Sellers Scare Buyers

My grandfather was a successful investor over his lifetime. He cautioned my older brother and me that the person on the other side of a stock trade was probably as smart as we were, if not smarter. As this week and month were drawing to a close on Friday afternoon, the stock market fell sharply. In the last half hour of trading the Dow Jones Industrial Average (DJIA) fell almost 70 points. In a so-called “normal” trading day the number of stocks rising is close to the number declining. On an unusually decisive day the ratio can be as high as 3 to 1, either way. On Friday there was five times the number of decliners than stocks gaining in price for the day. What happened? I don’t know, but my thoughts went to the wisdom of my grandfather. Traders have learned from bitter experience not to fight the tape by going against a strong trend. As one who has learned to take advantage of market disruptions I should have been a buyer, but I wasn’t. During this period of turmoil is it possible, perhaps probable, that the sellers know something? Normally both buyers and sellers can be correct on a given trade because they are using different time frames for their decisions and value the same bit of information differently. I believe the intensity of the selling caused normal buyers to pull back from trading. Compared to brief major price onslaughts in the past, there were few if any effective market stabilizing forces at work. Previously floor-based specialists and “upstairs” trading desks put their capital at risk to calm the market.

Possible explanations

As of this weekend there is no available, credible analysis on what set off the sharp decline but there are three reasonable triggers that could have caused concerns on the part of portfolio managers on the last day of the month.

1.  The market had completed four years from its bottom in March of 2009 and this summer/fall we will have passed six years from the prior peak. Just in the last five months the DJIA has gained 15.3% and the S&P500 14.3%. Some investors, typically in financials, did even better with gross gains of 23%. Clearly there is a strong desire to preserve good to great results in an aging bull market.

2.  Often I have suggested that the fixed income market can be an early warning device for the stock market. Very recently the yield spreads on high yield (junk bonds) has started to widen compared to comparable US Treasury issues. Separately, Barron’s has maintained a confidence index comparing the yield to maturities on selected high quality bonds and intermediate quality issues.  This week the ratio was 73.2 compared to 67.7 a year ago which suggests that there is some concern as to intermediate credits. A further indicator that fixed income investors/savers are looking for credit quality is the interest rate available on money market accounts which dropped to 0.46%, the lowest I remember seeing. Bottom line: I don’t see any Bond bulls.

3.  Quite possibly Japan has replaced China as the major foreign concern. In terms of China we are dealing with a well-advertised slowdown in its economy and a possible return of the Chinese to the commodity markets. What is replacing the China worry is the attempt of the Bank of Japan (BOJ) to utilize monetary quantitative easing. The BOJ is trying to induce a goal of 2% inflation to shakeup an economy that in a real sense has not grown in 24 years. The route that they are taking is to lower the value of the yen relative to all of its main trading partners. Some have called this the first shot in a currency war which already is not sitting well with Japan’s competitors. For some, this eerily looks like the currency war that made the industrial recession into the economic depression of the thirties. The BOJ’s strategy can only work if the US does not taper off its own “QE” and other countries do not retaliate with competitive devaluations. This last week the Chairman of the US Federal Reserve discussed looking into possible procedures for beginning a tapering-off process at some future point.

What to do?

Tops of markets usually don’t occur at convenient times. This weekend I reviewed the major winning positions in our stock portfolios as well as a number of winning positions in funds that we own for institutional and individual clients. In terms of the stocks even though they have advanced significantly, they are selling substantially below what I believe a knowledgeable strategic buyer should pay for a number of unique holdings. Worse, there is an understandable fear that once sold, similar “jewels” will be hard to find at reasonable prices. Perhaps what makes the decision to sell even harder are the attempts by various central banks to push us further along on the risk continuum just as their own balance sheets are taking on the attributes of a highly leveraged shadow lender. Yields on the DJIA are slightly higher and those on the S&P500 close to the yield on the ten-year US Treasury note. (By the way, we will start to see fund and manager advertising which touts 3 and 5 year performance, but the market is focusing on ten year periods as representative of possible future results.) 

My inclination

Recognizing that in all likelihood I will loose some of the gains that my accounts have received in 2013, I will probably hold onto most of our positions waiting for the return of the army of strategic buyers. Please share with me what are you doing or what do you advise me to do. I don’t want to be scared out of position by the sellers.

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