the Dow Jones Industrial (DJI) average

Despite its media ubiquity and the fact it has survived all these years, the DJI is a weird index:

–it contains only 30 names out of the thousands of publicly traded companies

–although the index owners have tried to make it more relevant in recent years by adding Apple, Microsoft and Nike, it still by and large represents the big-cap names of America’s yesterday

–the weighting of a given name is a function of its per share stock price, not the size of the company.  As a result, Microsoft counts less than Visa, despite being 3x V’s size.  MSFT is about 1200% the size of IBM, but has only a third more weight (stock price of 150 vs 110).  While the ease of calculation this brings might have been important in the pre-computer age, it’s an anachronism now

–because of all this, using the DJI is a convenient signal to the listener that a speaker knows very little about stocks.  Odd that it should be used by media stock “experts”   …or maybe not.

 

Pre-APPL, MSFT, NKE, the DJI did have one important use.  When it started to outperform, that meant that a rally was near its end (and portfolio managers were buying the least interesting, but cheapest stocks) or that pms were seeking the safety of large, mature companies.  The additions above have lessened that appeal.

However, in the current climate, the DJI is an interesting collection of coronavirus losers.

Year-to-date, as of the close on Monday, the Dow was down by 35%, the S&P 500 by 30%, NASDAQ by 24%.  Since then, the DJI has been by far the best performer.  Interestingly, the Russell 2000, which measures mid-cap US, was down by 40% on Monday and has bounced by about 8% since, tying it with the NASDAQ for smallest bounce.

Two days isn’t much to go on, but one read is the market thinks the bailout will mostly benefit the large old-guard industrials.  A caveat:  the 57% rise in Boeing over the past two days accounts for two percentage points of the DJI rise.

 

 

 

selectively bearish vs. crazy

Today’s US stock market has, at least as I’m writing this at 11AM, a much different tone than yesterday’s.  Yes, it may be disappointing that there hasn’t been a bigger bounce so far back from yesterday’s mauling.  But at least there seems to me to be a lot more selectivity to what’s being bought and sold.  The losers appear to be companies directly affected by the consumer quarantine, the winners the least consumer-facing.

A second pattern continues, though, that trading is being driven, among the losers at least, by reaction to media headlines rather than investor forethought.

 

For me, one of the more puzzling aspects of the US market throughout my professional career has been the fact that virtually no institutional money managers ever beat their benchmark index.  If, ex broker fees and commissions, investing is a zero sum game, there must be winners (who don’t disclose their results) to offset the highly visible losers.  It could be that the fees and commissions are the reason, but the extent of the professional losses seems to me to be too high.  This leaves private individuals.

I mention this because the reports I’ve read indicate individuals are buying as institutions are forced to sell to meet investor withdrawals.

is America great again?

stocks and economic forecasting

Historically the stock market has been the most reliable of the leading indicators of future US economy performance, turning up and down roughly six months ahead of domestic economic data.

The three main factors I see in making this so are:

–stock buyers have traditionally tried to look forward to anticipate future earnings performance, while the bond market has been more focused on the here and now;

–as financial instruments, stocks are sensitive to changes in Fed policy aimed at either accelerating or reining in the economy

–until the financial crisis, legions of veteran securities analysts collected and processed economic information that began to be factored into stock prices long before the data became public knowledge.

It’s not clear to me that this continues to be true, given that veteran researchers have all but disappeared on Wall Street, and that the characteristics of their AI replacements aren’t well know.

With that caveat, now that I’m trapped in the house and am trying to avoid compiling a bibliography for my thesis paper, however, I’m finding time to fool around with numbers and to blog.

stocks under Trump

Since the 2016 election (the numbers since inauguration are lower), the NASDAQ index is up by about 40%.

The S&P 500 has gained 35%+.

The Russell 2000, which is much more representative of domestic US businesses, is down by about 10%.

As a citizen, I think that the Russell 2000 wants better schools, better infrastructure and retraining for workers displaced by technological shifts.  Stock prices seem to indicate not enough of that is happening.

