Posts published in November 2013
Another holiday season is upon us. Whether preparing a traditional turkey meal, pushing the envelope with avant-garde culinary experiments, or celebrating the rare and delightful convergence of Thanksgiving and Hanukkah, this is a time of year when we like to take a moment to breathe, stand back from the daily craziness of our lives, and give thanks for all the blessings that are ours. In that spirit, we’ll spend less time in this week’s Market Flash dwelling on negatives like political dysfunction or corporate wrongdoings, in favor of the more positive attributes proceeding from the investment world for the year to date. For this week, at least, we will prefer to look on the bright side of life.
Recovery Slow, But Steady
We came out of the recession in early 2009 and have enjoyed consecutive quarters of GDP growth ever since. It’s not yet as much growth as we would like, but growth nonetheless. The unemployment rate has come down from over 10% in 2009 to just over 7% today. Now, as investment analysts we look at the unemployment rate as just another macroeconomic data point, an input to our predictive scenario models. But behind the numbers are real people: fathers and mothers, spouses and partners, humans trying to improve the quality of their lives through meaningful employment. Every downtick in the unemployment rate, every addition to the monthly nonfarm payrolls, is a reason to be thankful and hopeful.
In our weekly posts we are more often than not critical of political actors and policymakers. We certainly are not Pollyannas who think all is well with the world and its governments – far from it. But as cynical as we can be, watching another fiscal reform initiative or budget resolution get kicked down the road, we should be mindful of the fact that, with each crisis point, the worst outcome has been averted. For a good part of that we can thank the Federal Reserve and other central banks. Their decisions have in no way been perfect. But they have held the European currency zone together, smoothed over some of the rougher patches in our economic trajectory here in the U.S., and even helped to put long-suffering Japan back into position for economic recovery. We want the world to be a more prosperous place, and are supportive of measures that seek to accomplish prosperity within the boundaries of prudent economics.
Business Innovation Continues
Corporate America also frequently finds itself in the crosshairs of our unsmiling analysis in these pages – again, with good reason. But let’s also give thanks for the spirit of innovation and progress that we believe is still alive and well in our country. With top-line economic growth slow, the corporations that make up our major U.S. stock indexes have still managed to grow their profits to record levels. How have they done this? First, by seizing opportunities in new markets. Companies as diverse as Microsoft, GE and Cisco Systems have some of their largest operations and research facilities in places like India and China, and have learned how to expand their sales in these dynamic countries. Second, businesses are ever finding new ways to improve their cost structures and leverage technology. Profits are good for businesses and good for investors. As much as one can attribute the market’s strong recent performance to the Fed and quantitative easing, strong corporate profits have kept valuations reasonable and out of bubble territory.
As for us here at MVCM, we are thankful for the chance to do what we love doing every day of the week, and for the honor of managing the assets entrusted to us by our clients. A very happy Thanksgiving to each and every one of you.
16,000. 4,000. 1,800.
It’s the harmonic convergence or planetary alignment– pick your divine sign – of the capital markets. The three most widely tracked U.S. equity indexes are all flirting with these perfect round numbers, these Platonic metrics of stock market performance. The Dow Jones Industrial Average closed above 16,000 for the first time on Thursday, while the S&P 500 has moved above 1,800 in intraday trading, and the Nasdaq Composite is closing in on 4,000. The last time Nasdaq saw 4,000 was coming from the other direction, as it fell from the 5,000 level it briefly grazed at the height of the tech bubble in 2000.
Perception Becomes Reality
What’s with the round numbers fixation? It’s just a number, right? Actually, no, it’s not just a number. Sometimes perception has a way of becoming reality. Consider the following chart, which shows the price trend of the DJIA over the past three years.
The chart shows a fascinating repetition of support and resistance levels, all of which coincide with those perfect round whole numbers. Case in point: the Dow reached 12,000 in the first quarter of 2011, after a breakout above the previous support level of 11,000. It had trouble breaking 12,500 (an intermediate round number) but also managed to find intermediate support above 11,500. Then it broke through to rally up close to 13,000, which then became the next resistance level. This pattern of support, resistance and eventual breakout rally or pullback continues all the way to the present.
