looking for a bottom

A reader asked about my Monday comment on a possible “double bottom” in the US stock market.  I thought I’d elaborate.

 

What often seems to happen at market lows in the US is that stocks plummet sharply in a frightening way and then for no apparent reason other than that panic selling stops reverse course almost as sharply.

double bottom

Many times the selling stops at, or maybe slightly below a point where stocks bottomed before or where they have meandered around without much net movement for a considerable period of time.  For us, the two possible stopping points seem to be the point where stocks reversed themselves in December 2019 (just below 2400) and the period in 2015-16 when the S&P meandered around 2100.

Typically, the initial rebound lasts for about six weeks.   The market  then returns to–or somewhat below–the past lows before starting back up for good.

My observation Monday was that I’ve heard so many commentators predicting that we’re in a double bottom situation now that it may have become the consensus view.  That itself is a worry.  In my experience, the consensus view rarely comes to pass.  Sometimes everybody is wrong; more often by the time the news has passed down to TV talking heads, it has already been fully factored into stock prices and stocks will be influenced by something else.  I have no idea what the something else might be.

This shouldn’t be our most important concern as investors.

what we should be looking at/for, in my opinion anyway

The reality is that predicting the ups and downs of the US stock market accurately is very hard to do.  In 28 years as a professional investor, I never met anyone who could do it consistently–and plenty of people who lost their shirts–and their clients money–trying.

Market timing is riskier that it might seem, as well.  If I remember the number correctly, 40% of the gains in a market cycle come in 10% of the days–the lion’s share of that in the early stages of a bull market (which is just when the conventional wisdom is most bearish).

At a scary time like this, we all are getting a check on our risk tolerances.  If you can’t get to sleep at night, you now know you’ve taken on too much risk.  Not necessarily all at once, but over time you should readjust your holdings.

Everybody has stocks that blow up on them.  This is a good time to analyze clunkers you may have among your holdings, look for patterns in your decision-making that caused them and make changes.  This is harder to do than it sounds.  But it’s crucial.

If you own non-index funds, look at how well they’ve done versus the market.  Don’t just look at the past six months, look back at the fund record for as long as it has been around.  Be careful, though, to make sure that the long-term record isn’t just from a big bet that paid off a decade ago.

When I was training new analysts, I’d ask–“Suppose you bought a stock at $50 that you thought could go to $65 and it has fallen to $40 instead.  You’ve just found another stock with the same risk profile that you have the same level of conviction in.  It’s selling for $50 and you think it could go to $100.  But you have no extra money.  What do you do?”  Invariably the answer would be–“I’ll wait for the first stock to go back to $50.  Then I’ll sell it and buy the second one.”

That’s crazy.  Stock A can go up 60% and Stock B can double.  Why wouldn’t you sell some or all of A now to buy B?  The reason is that newbies don’t want to take a loss.  Their ego gets in the way of making money.  If your portfolio needs to be reshaped, in my experience the sooner you start the better off you will be.  Another reality is that the best professionals aspire to be right 60% of the time   …and they spend a lot of time trying to minimize the damage from the inevitable land mines.

the stock market now

The only thing I can see to hang my hat on is time.  I have no idea about the level at which stocks stabilize.  I think it’s reasonable to figure that the worst of the pandemic will be at least in sight by the end of June, particularly as China seems to be going back to work now.  Presumably the oil price war will still be on, which is bad for oil companies of all kinds, though particularly so for frackers, but probably a net plus for everyone else.

Three key questions:  will tech firms continue to lead the market during any recovery?  how will consumer behavior change in response to the fact of quarantine?  what struggling companies will be unable to survive a several-month shutdown?

 

 

 

 

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

 

Keeping Score for January 2020

I’ve just updated myKeeping Score page for January.   weaker world economy = interest rates lower for longer = more buoyancy in stock markets

Trump, tariffs, trading

There’s no solid connection among the three topics above, but the title gives me the chance to write about three only-sort-of connected ideas in one post.

The crazy up-and-down pattern of recent stock market trading in the US is being triggered, I think, by Mr. Trump’s tweets about trade–and about tariffs in particular.  I think a lot of the action is being caused by computers trading on the President’s tweets themselves, or some derivative of them–likes, media mentions, reflexive response to stock movements (or a proxy like trading volume).

my thoughts

–it’s hard to know whether the misinformation Mr. Trump is spewing about tariffs is art or he simply doesn’t know/care.

Tariffs are paid to US Customs by the importer.   In some small number of instances, a Chinese exporter may have a US-based, US-incorporated subsidiary that imports items from the parent for distribution here.  In this case, a Chinese entity is paying tariffs on imported Chinese-made goods.  To that degree. Mr. Trump is correct.  Mostly, however, the entity that pays a tariff on Chinese goods is not itself Chinese.

