Introduction
Future
stock market declines are inevitable unless we modify human behavior. Also, as
days follow nights, after the declines there will be future rises. None of these
statements are new or profound. The critical questions are, what to do in anticipation
and during a decline?
John
Vincent messaging through Seeking Alpha, regularly reviews the 13F reports
filed by investment management organizations as to their stock holdings. In
reviewing a number of independent investment managers with over $1 Billion in
their portfolios for the third quarter, I have observed some trends.
First,
many managers who have sold recently acquired positions did not report
significant profits. Secondly, sales of shares acquired years ago are producing
large returns, some on the order of two, three, or four times original cost.
Since my investment clients and I are long-term investors, it is the second
observation that becomes something of a guide to our management philosophy.
Since
few or any managers consistently buy at the bottom (or sell at the top), there
will be periods of time that they will likely hold positions at a loss before
they eventually sell at a profit. Thus, the critical question is how big a loss
is acceptable as a price to earning large profits? A further and more difficult
question is, how long does one have to wait to get into a profit condition?
Accurately
predicting the future without incorporating a mistake is a fool’s errand.
However one can apply both logic and past history as a guide. Stock prices
regularly decline for periods of one year or longer, “normally” two to three
times over a decade. These corrections may be 10% or more up to so-called “bear
markets of 20%+. Few investors have
experienced getting out at or near the top of a “normal” decline and getting
back in before prior peaks have been achieved. Thus one is probably better off
holding through a cyclical downturn and subsequent recovery.
On the
other hand once a generation stock prices decline in the range of 50% or more.
We have had bouts of these types of declines in 1973, 1987, and 2007-9. In the
last two cases we held through the declines in part because we recognized the
potential market risks after the decline had begun. There is a greater risk
that the recovery period could be extended. The recovery from the “Great
Depression” of the 1930s lasted until the mid 1950s for the average stock and
in the case of one of the popular growth stocks, RCA, until the mid 1960s.
Thus, there is a real advantage to attempt to sidestep an “abnormal” market
decline.
Even
if we can determine the odds of a forthcoming decline, particular diligence is
required to separate a future “normal” decline when the odds favor holding
through the decline and an “abnormal” decline when side stepping would be
advantageous. I am considering to attempt the last task. I do this with the
hope that my heritage will give me an advantage. The family folklore is that in
the late 1920’s my Grandfather persuaded
his clients to pay off their margin loans and go to cash. The family
legend is that they did.
Next I
am examining the current conditions to separate which of the current trends
point to a future “normal” decline and which could be indicating a larger
problem.
Trends that Presage a Decline
No single present trend guarantees a
future event and even the aggregate weight of trends do not guarantee a
particular result. One of the useful concepts learned at the race track and as
an analyst is to assign odds to various factors that could influence the result.
Always leave room for “racing luck” or “unknown unknowns” as well as unintended
consequences. Nevertheless, reasoned analysis is better than relying
exclusively on hope.
Sentiment Overriding Numbers
Utilizing the distinction that S&P* is
making between Growth and Value components of the S&P 500, one can see two
different stock markets being created. Value stocks are being evaluated on both
the basis of their financial statements and the near-term price and volume
trends in their business. Using many measures these stocks are being valued
within the range of fair value. Their stock price trend is moving up in tandem
with an economy that is somewhat errantly expanded. However, the value stocks
are moving slowly compared to the growth component.
Led by a little more than a handful of stocks
labeled as the FAANG group, Growth stocks are significantly outperforming the aforementioned Value stocks. This is
happening globally and particularly in terms of Asian security prices.
One of the reasons that up to the present
I felt that the next market decline would be of a “normal” type that we would
hold our good stocks through the cycle, is the general lack of enthusiasm for
stocks. I have not seen the kinds of enthusiasm I saw in the run up for the Dot
Com bubble. Nor did it reach the levels of enthusiasm seen many years earlier in
the South Sea Bubble or the Tulip Bulb craze. But the level of enthusiasm for
certain stocks and for the market in general is worth watching. Two of the
lenses that I look through are the research that Liz Ann Sonders puts out for
Charles Schwab & Co.* and the weekly
survey by the American Association of Individual Investors (AAII). This is a
very volatile time series. In the latest week only 29.4% of those surveyed are
bullish as compared with the prior week when the reading was 45.1%. If, over
time, the bullish contingent numbered consistently over 40% and the bearish
group is below 30%, I would be nervous short-term, as I view this particular
indicator as a contemporaneous measure.
