Is the “Two Step” the Last Dance of the Bull Market? - Weekly Blog # 487

Introduction

Many years ago when people actually held each other there a very energetic fast dance called the “two step” which exhausted the dancers and often at the end left them clinging to each other. I am wondering whether there is a reasonable chance that we are setting up a “two step” dance before we have the “big one,” a once in a generation major decline.

A Contrarian View of Current Sentiment

A basic belief derived from history is that the only attribute that market survivors share is a well earned sense of humility. A study of history through the ages, cultures, and fields of endeavor shows that at critical points most people are wrong, but not always. Viewing the current stock market through that lens raises the possibility that we can be on the edge of a meaningful market advance.

A number of good market analysts pay more attention to sentiments and shifts in sentiments than economic and financial ratios. There are a number of sentiment readings, some published in Barron’s each week. One that has caught my eye is the weekly readings from the American Association of Individual Investors which also parallels my sense of institutional investors thinking as indicated by changes in transaction volume. In the last three weeks the percentage of bullish individuals has dropped from 34.2% to 25.0% with only a minor increase in neutral views going from 33.0% to 35.1% with a major rise in the bearish column from 32.8% to 39.9%. One can understand that the current political and military events are matters of concern, but in theory investors should have longer term time horizons than day traders. Both my study of history in general and the learned analysis from the racetrack, suggests to me that the odds, not the certainty, is that the dramatic switch in sentiment is wrong.

Interesting to me is that market volume has not picked up. This indicates to me that while people are generally worried about conditions they are not now acting to preserve their wealth or that of their clients.

Stock Market Analysis

What is more interesting to me, particularly as an investor in some smaller cap funds, is that the NASDAQ index has gone to a new high. The older and broader indices both in the US and a number of other markets are in striking range of new highs. While the NASDAQ index did hit a new high on a light volume Friday, it did not go up to qualify as a clean breakout of a past trading range and could reverse and create a top. Recognizing I am intrigued with the possibility that the index will achieve a breakout velocity.

The tactical importance of a breakout, particularly if followed by others, is that the prior reversal patterns, called “head and shoulders” becomes a base for a material advance. The base will show a rather large volume of past sellers who may feel the need to get back into the market to participate in future gains. Often the past sellers left large relatively high quality stocks and now may feel the need to quickly catch up through more than normal (for them) speculative investing.

Thus a vigorous “two step” dance could be in our future.

Fears of “The Big One”

One way I attempt to keep up with investing globally is when possible to read English language foreign media both for their local and global views. Recently I read an article in The Star Online from Malaysia where Tan Sri Andrew Sheng who writes on global issues from an Asian perspective. While enjoying the 24.7% gain in the MSCI Emerging Market Index, he is concerned that we may be heading for a major drop. In this light he as we all should re-read Charles Kindleberger’s “Mania, Panics and Crashes” (Macmillan, 1996). He identifies the following steps to the collapse labeled the South Sea Company Bubble of 1720:

•           Displacement
•          Credit/ Monetary Expansion
•           Over Trading
•           Financial Distress
•           Fraud, Swindles, and Malfeasance
•           Revulsion, mistrust of shady products and intermediaries
•           Panic selling

We have seen similar risks attached to a number of other panics before and after the South Sea Company Bubble panic. His bullish view is that he does not see enough similarities to today’s markets to fear  a repeat  panic.

The odds are that he is correct that the next decline will be one of the more normal falls. In the US context when we had floor specialists and other well capitalized broker/dealer trading desks this meant declines in and around 25%, not the once in a generation collapse of 50%.

However, as the job of a prudent analyst is to think the impossible thoughts. I look at the above itinerary to panic and feel we may be on a similar somewhat predictive path. One might suggest that either the internet or bitcoin qualifies as displacement. The key concern with displacement is that it is an excuse at least temporarily in believing old rules of prudence no longer apply. The growing lists of unicorn valuations for private companies that have little or no profits but with perceived great futures. It makes me nervous that some very good mutual funds are currently profitably benefiting from their private equity investments. Some less sound funds may follow and could have liquidity problems.