This is not the end of the story, however.  The importer will attempt to recover the cost of the tariff through a higher price charged to the US consumer and/or through a discount received from the Chinese manufacturer.  In the case of washing machines, which I wrote about recently, for example, all US consumers ended up paying enough extra to cover the entire tariff  …and some paid more than 2x the levy.  The prime beneficiaries of this largesse were Korean companies Samsung and LG.

–one of the oddest parts of the current tariff saga is that Mr. Trump has decided not to work in concert with other consuming nations.  In fact, one of his first actions as president was to withdraw from the international coalition attempting to curb China’s theft of intellectual property worldwide.  The Trump tariffs are only bilateral, so there’s nothing to stop a Chinese company from shipping a partially assembled product to, say, Canada, do some modification there and reexport the now-Canadian item to the US.

The administration has been artful in selecting intermediates rather than consumer end products for its tariffs so far.  This makes it harder to trace price increases back to their source in Trump tariffs.  However, the fact that the administration has taken pains to cover its trail, so to speak, implies it understands that tariff costs will be disproportionately borne by Americans.

 

–in trading controlled by humans, a lot of tariff developments should have been baked in the cake a long time ago.  Continuing volatility implies to me that much of the reacting is being done by AI, which are learning as they go–and which, by the way, may never adopt the discounting conventions humans have employed for decades.

 

–I think it’s important to examine the trading of the past five days (including today as one of them) for clues to the direction in which the market will evolve.  Basically, I think the selling has been relatively indiscriminate.  The rebound, in contrast, has not been.  The S&P and NASDAQ, for example, are back at the highs of last Friday as I’m writing this in the early afternoon.  The Russell 2000, however, is not.  FB is (slightly) below its Friday high; Netflix is about even; Micron is down by 4%.  On the other hand, Microsoft and Disney are 1% higher than their Friday tops, Paycom is 2.5% up, Okta is 5% higher.

No one knows how long the pattern will last, and I’m not so sure about DIS, but I think there’s information about what the market wants to buy in these differences.   And periods of volatility are usually good times for tweaks–large and small–to portfolio strategy.  This is especially so in cases like this, where the movements seem to be excessive.

One thing to do is to confirm one’s conviction level in laggards.  Another is to check position size in winners.  In my case, my largest position at the moment is MSFT, which I’ve held since shortly after Steve Ballmer left (sorry, Clippers).   I’m not sure whether to reduce now.  I’d already trimmed PAYC and OKTA but if I hadn’t before I’d certainly be doing it today.  I’d be happiest finding areas away from tech, because I have a lot already.  On the other hand, I think Mr. Trump is doing considerable economic damage to American families of average or modest means, with no reward visible to me except for his wealthy backers.  Retail would otherwise be my preferred landing spot.

–Even if you do nothing with your holdings now, make some notes about what you might do to rearrange things and see how that would have worked out.  That will likely help you to decide whether to act the next time an AI-driven market decline occurs.

all clear?

My worst flaw as an investor–at least, the worst that I’m aware of–is that I’m too bullish.  So I have to be careful at a time like this when the stock market has been on a downtrend, to ensure that I don’t call a tactical bottom too early.

I should also point out that mutual funds have most likely been out of the market for the past few days, so the wicked intraday spikes we’ve been seeing in recent trading are more likely the work of algorithms than humans.  So the end of the mutual fund fiscal year is in itself no reason for these swings to stop.

Still, it looks to me as if the lows the market established early in 2018 are holding.  Also, many tech stocks, having lost a third of their value, are beginning to move up on what seems to me to be the flimsiest of positive news–a so-so earnings report or an upgrade by a brokerage house analyst.

So my guess is that the worst is over and that stocks will go sideways to up from here.

 

Several things to note:

–intraday swings have been unusually large, based on past instances of correction.  This may just be what machine-driven markets look like

–a change in market leadership often occurs after a correction.  I’m not sure what that would be in this case.  I’m still thinking that IT will lead, noting, though, that chip manufacturing businesses appear to be entering one of their periodic phases of oversupply (driven by the fact that capacity is added in huge chunks, and usually by everyone at the same time)

–the long-term economic negatives recently created by Washington–large-scale deficit spending; emphasis on reviving older, inefficient industries; policy directed at breaking down global supply chains–haven’t gone away.  The considerable social/cultural damage being done by the administration hasn’t, either.  At some point, these factors will begin to retard stock market progress, although they may be issues for 2019.

a US market milestone, of sorts

rising interest rates

Yesterday interest rose in the US to the point where the 10-year Treasury yield cracked decisively above 3.00% (currently 3.09%).  Also, the combination of mild upward drift in six month T-bill yields and a rise in the S&P (which lowers the yield on the index) have conspired to lift the three-month bill yield, now 1.92%, above the 1.84% yield on the S&P.