 

 

2009 vs today

back then

As a result of what I can only describe as massive industry-wide bank fraud, the world woke up one day to realize that major American and European banks were, in effect, bankrupt.  They were stuffed to the gills with virtually worthless securities that the American financial firms had manufactured and sold among themselves and to the rest of the globe.

The really bad news came not exactly from that but from the essential role banks play in world commerce.  Buyers’ banks routinely issue letters of credit to sellers’ banks, guaranteeing prompt payment for stuff when it’s delivered–including a provision that the issuing bank will cover any amount the buyer is unable to pay.  What good does that do the seller, though, if one or both of the banks go belly up while goods are in transit?  So suppliers stopped shipping.

Large companies, armed with supply chain management systems flashing red signals about inventory buildup–and regretting they’d ignored these signs in 2000–determined not to make the same mistake again.  They shut operations down and laid off tons of workers.

The world economy came to a screeching halt.

Many of the I-say-fraudulent-but-no-bankers-went-to-jail securities were based on highly dubious home mortgage loans the issuing banks had made to collect up-front fees and immediately fobbed off to others (the ultimate “dumb money” was, as usual, EU banks).  Those mortgages promptly blew up when economies shifted into neutral, causing a deep housing/construction crisis.

All in all, this was the worst economic calamity since the Great Depression of the 1930s–worse than 1973-74, when the World Bank had to be called in to rescue the UK; worse than the oil shock of 1978; worse than 24% short-term interest rates of 1982; worse than the internet meltdown of 2000.

COVID-19

COVID-19 is certainly a less calamitous situation economically (meaning, writing as a PM, not as a human being) than any of those listed in the previous paragraph.   In many ways, it’s much more clear-cut, too.  But it has its own complications.

–compared with a cyclical business downturn, it’s probably harder to say how much stocks will fall due to COVID-19 but easier to figure how long a time, my guess: about six months, before economic activity will be on the upswing again

–many veteran equity portfolio managers and securities analysts (particularly on the sell side) have been fired over the past decade.  What we’re left with is bots trading on newsfeeds generated by: writers who have lost their industry sources and presenters on financial shows playing acting roles as financial professionals.  Because of this, other than when trading generated by company financial announcements, it looks to me like daily price moves are not as fact-informed as they used to be.  Resulting large moves and swift reversals driven by machines operating on faulty information make short-term trading more perilous (even) than in the past.  They also make it more difficult to “read” the traditional signs of a market bottom.

–the final complicating factor is the potentially dangerous head-in-the-sand approach of the executive branch to COVID-19.  It’s a scary vibe of incompetence.  Although I have no idea how to quantify this, it must be a factor in the intensity of the current selloff.

 

 

 

 

 

 

 

 

 

an ugly day: coronavirus + oil

oil

In normal times, the world produces about 100 million barrels of oil daily and consumes about the same amount.  Small changes in either supply or demand can cause huge changes in price.  That’s because demand–autos, jet fuel, heating oil…is relatively inflexible (if seasonal).  Supply is also inflexible, because a cartel of suppliers, led by Saudi Arabia has been able to control output levels.  Their goal:  highest price possible without encouraging substitution.

A problem has surfaced, however.  A mild winter + reduced demand from airlines have combined to cause a potential supply overhang.  Negotiations between Saudi Arabia and Russia about production cuts to offset this and keep prices high broke down.  Not only that, but the Saudis have apparently decided to punish Russia (and themselves) by starting to sell large amounts of oil at about $30 a barrel, or $10 a barrel below Friday’s price.

