Tag Archives: investment strategy

analyzing the past week in stocks

August 28, 2015 By in Current Market Thoughts, Recent Market Action, securities markets, stock market, Strategy Tags: , , , , , , , , Leave a comment

a roller coaster ride

The past five or six days of stock market trading around the globe have been very unusual, to put it mildly.  To recap quickly, the S&P 500 (which will be my main focus here) peaked on July 31st at a value of 2114.  On Thursday August 21st, the index closed at 2026.  Then…

—on Friday the 21st, the S&P fell by 3.2%

–on Monday the 24th, the S&P opened down 5.2%–with major stocks falling by as much as 20%.  The index rallied back to breakeven before fading late in the day to close down 4%.

–on Tuesday the 25th, the index opened up slightly, added 2.5% to the initial print and then turned around to close 1.5% lower.

–on Wednesday, the index gained 4%+.

–on Thursday the S&P opened up slightly, rose steadily to gain a total of 2.5%, reversed course to lose almost all of that  …before reversing course again to end the day at +2.4%.

All this occurred on 2x -3x normal volume each day.

To add to the fun, the computers at Bank of NY-Mellon, which prices a good number of ETFs, failed over last weekend and still aren’t functioning normally.  So for days, traders of ETFs lost the NAV anchor on which to base their actions.  This may be a reason for my impression that bid-asked spreads for ETFs were wider than normal earlier this week.

As I’m writing this early Friday afternoon, the S&P is flattish.  Volume is about half – two-thirds of what it was earlier in the week.

why?

If the question is why a sharp decline now rather than, say, two weeks ago, there’s never a good answer.

If the question is what forces caused the big fall–and equally sharp rebound–that’s almost as difficult.  We might view this week as the panic-filled culmination of an equity slide that began on the first trading day of August and which is based, I think, mostly on extended valuation.  The decline in the oil price below $40 a barrel can’t have helped sentiment.  Nor would spirits have been perked up by the weakness of Chinese stocks as speculative excess continues to be washed out of that market.

Of course, battling computer trading algorithms could have been the driving force.  That would at least explain how quickly everything moved.

For my money, though, a technical correction in a pricey market is a good enough story.

 

A more important question for us as investors is whether the selling, however motivated, is over.  The optimistic part of me (which is virtually my entire body) says that the rebound from the opening lows on Monday is an important positive psychological sign.  However, I think volumes have to return to normal, time has to pass, and the market has to begin to drift upward before I’ll be completely convinced.

Let’s say, just for the sake of argument, that this week has seen the establishment of an important resistance level for the S&P.  Remember, I’m not yet willing to bet that this is the case.  But if it is, three considerations are important:

–the market often rises for a while, but then returns to visit the prior low before bouncing up again off it.  This action forms the so-called “double bottom,”–which technicians take as a very bullish sign

–in a major reversal of direction, market leadership often changes, meaning some star groups become clunkers going forward and some clunkers regain the market limelight.  Although I’d scarcely call this past week a major event, we should still look carefully for hints of leadership change

–we’re fast approaching the yearend selling season for mutual funds (most mutual funds have a fiscal year that ends on Halloween), which typically extends from mid-September to mid-October.  The prospect of such selling could keep a lid on stocks over the next weeks, and would be the vehicle for retesting Monday’s lows.

what to do?

That’s my topic for Monday.

 

 

a strange story involving the business cycle and being wrong

August 14, 2015 By in confirmation bias, Constructing a Portfolio, fast death vs. slow death, Fixing mistakes, Portfolio management, securities markets, selling a stock, stock market, taking out a clean sheet of paper Tags: , , , , , Leave a comment

I once had a young colleague with lots of potential, whom I liked very much and who was an excellent securities analyst  …but who had only limited stock market success despite loads of potential.

Ass an apprentice portfolio manager, this person came to me with the idea of building a significant position in a company that made carpets.  The firm was well run, apparently had sustainable earnings growth momentum and was trading at a low price earnings multiple.   In this instance, I didn’t do my job as a supervisor well, more or less rubber-stamped the idea and okayed the purchase.

Soon after that (this was 1993), the Fed began to raise interest rates.  This is something I had been anticipating but–maybe because this wasn’t crucial to the structure of my own portfolio–was information I failed to bring to bear on the carpet company idea.  Higher interest rates slow down both residential and commercial construction, something which is bad for, among other things, sales of carpets.  Replacement demand slows down, too.

I went to my colleague, explained the situation–including the source of my mistake, and urged selling the stock.  We did, with a modest loss.  The issue ended up losing almost two-thirds of its value in subsequent months.

Now the weird part.

Eight years or so later, my colleague came into my office to rehash this trade–which I had long since forgotten.  The point was not to suggest that we buy the stock again–which would have been a fabulous idea, since business cycle conditions were finally very favorable.  Instead, it was to say that my colleague had in fact been 100% correct in recommending the stock all those years ago (apparently the stock has finally reached the point where its cumulative performance matched that of the S&P 500.