Fixed Income Signals
As has been often pointed out that most of
the modern declines in stock prices were preceded by some disruptions in the
fixed income markets. We have already seen some price nervousness directed at
the High Yield bond market in spite of
no generally expected increase in defaults by the major credit rating agencies.
This nervousness has not yet been felt in the intermediate credit market. Barron’s
has two bond indices, one labeled Best Grade Bonds which saw its yield rise 5
basis points this last week. The other
measure, for the Intermediate Grade bonds, saw its yield drop by a
single basis point. This suggests to me that there is wide scale disenchantment
with the credit market this week.
My main worry after the collapse of Lehman
Brothers and Bear Stearns is not the price/yield of credit instruments but
their availability in a stressed market. Recently I have mentioned that the
market for US Treasuries is considered to be the most crowded and is under
investigation for price manipulation in the related foreign exchange currency
markets. There are some professional press articles raising concerns about
liquidity. A liquid market is one where trades can be executed without moving
prices. Most high grade markets are extremely liquid almost all the time. The
meaning of the last sentence pivots on “almost.” At the final point of their
crunch both Bear Stearns and Lehman could not access the repo market to satisfy
their desperate need to refinance short-term debt.
I don’t have any independently derived
measures of liquidity. However, I may
something of a mirror image of available liquidity looking at major Money Market funds. (Remember when
Lehman went down it caused one large Money Market fund to “break the buck” or
to be slightly valued below the level of its deposits including interest
earnings? They had to suspend redemptions which could have created a “run” on Money Market funds if the government did not step in. Thus, liquidity is very
important to Money Market funds. JP
Morgan has four large multi billion dollar funds in the US. These four range in
size between $21 Billion and $140 billion. What is perhaps of interest in this
matter is that three of the four have
between 50% and 64% of their investments maturing in eight days or under. Only
their 100% US Treasury Securities Money Market Fund is much more exposed to
longer maturities, with only 21% maturing in eight days or less. This
difference could be due to a belief that the owners of this fund are less
likely to need cash as quickly as the owners of the other funds.
Two of the four funds have more than 50%
of their holdings in repurchase agreements, largely with other capital markets
providers. (What we do not know is whether JPMorgan is on the other side with
the same organizations so their net exposure may well be much less.) The real
key to the questions as to the size and nature of short-term liquidity is that
it is a matter that is currently being worked on by the major participants - not
because they want to for the tiny current interest rates - but because they
must to keep the global financial system working.
The Thanksgiving Weekend Visit to
the Mall
As many of our long term subscribers to
these blogs may know, my wife Ruth and I visit the glitzy Short Hills Mall in
New Jersey to frequently do our market/economic research. Due to family
commitments, we could not get over to the Mall until Sunday afternoon. The Mall
was crowded but not jammed. The high end stores were generally attracting a
good crowd, but this was not universally true. While a number of jewelry stores
were busy, Tiffany looked sparse as some of the others were almost vacant. Both
Verizon and Apple* were doing good to great business, we think. While some
couples had a handful of bags, they did not seem to be burdened down. There
were a few empty store spaces and ads for sales help were generally lacking. I
had the feeling that most merchants were not over-inventoried, as some were in
the past. All in all a good but not a great beginning to the shopping season. We
don’t yet have a view on the online business and whether shopping habits have
shifted.
From an investment viewpoint retail will do okay
but won’t be a leader.
*Held personally or in the private
financial services fund I manage.
Conclusion
We should be careful with our investing.
There are too many moving parts to this puzzle to be dogmatic, but risk levels
are probably rising.
__________
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Michael Lipper, CFA
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