what about last Wednesday?

That’s the day the S&P 500 took a dramatic 2% plunge, with recent market leaders doing considerably worse than that, right after the index had reached a high of 2400.

Despite closing a hair’s breadth above the lows–normally a bad sign–the market reversed course on Thursday and has been steadily climbing since.  The prior leadership–globally-oriented secular growth areas like technology–has also reasserted itself.

My thoughts:

–generally speaking, the market is proceeding on a post-Trump rally/anti-Trump agenda course.  Emphasis is on companies with global reach rather than domestic focus, and secular change beneficiaries rather than winners from potential government action that have little other appeal

–while trying to figure out whether the market is expensive or cheap in absolute terms is extremely difficult–and acting on such thoughts is to be avoided whenever possible–the valuation of the S&P in general looks stretched to me.  Tech especially so.  This is especially true if corporate tax reform ends up being a non-starter.  My best guess is that the market flattens out rather than goes down.  But as I wrote a second or two ago absolute direction predictions are fraught with peril

–tech is up by 17.0% this year through last Friday, in a market that’s up 6.4%.  Over the past 12 months, tech is up by 35.2% vs. a gain of 16.8% for the S&P.  Rotation into second-line names appears to me to be under way, suggesting I’m not alone in my valuation concerns

–currency movements are important to note:  the € is up by about 10% this year against the $, other major currencies by about half that amount.  Why this is happening is less important, I think, than that it is–because it implies $-oriented investors will continue to favor global names

–the next move?  I think it will eventually be back into Trump-motivated issues.  For right now, though, it’s probably more important to identify and eliminate faltering tech names among our holdings (on the argument that if they can’t perform in the current environment, when will they?).  My biggest worry is that “eventually” may be a long time in coming.

 

 

investing in tech

A reader asked me to write about how I approach investing in tech stocks, an area I like and one which I think I’ve acquired some competence in over the years.

IT as a component of the S&P 500

Let’s start with the structure of the S&P 500, which, as of yesterday’s market close, looked like this:

Information Technology          22.5% of the index

Financials          14.1%

Healthcare          14.0%

Consumer discretionary          12.5%

Industrials          10.2%

Staples          9.3%

Energy          6.3%

Utilities          3.2%

Real estate          2.9%

Materials          2.9%

Telecom          2.3%.

Source:  Standard and Poors

Yes, the numbers add up to 100.2% but that’s just rounding and doesn’t affect analysis.

 

An obvious conclusion from this list is that when we buy an S&P index fund, almost a quarter of what we get is already tech.

A second observation is that 22.5% is a big number.  But if we look back to the end of 2009, when the current bull market was in its earliest stage, IT represented 19.8% of the index.  In other words, by far the largest determinant of IT sector performance in the bull market has been the upward movement of stocks in general.  (For what it’s worth, by far the largest losing sector has been Energy, which comprised 11.6% of the S&P 500 back then.)

Still, there have been spectacular winners, both individual stocks and subsectors, in IT.  So taking the time and effort to study IT stocks can pay big dividends.

placing IT in a business cycle context

Let’s group stocks by the sensitivity of their profits to the ups and downs of the business cycle, starting with the most aggressive (meaning most sensitive) and ending with the most defensive.  This is my list:

most aggressive

Materials

Energy

IT

Industrials  (this would be #3, except US industrials make mostly consumer            products)

less aggressive 

Consumer discretionary

Real Estate (this would be #4, except that a lot of the publicly traded vehicles are income-                            oriented REITs)

Financials

defensive

Healthcare

Staples

more defensive

Telecom

Utilities.

I’m sure that the lists others would come up with would rank the sectors differently.  Try it yourself and see.

What I make of my list is that IT will likely outperform anything lower on the list during an economic upturn and underperform during a downturn.

Two reasons:

–most consumer IT purchases, like a new smartphone or a new PC/tablet, are discretionary and can easily be postponed when times are tough, and

–for many modern corporations, capital spending means software.  And, in my experience, no matter how they say they maintain steady investment in their business, companies rarely outspend their cash flow.  When bad times lessen cash flow, companies–despite their promises–cut capex (i.e., software) spending.  Consumers, on the other hand, are much less draconian in their cutbacks, at least in the US.

 

Tomorrow, secular trends.

 

 

 

the stock market cycle–where are we now?

As I wrote yesterday, stock market price-earnings multiples tend to contract in bad times and expand during good.  This is not only due to well-understood macroeconomic causes–the effect of higher/lower interest rates and falling/rising corporate profits–but also from psychological/emotional motivations rooted in fear and greed.

(An aside:  Charles McKay’s Extraordinary Popular Delusions and the Madness of Crowds (1841) and Charles Kindleberger’s Manias, Panics and Crashes (1978) are only two of the many books chronicling the power of fear and greed in financial markets.  In fact, the efficient markets theory taught in business schools, which denies fear and greed have any effect on the price of financial instruments, was formulated while one of the bigger stock market bubbles in US history, the “Nifty Fifty” years, and a subsequent vicious crash in 1973-74, were taking place outside the ivory tower.)

Where are we now?

My take:

2008-09  PEs contract severely and remain compressed until 2013

2013  PEs rebound, but only to remove this compression and restore a more typical relationship between the interest yield on bonds and the earnings yield (1/PE) on stocks.

today  The situation is a little more nuanced.  The bond/stock relationship in general remains much the way it has been for the past several years, with stocks looking, if anything, somewhat undervalued vs. bonds.  But it’s also now very clear that, unlike the situation since 2008, that interest rates are on an upward path, implying downward pressure on bond prices.

In past plain-vanilla situations like this, stocks have moved sideways while bonds declined, buoyed by an early business cycle surge in corporate profits.

