trouble began.
What dd surprise me was the report in today’s Financial Times that the company’s notes due in 2018 were trading at close to par a couple of weeks ago–vs. $.28 on the dollar now.
How could this be? Holders were apparently betting that TRU would limp through the holidays and then refinance its 2018 debt obligations–allowing these “investors” to collect a coupon and exit if they so chose.
The fact that professional investors would commit money to this threadbare investment thesis shows how desperate for yield they are in fixed income land at present. As/when rates begin to rise, things could easily get ugly, fast.
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.