In fact, today is a textbook day in the annals of the round number fetish. As we write this the Dow is about flat for the day, holding on above the 16,000 mark it reached yesterday. Meanwhile, the S&P 500 is juuuuust below 1,800, trying to make the most of a generally upbeat trading day. As for the Nasdaq, it would simply take an afternoon trading surge to propel it from its current intraday level of 3,985 up above that magic 4,000 level. Perhaps it will be there by the time you read this.
Traders of a Feather Flock Together
The only reason why there is anything special about the round numbers is because traders (of both the human and algorithmic variety) make them special. Professional traders for the most part have a day-to-day mentality. They will take profits, hedge their bets and re-up the ante in measured steps. When the market approaches one of these round number inflection points, the general sentiment will be to stay one’s hand for a bit, maybe realize some profits (or cut some losses), and trade cautiously ahead of the next breakout. If one trader does this, it’s nothing special. If lots of traders do it, it becomes a regular feature of the market.
From 16,000 to Where?
Of course, seeing a pattern of resistance and support is one thing; figuring out where the market’s going to go next is quite another entirely. You can see from the chart that not all round number events are of equal duration or magnitude. For example, when the Dow reached 14,000 in the first quarter of this year it didn’t pause for very long, a couple weeks or so, before breaking above resistance to rally up to 15,000. On the other hand, it took more than a year for the index to finally shake the 12,000 support level for once and for all.
We have to weigh several factors that could be key influences in the weeks ahead. We’re heading into the last month of the year, which is often a momentum month that amplifies whatever trend is currently underway. However, the major indexes are all comfortably above 20% for the year to date, so in the absence of new news there may be a limit to how much farther a year-end “melt-up” can go. There is also quite a bit of chatter among industry pundits about current price levels relative to earnings prospects for next year. We shall have to see what this round number inflection point holds – and whether it holds in the same way for 16,000, 4,000 and 1,800.
If you stand in the check-out line of a supermarket on a regular basis, then you know that a significant percentage of Americans have an extreme interest in the goings-on of anybody named Kardashian, or the unfortunate apparel choices of Miley Cyrus, or the latest rehab adventures of Lindsay Lohan. Now, picking up a celebrity tabloid from time to time is arguably nothing more than a harmless guilty pleasure. However, the same cannot be said for another species of sensationalist reporting, what we like to call the financial tabloids. What’s the difference? Well, you won’t find the financial tabloids bedecked in garish coloring, perched among the likes of National Enquirer and OK! magazine at your local Safeway. The financial tabloids intend for you to take them seriously, and that’s why they are dangerous.
Clickbait Above All Else
The Internet has changed the way we read, and the way that publishers of content earn money. The ultimate goal of an online magazine or newspaper is the almighty click. The more clicks, the more eyeballs, and the more eyeballs, the more advertisers will pay to market their wares on your site. Quod erat demonstrandum – clicks = profits.
Increasingly, the method of choice to get those eyeballs is the “clickbait” technique. This technique usually involves a headline or teaser spiced up with something alluring to bring you in. The online versions of those celeb rags can do this just by dropping “Kardashian” into the headline. The financial tabloids, of course, know that they’re not going to lure the unsuspecting masses into their lair with a lead-in like “Stock Market May Be Trending Towards Higher Than Average Valuation Levels”. They prefer to play the doomsday card: “Market Crash In Next Two Weeks? Find Out What The Experts Think!”. It may be accompanied by what the industry likes to call a “sad trader photo”. You know – the iconic trader at his desk, face in hands, while hundreds of blinking lights flash red behind him. Get those emotions flowing!