Implications:

–the consensus view is that Saudi Arabia, radically dependent on oil exports, needs a price of $80+ to balance its budget; Russia, smaller and economically much weaker, needs $40+.  So both are it trouble.  Riyadh’s calculation must be that Moscow will soon feel the pain more quickly and will agree to production cuts

–a $30 price has two bad consequences for oil production companies in the US and elsewhere.  The lower price reduces revenues and profits.  This is an acute problem for some US shale companies, which have borrowed heavily in the junk bond market.  In addition, a standard way of evaluating natural resource companies is to compare the stock price with the per share value of the reserves they hold.  The price fall not only reduces the value of those reserves but also shrinks the amount, since some oil that’s viable at $40 becomes economically unfeasible to drill for at $30.

–if oil companies make up 4% of the S&P 500 and we say that they have lost a third of their value over the weekend, then the S&P should open 1.2% lower because of that.  Add in banks that will be in trouble and maybe that figure drops to down 2%.  Conceptually offsetting that would be the benefit to oil consumers of lower prices.  But that’s a diffuse group that is typically overlooked in a market downdraft   …and in this case prime beneficiaries like transport companies are being hit by coronavirus fears.

–as I’m writing, the S&P 500 is trading down about 5% in the premarket.  So the other 3% must be due to other factors–presumably coronavirus fears.  Those, in turn, break out, I think, into two factors:  the virus itself and the efforts of the Trump administration to prevent disease preparedness, information exchange and treatment.  To my mind, the last is the scariest part.

–if we were to posit no AI involvement in the premarket decline, this would look to me like the start of an old-fashioned selling panic.  In an AI-driven world, however, it’s not clear that that the idea of a cathartic release of pent-up fear setting the emotional stage for the next upswing still holds water.

All in all, for almost everyone a day to turn off the screen and go out in the sunshine.

dealing with market volatility

Beginning rant:  finance academics equate volatility with risk.  This has some intuitive plausibility.  Volatility is also easy to measure and you don’t have to know much about actual financial markets.  Using volatility as the principal measure of risk leads to odd conclusions, however.

For example: Portfolio A is either +/- 1% each week but is up by 8% each year; Portfolio B almost never changes and is up by 3% every twelve months.

Portfolio A will double in nine years; Portfolio B takes 24 years to double–by which time Portfolio A will be almost 4x the value of B.

People untrained in academic finance would opt for A.  Academics argue (with straight faces) that the results of A should be discounted because that portfolio fluctuates in value so much more than B.  Some of them might say that A is worse than B because of greater volatility, even though that would be cold comfort to an investor aiming to send a child to college or to retire (the two principal reasons for long-term savings).

more interesting stuff

–on the most basic level, if I’m saving to buy a car this year or for a vacation, that money should be in a bank account or money market fund, not in the stock market.  Same thing with next year’s tuition money

–the stock market is the intersection of the objective financial characteristics of publicly-traded companies with the hopes and fears of investors.  Most often, prices change because of human emotion rather than altered profit prospects.   What’s happening in markets now is unusual in two ways:  an external event, COVID-19, is causing unexpected and hard-to-predict declines in profit prospects for many publicly-traded companies; and the bizarrely incompetent response of the administration to the public health threat–little action + suppression of information (btw, vintage Trump, as we witnessed in Atlantic City)–is raising deep fears about the guy driving the bus we’re all on

–most professionals I’ve known try to avoid trading during down markets, realizing that what’s emotionally satisfying today will likely appear to be incredibly stupid in a few months.  For almost everyone, sticking with the plan is the right thing to do

–personally, I’ve found down markets to be excellent times for upgrading a portfolio.  That’s because clunkers that have badly lagged during an up phase tend to outperform when the market’s going down–this is a variation on “you can’t fall off the floor.”  Strong previous performers, on the other hand, tend to do relatively poorly (see my next point).  So it makes sense to switch.  Note:  this is much harder to do in practice than it seems.