Our friendly central banks and deficit spending by governments and the growing number of new credit funds are certainly expanding money supply to the market systems. The mere hint of a “tapper” can cause both bond and stock markets to shudder.

At the moment most of the remaining sign points are not flashing great concern which is why I have not built reserves up in our long-term oriented mutual fund managed accounts. However, I am very concerned about the item of revulsion and mistrust of intermediaries. Some in the media are perfectly looking to shout “fire” in a crowded space. In addition, numerous politicians may act against all the intermediaries and their favored products. Their math is not based on dollars or other currencies, but on numbers of potential swing votes. As a critical element of self protection those of us who are professionals in the market need to have our clients and their beneficiaries understand that while we undoubtedly make mistakes, we are essentially honest and place them ahead of our own short-term financial interests.

It is a mistake to rest our relationships primarily on performance, particularly short-term performance.

With appropriate level of concern and caution I am still a believer that the process of prudent investing can generate longer lasting wealth than most activities, as long as it is based on our best efforts.

Momentary Input

On an intermittent rainy Sunday on the Labor Day weekend, the crowd at one of the glitzy shopping malls, The Mall at Short Hills, crowds approached the Christmas season levels. The big difference that I noted is that more men were in attendance, not just as bag carriers. They were actually shopping and often not in the company of female companions. At numerous stores there was a major effort to divert credit card sales to their home or co-sponsored brands. Retailers are also looking to capture long-term relations not just current sales. This is a necessary effort, hopefully it is not too late to keep any of the stores open for business in the malls.

Question: How quickly will your humility permit you to reverse some of your investment choices?                                

__________

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Behavior Patterns Help and Hurt

Introduction

Investment professionals and seasoned investors prize numbers including repetitive patterns. With these abstractions of reality we can build nice neat statistical formulas that give us a good chance to be correct most of the time. The problem with that belief is the recognition that we won’t be right all of the time and some of the time when we are wrong the results are costly. Probably the best known user of numbers was the physicist Albert Einstein, who was lured away from Caltech to Princeton by more money (again numbers).  According to John Mauldin’s latest letter the Professor had on his desk a sign which read “not everything can be measured and not everything which counts can be measured.” Clearly he was recognizing that the “unknown unknowns,” as Donald Rumsfeld has said, make us understand that we can not have complete confidence about both the understanding of the current situation and our ability to predict the future.

Behavior

Many learned institutions around the world, including Caltech have been studying how various elements in the brain’s circuitry light up repetitively as reactions to (or possibly causes of) specific behavior patterns. Of the work that I have seen, the connections between the specific brain waves and human acts are pretty simple and rely on learned memories of past pleasures or pains; e.g., digesting food when hungry. So far I have not seen how our minds react to indirect stimuli. This is important in that we live in a dynamic world where threats of bubbles and forgone opportunities are present at a much accelerating rate.

Opportunities

My study of history indicates that every single day some people are not only making money, but each day someone begins the climb to real wealth. Often those periods when great fortunes were ignited were described by the headlines of the day as troubled. Many investors, some seasoned and some not, are perturbed by the level of real unemployment or underemployment throughout the age range, but particularly for the youth with or without college education. They are concerned by the political uncertainties in most democracies. The low level of interest rates manipulated by the major central banks is leading many into uncomfortable, and in some cases, unusual investments. In other words, many investors lack confidence and are unhappy. On the other hand, currently most economic and financial conditions as reported are not getting worse. The relatively low level of financial and investment activity is reassuring to some that are current market participants, as there are less chances that global transaction prices go crazy, with the exception of extreme high-end real estate.

Perhaps in the real world that is beyond the financial and political communities, people are coping. They are getting on with their lives and new hard-worked fortunes are beginning. What our academic friends have not yet captured is the ability of humans to cope with conditions that they have no historical preparations. Think in terms of the recoveries of people in London, during and after their bombings, New York City after 9/11, Japan after the Fukushima disaster, and in Boston after the explosions at their Marathon. Humans can eventually figure out how to survive and then prosper by using their developed problem-solving abilities that have no direct historical parallel. I believe we are in such a period now. Coping is working slowly and we are making some progress. We have a framed motto in our home from the US Marine Corps which intones “Adapt, Improvise, and Overcome.” People all over the world are doing just that.  This is not to say that everything is wonderful for all or that in the future we won’t suffer from human-induced bubbles.