Since last November’s presidential election, stocks have risen by 10%+.  This is unusual, in my view, because we’re not at the dawn of a new business cycle.  It comes from anticipation that the Trump administration will introduce profit-boosting fiscal stimulus and reforms.  The “Trump trade” has disappeared since the inauguration, however.  Our new chief executive has displayed all the reality show craziness of The Apprentice, but little of the business acumen claimed for the character Mr. Trump portrayed in the show–and which he asserts he exhibited in in his long (although bankruptcy-ridden) career in the family real estate business.

Interestingly, the stock market hasn’t weakened so far in response to this development.  Instead, two things have happened.  Overall market PE multiples have expanded.  Interest has also shifted away from business cycle sensitive stocks toward secular growth stocks and early stage “concept” firms like Tesla, where PEs have expanded significantly.  TSLA is up by 76% since the election and 57% so far this year–despite the administration’s efforts to promote fossil fuels.  So greed still rules fear.  But animal spirits are no longer focused on beneficiaries of action from Washington.  They’re more amorphous–and speculative, as I see it.

Personally, I don’t think we’re at or near a speculative peak.  Of course, as a growth stock investor, and given my own temperament, I’m not going to be the first to know.  It does seem to me, however, that the sideways movement we’ve seen in the S&P since March tells us we are at limits of where the market can go without concrete economic positives, whether they be surprising strength from abroad or the hoped-for end to dysfunction in Washington.

 

yesterday’s S&P 500 stock price action

Yesterday may have marked an inflection point in the US stock market.  Today’s potential follow through, if it happens, will give us a better idea.

Domestically, Mr. Trump appears to be moving on from pressing his social program to tax reform–and, maybe, infrastructure spending, both of which are issues of potentially great positive economic significance.  At the same time, results of the first round of the French presidential election (which pollsters got right, for once) seem to suggest the threat that France might leave the euro, thereby reducing the fabric of the EU to tatters, is diminishing.

yesterday’s S&P 500

How did Wall Street react to this news?  The sector breakout of yesterday’s returns, according to Google Finance, are as follows:

Staples          +1.7%

Finance          +1.6%

Industrials          +1.4%

IT          +1.4%

Materials          +1.2%

Healthcare          +1.1%

S&P 500          +1.1%

Energy          +0.8%

Consumer discretionary          +0.7%

Utilities          +0.6%

Telecom          +0.3%.

winners

Staples led the pack, presumably because this sector has the greatest exposure to Europe–and a rising euro.  Financials advanced significantly also, on the idea that stronger economic growth will lead to rising interest rates, a situation that benefits banks.

Industrials and Materials perked up as well.  Again, these are sectors that benefit from accelerating economic growth.

losers

Energy marches to the beat of its own drummer. The rest are consistent with the story behind the winning sectors, either defensives or beneficiaries of moderate (that is, not rip-roaring) economic performance.

My guess is that this pattern may continue for a while yet.  Personally, I’m most comfortable participating through Financials and IT.

 

 

 

 

August-October in mutual fund/ETF-land

 August has traditionally been a slow month in financial markets, for two reasons:

–Europe, including European factories and stock markets, pretty much closes up for the month and everyone goes on vacation

–on this side of the Atlantic, high-level Wall Streeters head for the Hamptons, leaving behind cellphone numbers and assistants who have less authority to make independent decisions–and who certainly don’t execute changes in strategy.

Yes, in today’s world the EU is much less significant than it used to be and Industrials as a group are a mere shadow of their former selves.  But the vacation effect is still a powerful soporific.

 

In September, mutual fund/ETF minds turn toward the end of the fiscal year, which occurs on Halloween.

Mutual funds/ETFs are special-purpose corporations.  Their activities are restricted to investing; they’re required to distribute to shareholders as dividends each year virtually all of the profits they recognize.  (In return for these limitations, they’re exempt from corporate income tax on their gains.)

About thirty years ago, with government encouragement, the industry moved up the end of its fiscal year from December to October.  This gave funds two months post-yearend to put their books in order and get checks in the mail in December, so the IRS could collect income tax from holders on those distributions in the current year.

Because of this, fund/ETF preparation for the October 31st yearend typically begins in early or mid-September.  It invariably involves selling.

How so?

For reasons that completely escape me, mutual fund holders like to receive distributions. They regard it as a mark of success.  And they seem to like a payout of around 2% -3% of asset value.

For most of the year, the tax consequences of their decisions are not in the forefront of portfolio managers’ minds (strong industry belief is that taxes are tail that shouldn’t be allowed to wag the portfolio dog).  As a result, distribution levels most often require fine-tuning.  This means either selling to realize an additional gain, or selling to realize an additional loss.  Either way, it means selling.

At the same time, this occurs close enough to the end of the calendar year that PMs often use the opportunity to begin to make major portfolio revisions in anticipation of what they think will play out in the following calendar year.  This means more selling.

 

October often sees the beginning of a rally that lasts into December, as the fiscal yearend selling pressure abates.  Accountants play a role here, as well.  Every organization I’ve been in requests that PMs avoid trading, if possible, during the last two weeks of the fiscal year.  That’s to avoid the possibility that a trade has settlement problems and isn’t completed until the beginning of the following fiscal year.  PMs mostly play only lip service to requests like this, but it does ensure that purely tax-related selling is over by mid-month.

 

a(n important) footnote

Like any other corporation, if a mutual fund/ETF has net losses, it carries them forward for use in subsequent years.  Virtually every fund/ETF has been saddled for years with large tax loss carryforwards generated by large panic redemptions at the bottom of the market in 2008-09.  These had to be offset by realized gains before a distribution would be possible.

Last year was the first time that enough funds/ETFs had used up losses and were able to make distributions.  During the second half of last September, the S&P 500 fell by about 5%, before rallying from  early October through late November.