–when all else fails, i.e., after the market has been going down for a while, even professionals revert to the charts–something no one wants to admit to.  Two things I look for:

support and resistance:  meaning prices at which lots of people have previously bought and sold.  Disney (DIS), for example, went sideways for a number of years at around $110 before spiking on news of its new streaming service.  Arguably people who sold DIS over that time would be willing to buy it back at around that level.  Strong previous performers have farther to fall to reach these levels

selling climax:  meaning a point where investors succumb to fear and dump out stocks without regard to price just to stop losing money.  Sometimes the same kind of thing happens when speculators on margin are unable to meet margin calls and are sold out.  In either case, the sign is a sharp drop on high volume.  I see a little bit of that going on today

 

more on Monday

 

more on coronavirus and the stock market

In an earlier post, I outlined what I saw then as differences between SARS in 2002 and the new COVID-19 in 2019.

Updating:

–it appears China has mishandled COVID-19 in the same way it bungled SARS, surpressing information about the disease, allowing it to become more widespread than I might have hoped.  Not a plus, nor a good look for Xi.

–if press reports are correct, the administration in Washington is ignoring the advice of the Center for Disease Control and approaching COVID-19 in the same (hare-brained) way it is dealing with the economy–potentially making a bad situation worse

 

I think COVID-19 will be in the rear view mirror by July–as SARS was in 2003–but the road to get there will be bumpier than I would have guessed.

 

–the way the stock market has reacted to the new coronavirus  gives some insight, I think, into the differences between how AI discounts news vs. when human analysts were in charge.

when humans ruled 

Pre-AI, analysts like me would look to past examples of similar situations–in this case, SARS.

Immediate points of difference:  COVID-19 is not a unique occurrence–it’s the latest coronavirus from China but not the first so the fact of a new coronavirus should not be as shocking as the first was.  COVID-19 carriers are contagious before they exhibit symptoms, so quarantine is more difficult–i.e., transmission is harder to stop.  On the other hand, the death rate appears to be significantly lower than from SARS.

Two other factors:  the first half of 2003 was the time of greatest medical risk; generally speaking, the stock market back then rose during that period (because the world was just entering recovery from the popping of the stock market internet bubble in early 2000;  given that we’re in year 11 of recovery from the financial crisis, gains shouldn’t be anywhere top of the list of possibilities).

Obvious investment areas to avoid would be operations physically located in China or with large sales to/in China; anything travel- or vacation-related, like airlines, hotels, cruise ships, amusement parks, tourist destinations.

It’s harder for me to think of areas that would prosper during a time like this, mostly because I’m not a big fan of healthcare stocks.  Arguably anything operating totally outside China and not dependent on inputs from China; highly-automated capital-intensive operations rather than labor-intensive,   Public utility-like stocks.

Portfolio reorientation–becoming defensive and raising cash–would have started in early February.

the AI world

What I find interesting is that the thought process/behavior I just described only started happening, as far as I can see, about a week ago. That’s when news headlines began to emphasize that COVID-19 was spreading to areas outside China.  Put another way, the selloff came maybe three weeks later than it would were traditional investment professionals running the show.  In the in-between time, speculative tech stocks shot up like rockets.  The ensuing selloff has hit those high-fliers at least as badly as stocks that are directly affected.

In sum:

–late reaction

–violent, December 2018-like selloff

–recent outperformers targeted, whether fundamentals affected or not.

what to do

Better said, what I’m doing.

The two questions about every market selloff are:  how long and how far down.  On the first front, it seems likely that COVID-19 will be a continuing topic of concern through the first half.  The second is harder to gauge.  There was a one-month selloff in December 2018 that came out of nowhere and pushed stocks down by about 10%.  Today’s situation is probably worse, but that’s purely a guess.

I’ve found that even professional investors tend to not want to confront the ugliness of falling markets, and tend to do nothing.  However, in a downdraft stocks that have been clunkers don’t go down as much as former outperformers.  Nothing esoteric here.  It’s simply because they haven’t gone up in the first place.

A market like the one we’re in now almost always gives us the chance to get rid of clunkers and reposition into long-term winners at a more favorable relative price than we could in an up market.  My experience is that this is what we all should be doing now.  As I wrote above, my hunch is that we don’t need to be in a big hurry, but there’s no reason (especially in a zero commission world) not to get started.