I didn’t know what to say.  This was somewhat akin to my aunt Agnes explaining that she was switching from natural gas to oil because the gas burner in the basement was really a malevolent space alien.

Why am I recalling this strange story–much less writing about it–now?

Two reasons:

–we’re coming very close to another period of Fed-induced interest rate hikes.  This is bad of early business cycle companies, including housing, commercial construction and related industries in the US, and

–it’s a life lesson about investing.  My former colleague had extreme difficulty in recognizing an analysis was wrong or that a stock, for whatever reason, wasn’t working.  But portfolio investors in the stock market are always acting on very imperfect information.  And economic conditions, both overall and in inter-firm competition, are changing all the time.  So having what one thinks is a better analysis than the other guy simply isn’t enough to ensure success.   Recognizing when things aren’t going well, stepping back to regroup and seeking out possible sources of mistakes are all crucial, too.  Denial may salve the ego, but it makes us poorer, not richer.

 

bracing for higher interest rates

August 5, 2015 By in bond market, Constructing a Portfolio, Current Market Thoughts, Portfolio management, securities markets, stock market, Strategy Tags: , , , , , , , Leave a comment

Long-time readers may remember that in an embarrassingly premature fashion, I began writing about the upward path away from non-crisis interest rates toward normal several years ago.  It looks like liftoff day has finally come, however.

The consensus expectation, informed by judicious leaks by the Fed, is now that the Fed Funds rate will rise by .25% next month, and by another .25% before yearend–meaning short rates will exit 2015 at .50%.  A highly stylized view of the Fed’s intentions is that it will continue to raise rates at the same 1/4% clip at every second Fed meeting next year–meaning another 1.0% increase during 2016.  The goal of rate normalization is an endpoint for Fed Funds of around 3% (but probably lower).

This is a potentially important change of direction for two reasons:  rates have been at emergency lows for an extraordinarily long time, and the thirty-five year war against inflation has been long since won.  The secular trend of ever lower nominal interest rates–for many financial market participants, the only trend they have ever seen in their working lives–is over.  Barring another world financial disaster, nominal rates may be higher in the future, but there’s no chance they’ll ever be lower.  So the thought habits of a lifetime are about to be shaken up.

What does this mean for stocks?

Past tightening cycles have been bad for bonds, but stocks have been flat to up.  The generally accepted explanation for the latter phenomenon is that the negative effect of higher rates is offset by robust profit growth.  Said another way, positive earnings surprises (more than) offset the negative effect of price earnings multiple contraction.

Personally, I think this explanation is the right one.

Critics of the applicability of the idea to the present situation point out that this time rates will be rising long after the business cycle has turned.  Therefore, they argue, the chances of a surprisingly large corporate profit surge are slim.  In consequence, the “normal” protection for stocks against Fed tightening is absent.

Four thoughts:

–the reason rates are still at 0% is that the “normal” cyclical profit surge hasn’t happened yet.  Maybe surge isn’t the right word for today’s situation, but world economies certainly aren’t firing on all cylinders yet.

–profit rises and Fed tightening aren’t independent events.  The Fed has made it clear that it intends to tighten only to the extent that economic strength allows.  The agency has often referred to the repeated disastrous mistakes Japan has made over the past quarter-century by tightening too soon.  If profit growth doesn’t permit, tightening will go more slowly than many expect.

–for the S&P 500, half the index’s profits come from abroad.  The EU (25% of profits) will likely be stronger next year than this; China may be, too.

–where else will money go?  Certainly not into bonds.  Cash is the only safe haven.  It’s possible there will be a large outflow of money from stocks into cash.  I don’t think so.  That’s partly (mostly?) because I like stocks.  More substantively, institutional investors may shade their portfolios a bit toward cash, but their large size means they can’t maneuver quickly, so the risk to them of betting against stocks in a major way and being wrong is enormous.  In addition, my sense is that a defining feature of the bull market that began in 2009 is the lack of retail participation.  If so, retail has already bet heavily–and incorrectly–against stocks.

A final point:

–yielding 0%, cash isn’t an attractive alternative to me at.  However, given that the period of zero interest rates is coming to an end, I’ve got to ask myself at what level would it be?

If we assume that inflation will be steady at 2%, I would find 3% cash and a 4%+ long bond very attractive.  That may be evidence that we’ll never get there.