What does this mean?

For me, the simple-minded reading is the best–this marks the end of the decade-long “no brainer” case for pure income investors to hold stocks instead of bonds.  No less, but also no more.

The reality is, of course, much more nuanced.  Investor risk preferences and beliefs play a huge role in determining the relationship between stocks and bonds.  For example:

–in the 1930s and 1940s, stocks were perceived (probably correctly) as being extremely risky as an asset class.  So listed companies tended to be very mature, PEs were low and the dividend yield on stocks exceeded the yield on Treasuries by a lot.

–when I began to work on Wall Street in 1978 (actually in midtown, where the industry gravitated as computers proliferated and buildings near the stock exchange aged), paying a high dividend was taken as a sign of lack of management imagination.  In those days, listed companies either expanded or bought rivals for cash rather than paid dividends.  So stock yields were low.

three important questions

dividend yield vs. earnings yield

During my investing career, the key relationship between long-dated investments has been the interest yield on bonds vs. the earnings yield (1/PE) on stocks.  For us as investors, it’s the anticipated cyclical peak in yields that counts more than the current yield.

Let’s say the real yield on bonds should be 2% and that inflation will also be 2% (+/-).  If so, then the nominal yield when the Fed finishes normalizing interest rates will be around 4%.  This would imply that the stock market (next year?) should be trading at 25x earnings.

At the moment, the S&P is trading at 24.8x trailing 12-month earnings, which is maybe 21x  2019 eps.  To my mind, this means that the index has already adjusted to the possibility of a hundred basis point rise in long-term rates over the coming year.  If so, as is usually the case, future earnings, not rates, will be the decisive force in determining whether stocks go up or down.

stocks vs. cash

This is a more subjective issue.  At what point does a money market fund offer competition for stocks?  Let’s say three-month T-bills will be yielding 2.75%-3.00% a year from now.  Is this enough to cause equity holders to reallocate away from stocks?   Even for me, a died-in-the-wool stock person, a 3% yield might cause me to switch, say, 5% away from stocks and into cash.  Maybe I’d also stop reinvesting dividends.

I doubt this kind of thinking is enough to make stocks decline.  But it would tend to slow their advance.

currency

Since the inauguration last year, the dollar has been in a steady, unusually steep, decline.  That’s the reason, despite heady local-currency gains, the US was the second-worst-performing major stock market in the world last year (the UK, clouded by Brexit folly, was last).

The dollar has stabilized over the past few weeks.  The major decision for domestic equity investors so far has been how heavily to weight foreign-currency earners.  Further currency decline could lessen overseas support for Treasury bonds, though, as well as signal higher levels of inflation.  Either could be bad for stocks.

my thoughts:  I don’t think that current developments in fixed income pose a threat to stocks.

My guess is that cash will be a viable alternative to equities sooner than bonds.

Continuing sharp currency declines, signaling the world’s further loss of faith in Washington, could ultimately do the most damage to US financial markets.  At this point, though, I think the odds are for slow further drift downward rather than plunge.

 

 

 

where to from here?

I’m not a big fan of Lawrence Summers, but he had an interesting op-ed article in the Financial Times early this month.  He observes that, unnoticed by most domestic stock market commentators, the foreign- exchange value of the dollar has steadily deteriorated since Mr. Trump’s inauguration.  Currency futures markets are predicting a continuing deterioration in the coming years.  He thinks the two things are connected.  I do, too.

To my mind, what is happening  on Wall Street recently is that currency market worry is now seeping into stock trading as well.  If someone forced me to pick a catalyst for this move (I would prefer not to), I’d say it was the possibility, introduced in the press investigation of Cambridge Analytica, that what we’ve believed to be Mr. Trump’s uncanny insight into human motivation (arguably his principal redeeming feature) may be nothing more than his reading a script CA has prepared for him.  This would echo the contrast between the role of successful businessman he played on reality TV vs. his sub-par real-world record (half the return of his fellow real estate investors while assuming twice the risk).

 

The real economic issue is not Mr. Trump’s flawed self, though.  Rather, it’s the idea that public policy in Washington generally, White House and Congress, seems to have shifted from laissez faire promotion of businesses of the future to the opposite extreme–protecting sunset industries at the former’s expense.   In this scenario, overall growth slows, and the country doubles down on areas of declining economic relevance.

We’ve seen this movie before–in the conduct of Tokyo, protecting the 1980s-era businesses of the descendants of the samurai while discouraging innovation.  The result has been over a quarter-century of economic stagnation + a collapse in the currency.

 

More tomorrow.