Introduction
William Shakespeare’s three witches
in Act IV of Macbeth may have been one of the first to warn of bubbles when
they chant “Double, double,
toil and trouble;
fire burn and cauldron bubble.
(emphasis added).
This prescription is a warning to me. I manage one account that is not being
offered, starting in 1999 and is up 3.39 times original cost closing in on
double, double.
Are we headed for trouble on the
way to a bubble? Further, worth noting is that there are a number of SEC
registered mutual funds that have doubled this year. Even some mutual fund
averages have gained about four times a normal year’s gains with twelve
separate fund peer groups rising 44.61% to 30.29% up to the penultimate day of the year. (The last that was available at
this writing, the final day did not show much movement.)
The above mentioned trouble could
be that driving these funds’ performances is about ten global tech equities.
Typically at the top of many markets there are only a few leaders enjoying
outsized gains.
In Shakespeare’s play it takes some time and plot development from the witches’ chant to fulfill their prophesy. Thus, it may take some future market developments for a similar fulfillment, or it may not happen. The way I track the route to an eventual peak is through watching sentiment, surprises and confidence indicators.
Sentiment
In its weekly poll of the sample of members, the American Association of Individual Investors (AAII) as published
weekly in Barron’s,
divides its views into Bullish, Bearish,
and Neutral. For the last two weeks this very volatile poll is showing over
half of the respondents are bullish. Typically the split to the leader is more
likely to be in the high 30% to low 40%.
There are many different ways to
measure sentiments of investors in aggregate. To me the most useful lens is to
look through the changes in valuation. Prices currently show what investors are
willing to pay for various elements of fundamental data, dividends and
interest; reported operating and GAAP earnings; reported and adjusted book
value; among others. Currently with the stock market prices going up at a
faster rate than announced and/or analyzed results, there is an increasing
amount of optimism. Merrill Lynch has labeled 2018 as the Year of Euphoria. (I
hope it is just a year of increasing optimism which normally leads to a normal
price decline. Bouts of euphoria are rarer and lead to major market turning
points that create subsequent, substantial declines to a lower level than when the
rising stock market began.) Merrill and most of the investment world is
cheering on the rise in various economic statistics with the belief that the
best is yet to come.
Better news and higher projections are increasingly being valued more highly. In most cases these are in the upper regions of their historical time series, but not yet setting new high watermarks in valuations. Traditionally auto analysts and some industry economists (after a particularly strong automotive sales year) worry that a great year brings forward demand from future years. When those succeeding years' occur they would be significantly below the normal sales trend line and produce a pro-cyclical rather than a continuation of the pro-growth periods.
Better news and higher projections are increasingly being valued more highly. In most cases these are in the upper regions of their historical time series, but not yet setting new high watermarks in valuations. Traditionally auto analysts and some industry economists (after a particularly strong automotive sales year) worry that a great year brings forward demand from future years. When those succeeding years' occur they would be significantly below the normal sales trend line and produce a pro-cyclical rather than a continuation of the pro-growth periods.
Part of the problem of creating
unsustainable peaks is that global political leaders are attempting to push job
creation policies as measured by labor productivity. We may be entering a
period of over-hiring because it is too difficult to find the right workers
with appropriate skills and good job attitudes and discipline, thus we may soon
be entering a job hoarding phase. Instead of focusing on the relatively small
number of unemployed and under-employed, we should be looking essentially for
higher consumption productivity. More people would benefit for higher quality
products and services where increased demand leads to slower price increases
and better service for consumers.
Near-term rise in sentiment is
anticipatory of better future results, but probably can not be sustained as we
fill the demands of consumers for goods and services at reasonable prices and
quality. As sentiment normally follows an accelerating curve rather than a
normal trend line, with the gains created it also creates a risk as to when it
reverses a fall at a faster rate than in its acceleration phase. Enjoy, but be
prepared.
Surprises
Shortly my good friend and former member with
me on the board of the New York Society of Security Analysts, Byron Wien, will
publish his annual list of at least ten surprises. For a condition to make the
list its possible occurrence must be disbelieved by the majority of the
professional investment community. Byron has a good batting average with over
half of his “surprises” turning out to be accurate.
I recognize that there will be surprises that most of us don’t anticipate. These can be positive or negative surprises. In terms of impact, with sentiment rising and therefore accepted, the upside is likely to be less than the downside surprises.
Many of the financial media and other pundits focus much of their attention on the US. Clearly, there will be some US-centric surprises that will move the market. However we can not avoid being a consumer and investor in the globe.
I recognize that there will be surprises that most of us don’t anticipate. These can be positive or negative surprises. In terms of impact, with sentiment rising and therefore accepted, the upside is likely to be less than the downside surprises.
Many of the financial media and other pundits focus much of their attention on the US. Clearly, there will be some US-centric surprises that will move the market. However we can not avoid being a consumer and investor in the globe.
I suspect that some of the most
impactful surprises will come from Asia, the Middle East, Africa and Latin America. The
interesting thing about the initial market movements upon the discovery of the
surprise will be reversed subsequently. To me the key to these surprises is
that we are not sufficiently paying attention to areas and subjects. One somewhat overlooked opportunity caused by
a surprise is often a chance to be on the other side of the reaction trade, buy
when others are selling without price discipline or supplying to the market
when there is excess enthusiasm. As sentiment rises, playing surprises could be
a good tactic.
Based on many of the past large stock
market declines, the biggest surprise is likely to be in credit creation. Some
actual or rumored credit user or groups of users at an instant in time may be
deemed unable to repay their debt and/or interest, and could cause a sharp drop
in the stock market in more than one country. Credit like money is fungible.
When credit is withdrawn it creates a
vacuum which is answered by rapid shifting of credit support to, at that time,
the most credit-worthy borrowers. One way or another equity markets ride on a
sea of credit to earn a rate of return in excess of interest rates charged.
Confidence
One should not equate confidence with
sentiment. Based on political history and my experience at the racetracks, in
only a minority of the cases do they come to exactly the same conclusion at the
same time, but they do every once in awhile. One of the better measures of
confidence is to examine the age and experience of the most confident players
and pundits compared with the least. Most people that are confident of the
result have no idea how their confidence will actually work out. They don’t
understand the tactics and mechanics of what will happen after the victory
celebration.
Current View
The larger level of enthusiasm by
people/investors who are not experienced, the closer we are probably to a
significant change in direction, but as Saint Paul pleaded with God, “Not yet.”
__________
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A. Michael Lipper, CFA
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