Still, what I’m trying to get at is that there will come a point in the tightening cycle where even an equity fan like me will have to reallocate toward fixed income.  We’re nowhere near that now, in my opinion.  But I think this, not the start of tightening, will be the real showstopper for stocks.  This is not an idea to act on, but it is one I think we should keep in the back of our minds.

more on oil

August 4, 2015 By in emerging markets, Energy, Industry Analysis, shale oil Tags: , , , , , , , , 1 Comment

As I was thinking about this post, I knew that oil is a complicated subject and that there’s a risk of getting lost in the details.  So I decided to sketch out the structure of the post carefully on paper before I began to write.  Several pages of notes later, I abandoned the attempt, in favor of extreme simplicity (I hope).

oil

Like any other mineral commodity, oil is subject to boom and bust cycles.  We’re now in bust, meaning that supply is structurally higher than demand, exerting continuous downward pressure on prices.

As with any other commodity, prices will stay low until supply and demand come back into balance.  The slow way for this to happen is for demand, now at about 93 million barrels per day and growing at 1%+ per year, to expand.  The fast way is for prices to stay low enough, long enough for high-cost producers to go out of business.  As I see it, adjustment will primarily come the fast way.

Oil is peculiar, though, in two respects, both of which argue that prices will stay low for a considerable time:

–many major oil producing countries (e.g., the Middle East, Russia) have relatively simple economies that are radically dependent on exports of oil for government income.  Over the past year, OPEC oil output has actually risen by about 1.5 million barrels per day, despite the expanding glut.  This indicates that, unlike prior periods of oversupply, the group has no desire to try to moderate the downturn.

–the long-term geological damage to a big oilfield from turning the taps off and on can be great.  So producers are more hesitant than in other industries to do so.

the catalyst

Arguably, what has upset the pricing applecart is the unanticipated surge in oil production in the US, which was 5.6 million barrels per day this time in 2011 and is 9.5 million today.  Hydraulic fracturing is the reason for this.

where to from here?

US oil production is still averaging more than a million barrels per day higher than in 2014.  However, the steady month by month march upward of output figures may have been broken in May, when liftings were about 200,000 barrels a day less than in April.

My guess (and I’m doing little more than plucking numbers out of the air) is that at $50 a barrel or below, new fracking projects won’t get started. Under $40 a barrel, some wells may be shut in.  If a production falloff comes solely through the former mechanism, we’re probably a year away from a meaningful (translation:  more than a million barrels, but after that, who knows) decline in fracking output.

That would likely mean a higher oil price then than now, IF (…a big “if”) OPEC nations desperate for cash don’t up their production further.

what I’m doing

I have no desire to buy oil stocks today, because I think we’re not that far along in getting supply and demand back into balance.  In the early 1980s, for example, the entire process from top to bottom took about half a decade.  I’m also thinking that there might either be another sharp price decline, or simply a further sharp selloff in oil stocks before the current oversupply is over.  I’ve just started to think about what I might buy if either were to happen.  One thing is certain, though.  It won’t be the big oils, or tar sands, or LNG.

more than you ever wanted to know

When I started on Wall Street as an oil analyst, oil and natural gas sold for roughly the same price per unit of heating power.  Natural gas has been less than half the cost of oil on a heating equivalent basis for many years, however, because it isn’t in widespread use as a transportation fuel and because it takes a pipeline to deliver it to customers.  Natural gas is already being substituted for coal in power generation.  Will it ever have a dampening effect on the ability of the oil price to rise?

The Signal and the Noise

July 23, 2015 By in Academic Theories, Books, Getting financial advice, Portfolio management Tags: , , , , 1 Comment

I’ve been reading statistician Nate Silver’s 2012 book The Signal and the Noise.  He makes three points that I think are useful for us as investors:

1.  Some ostensible information sources aren’t really that.

TV and radio weathermen, for example, deliberately forecast more rainy days, and amp up the amount of rain that will fall, than they actually think will occur.  Why?  People apparently like to hear about bad weather.  Also, we only get mad if the weather is worse than predicted.  If it’s better ,we regard it as a pleasant surprise.  So there’s every reason for TV and radio to have a consistent “wet” bias–and they do.

Same thing for shows on politics.  Pundits on the McLaughlin Group, for example, have a startlingly bad record at making political predictions.  The show’s many fans don’t seem to care.  Broad, sweeping views, confidently and articulately presented, are all that matters.

It seems to me the same applies to TV financial shows.

 

2.  The group with the absolute worst forecasting record is professional economists.  In fact, predictions about the course of the overall national and world economies are not only highly inaccurate, they’ve gotten worse over time, not better.

In other words, don’t bet the farm on a macroeconomic forecast.

 

3.  Foxes are better thinkers than hedgehogs.

Silver separates forecasters into successful = foxes (he’s one), and really bad = hedgehogs.

The differences:

hedgehogs

highly specialized

“experts” on one or two narrow issues that define their careers; contemptuous of “generalists”

often in the academic world

all-encompassing theories

theory over facts

believe in a neat universe, defined by a few simple relationships

highly confident, meaning resistant to change

foxes

interdisciplinary

flexible

self-aware and self-critical

facts over theory

think the world is inherently messy

careful, probabilistic predictions.

In other words, be careful of highly confident people with overarching theories and elaborate forecasting systems.