Bubbles

Many keen observers of market prices have written about bubbles for hundreds of years. The most famous in the English language was Charles Mackay’s “Extraordinary Popular Delusions and the Madness of Crowds.” Other insightful authors were Charles Kindleberger and Hyman Minsky. Not at the same level but an effective scribe is John Mauldin who is promoting his latest book through his weekly letter, quoting others that have written well on bubbles.

Most of the time financial prices act in a rational fashion often extrapolating near-term trends into the nearby future. Major price swings are largely absent and can be easily explained. In other words most investments are dull, which is the best possible operating conditions for disciplined traders. However, what the media and the amateur investors focus on are bubbles which distort for a period of time the normal price trajectories. I have not seen a good definition of a bubble so let me suggest one:

 

     An exponential price move (multiple doubles) in a relatively compressed period of time, normally 250 or less trading days on the way up and a similar (or more frequently, a smaller number of trading days in decline). 

     Unless one is in control of one’s investment emotions these not infrequent disruptions can destroy a sound careful investment strategy.

What is particularly disturbing about bubbles is that they start out as recognition of some important price trend outside the normal trading markets for most investors. While the mathematical description of bubbles is remarkably consistent, the external factors are different. There is the so-called Kindleberger-Minsky Perspective of five stages. The first is heralded change to the perceived order of things the widespread advent of electricity, radio, nuclear power, Internet and new debt instruments. In the second phase early adapters enjoy a boom. By the time of the third stage almost everyone has joined in the Euphoria. 

I remember the bubble in transistors the forerunner of semiconductors. We were told to think about how big the market would be for transistor radios when they penetrated each village in India and how much better the world would be. This in turn led to the fourth stage or crisis. (Something happened between the bullish case of the 1960s and now when cell phones are helping lower-earning farmers to negotiate better prices for their crops knowing what the markets are paying.) What happened was over-capacity and under-financed marginal companies bombed the prices for transistors. The final stage of the cycle is one of revulsion. I remember one large mutual fund in the 1960s that was heralded for having little to no investments in electronics. It was the equivalent of having a closet full of Nehru jackets or for women having skirts of the wrong length.

I do not know when and from what sector a bubble will appear. Others have identified bubbles in 1929, 1962, 1987, 1998, 2000 and 2008. I might add some others that I have lived through. The main point is that we could be due for one which will be called an upside breakout to recognize how productive the world will be in the future. What has me particularly concerned is that various studies at Caltech and elsewhere have found that many participants in a simulated bubble knew it was risky, but were playing the so-called “bigger fool theory” that were paying too much but believed that they could sell at a bigger price. When the eventual decline is underway the most likely panickers will be the bigger-fools turning on themselves.

Statistical hurdles

In trying to convince investors of the soundness of any manager or investment thesis, back-tested results are brought out. Notice none are shown that put the proposed concept at a disadvantage. While I am skeptical about all back-testing I am particularly cynical of ideas that do not show the purported annual performance since 1990. Better yet would be quarterly performance since 1985. The comparisons should be against live, expense-paying competitors not a publisher’s collection with its own biases.

Investment applications

Far too many investors and some managers are using Index funds, ETFs and closet indexers to meet the investment needs of their institutional and individual clients. These are closed minded systems that only change their holdings when required to by outside forces that have nothing to do with sound investment judgment. One of my real concerns is  that in the rapid acceleration phase of a bubble; e.g., the run-up of Apple’s price to $705 in NASDAQ and other portfolios created all kinds of risks. This was just the parabolic performance impact of one stock; imagine the long term impact of a bubble on the whole index. This may well explain why the NASDAQ Index is still well below its peak during the Internet bubble of the 1990s even though many of the companies within the index have prospered.

Professor Einstein had it right when he focused on what we can measure and what we can’t.

What are you not measuring that you should?           

_______________________

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.