wheat vs. chaff (v)

There have been a number of brokerage strategy reports recently describing a typical business cycle-driven bear market. The first stocks to decline tend to be smaller companies, at high PE multiples (meaning the best earnings are in the future, not the present), and in cyclical industries. Selling gradually rotates into larger, more mature (therefore lower PE) companies and into what are normally regarded as defensive industries. The rotation is typically driven by two factors: relative valuation and the gradual realization that even defensive companies suffer as spending declines in an economic downturn.

The whole process takes something like a year to play out, both in the real world and in the financial markets. The stock market, though, tends to bottom several (six?) months ahead of the economy. This is at least in part because government policy begins to shift away from its most restrictive stance.

This is a useful framework, which I think will continue to be a key part of AI-controlled trading strategies. So in a sense it’s a self-fulfilling prophesy. What I think is equally important, but overlooked in the cyclical bear scenario, are the implications of several external shocks. They are:

–the pandemic, predominantly now the negative effect on global supply chains, resulting in sometimes sharply rising prices for what goods are available

–the Russian invasion of Ukraine, which I see as triggering fundamental changes in the world market for oil and gas, as well as more temporary changes in agricultural commodity markets

–to a lesser extent (at present, anyway), the fundamental changes in the world semiconductor market being driven by the key importance of Arm Holdings and TSMC in their design and manufacture, and the precarious nature of the ownership of both firms

more tomorrow.

wheat vs. chaff (iv)

In constructing a portfolio, or evaluating one that’s already build, there’s a pretty straightforward checklist I use:

–are things going to be better in the US or outside? Right now, I think the answer is pretty clearly in the US. So we should prefer stocks whose earnings come from the domestic economy rather than abroad.

–are we in an up-trending market (meaning an expanding economy, stable or falling interest rates) or a down-trending one (decelerating economy, rising rates)? Right now, the US economy is in pretty good shape, but the Federal Reserve is raising rates to slow things down. This second is the dominant market factor, so the answer is down-trending, with the footnote that maybe we’re bouncing along the bottom.

–are there any secular themes–positive or negative–that we should take account of? …examples from the recent past might be: cloud computing, e-commerce, electric vehicles…

In the current market, I can think of several:

–the shift in consumer behavior as the pandemic comes under control and the stay-at-home economy wanes

–the retreat from the extremes of globalization, sparked by worries over access to advanced computer ships made in Taiwan and the effects of the invasion of Ukraine on commodities industries like oil and gas, mining and agriculture

–the changes that AI-driven trading have made in the short-term risk profile of the stock market. As I see it, when a company reports negative news, the bid side of the market for the stock evaporates. A stock that might have lost, say, 10% of its value on the news in prior times now falls by a third or even half before buyers emerge. The result is that the risk/reward balance for many growth-oriented stocks is considerably less favorable than it has been in the past.

more tomorrow

wheat vs. chaff (iii)

Stock prices move higher in bull markets for two reasons: company earnings are better than expected and the time horizon over which investors are willing to pay for future earnings gradually expands from a year or so to two or three.

Stock prices move lower in a bear market less because news developments are unexpectedly bad than because the market continues to discount and rediscount the same bad news over and over again. I have no idea why. Maybe it’s because the bad news only sinks in slowly. Maybe its because that’s all the news there is.

Both bull and bear markets both tend to end more on a judgment about stock prices that comes in advance of a change in the economic winds–that every bad (good) thing that can happen is already factored into today’s price, implying that the only sensible bet is that the next significant move is a reversal of the prevailing trend.

One strategy for coping with a bear market is to make your holdings look as much like the index as possible and wait for happier times. For investors like me, who have an up-market mentality, this is the first step to take. In my case, I never do enough, but some thing is better than nothing.

Every bear market has its own characteristics or themes, some of which will remain relevant as the market turns up. So for anyone willing to deal with the ugly reality of portfolio holdings generally going down, there are typically chances to reposition defensively in a way that also prepares for the next up market.

In the present case, the key general issues seem to me to be:

–the return of interest rates to normal as the pandemic recedes;

–the character of current inflation and the extent to which it will abate as the supply chain normalizes;

–winners/losers as the world shifts from stay-at-home to back-to-work; and

–the effect of Russia’s invasion of Ukraine on world commodities markets.

more tomorrow

wheat vs. chaff (ii)

The global investment landscape is extraordinarily complex. There are stocks and bonds and commodities, and a whole array of derivative instruments based on them. There are tons of national markets, all with different notions of what kinds of companies are appropriate to be publicly listed and what is most important in valuing them (typically either growth potential or income generation).

It’s impossible for even an apex-of-the-pyramid professional to be an expert in all of these areas.

For you and me, I think this is the most important thing to realize. Its most crucial implication is that it’s much better to know a lot about a small number of things rather than skim the surface in many areas–and, in essence, become the dumb money everywhere.

–For individual companies whose stocks we hold, it’s key to know the nuts and bolts of how the firm works. For most major companies, there’s a wealth of information in their SEC filings. There will likely also be useful data in annual reports, although it’s important to realize that these are marketing documents, held to a lower standard of completeness and rigor in their disclosure than the 10-K. We’ll certainly see the good stuff in the annual, but not any potential warts.

–it’s also important, particularly for investors with shorter investment horizons, to have at least a basic economic “weather report.” That is to say, is the general economy expanding or contracting? are interest rates rising or falling? are either inflation or deflation a problem?

more on Monday

wheat vs. chaff

Let’s assume I’m correct that the bulk of the market downturn that began last November is behind us but that we’ll continue to be in a bear market, characterized mostly by an unusually high volatility, for several months. (We should all keep clearly in mind that this is an hypothesis and that the market generally acts in a way to make the greatest fools out of the largest number of people. So almost nothing is ever a “bet the farm” idea. But we have to start somewhere, and this is my best guess.)

One piece of evidence that we’re in this kind of market is the performance of stocks after reporting quarterly earnings. Companies that disappoint fall a lot, sometime losing a quarter or a third of their value, even though we can find ample evidence that this kind of earning outcome should have been anticipated. Companies with exceptionally strong results, on the other hand, are lucky to rise, say, 5%–and are as likely as not to give back a big chunk of that in the following few days.

My simple reading is that on bad news potential buyers disappear; on good news aggressive selling cuts short any gains.

What should we do while we wait for the market mood to shift?

My experience is that most people decide just not to look at their portfolios. I don’t regard this as the best course of action. But it takes a strong stomach to look at the damage that a long string of down days can do to holdings. And there’s a real danger of getting caught up in the highly emotionally-fueled collective panic selling that often marks the market bottom. So self-knowledge may tell you that, especially if your portfolio doesn’t deviate too much from the market, not getting caught up in the daily knife fight of bear market trading is the optimal strategy for you.

If you’re like me, and have substantially different holdings than the market, it’s important that you have a strategy that explains why you hold what you do and to monitor how and why the market is reacting to what you hold.

more tomorrow