The High Art of Cherry-Picking Data
The financial markets are awash in data. Price, valuation, risk and many other metrics abound, as do expert opinions about what the data points are telling us at any given time. When reporting on, say, the outlook for the stock market, a good financial article will present a balanced view of competing (often contradictory) data points and arguments. The financial tabloid will take a different approach. It will cherry-pick the data that offer evidence for whatever sensationalist claim it is making, and usually rely on one or two sources to supply the arguments without presenting other opinions to the contrary. Now, if you read the article closely you will be able to draw out all kinds of hedges and weasel-words (the tabloids don’t want lawsuits any more than anyone else). The hope, though, is that you’ll just skim the article and come away petrified. Maybe even that you’ll click onto that e-brokerage firm ad helpfully placed next to the article, where you can sell all your stocks in a panic and generate fat commissions for someone.
Serious or Sensationalist?
All well and good, you might say, but how can I tell whether the respectable-looking site I’m visiting is a tabloid or a serious financial paper? That’s a real problem, because there are so many financial publications of poor, sloppy and sensationalist quality that dress themselves up to look just like the ones you can usually rely on for sober, relatively unbiased news. Without naming names, we at MVCM tend to stick with a small handful of established media concerns that have built strong reputations over many years of high quality reporting. For us they are reliable, insightful sources for keeping informed about markets, assets and economies, with a refreshing absence of “Apocalypse Tomorrow” headlines.
What a difference eighteen months make. That’s the amount of time which has elapsed since Facebook’s ill-fated debut into the public markets: a debut marked by overly optimistic pricing, trading glitches, and sour investors resolutely not “liking” the social media behemoth.
Not so this time around. November 7th marked the coming out party for yet another denizen of tech Valhalla, Twitter (NASDAQ: TWTR). On a day when the NASDAQ composite fell by more than 1%, shares of Twitter soared 73% from the primary offering price on the back of strong retail demand. Once again, those of us who make a living observing and studying the habits of markets and investors are left debating the merits and potential pitfalls of investing in a company with a larger market capitalization than General Mills, and no profits as far as the eye can see.
Institutions to Retail: Thks & Cya
The future fortunes of Twitter probably matter very little to many of the institutional investors invited to the ball. The primary offering was 90% subscribed by institutions, with only 10% allocated to retail investors. The institutions were presumably happy to gobble up the shares at the $26 offering price and then regurgitate them to the masses who poured into the secondary market. As the chart below shows, the opening bid was just under $46 and shortly thereafter soared briefly above $50. According to the Financial Times, up to 30% of those initial secondary market trades were retail investor-driven.
So the institutional investors who did sell out in those early moments booked a tidy profit of as much as 100% – nice work if you can get it! For the others left holding their shares at the end of the day, though, there are some serious questions about what those shares may be worth in the future. We’ve seen this story play out before. It’s just that, knowing very little about how this company ever intends to generate positive cash flows, the story’s end is completely unpredictable. When Amazon went public in 1997 it was also a giant money-loser. It still is, but it also dominates its market in a way that has investors keeping the faith. Other “wing and a prayer” offerings from that era of Internet 1.0 didn’t fare nearly as well. Pets.com and its loveable sock puppet joined many other once-promising enterprises on the ash heap of investment history when the bubble burst. It’s entirely possible that this 140-character mode of communication will come to dominate our lives more and more…and it’s entirely possible that it will prove to be little more than an effervescent fad.
The Compressed Tech Business Cycle
One of the biggest challenges facing any tech company today is the extremely short lifespan of the product life cycle. One day we’re addicted to something we couldn’t even imagine a year earlier, and then in the blink of an eye some other Pied Piper has lured us down another path entirely. Think of Research In Motion, the company that pioneered the BlackBerry. BlackBerry was not the first smartphone (that honor would probably go to NTT DoCoMo’s iMode in the late 1990s), but it had features and capabilities that at the time were truly revolutionary. In the mid-2000s the world of hip urban professionals was hooked on the “CrackBerry”. Then along came the iPhone. Today the BlackBerry is arguably as obsolete as the home fax machine or the VHS, and RIM can’t find anyone who wants to buy it.
The future is unpredictable. Maybe Twitter will succeed, maybe not. But there is too little hard, quantifiable information available today for us to feel comfortable with any kind of an informed decision one way or the other.
We have been in a growth market environment since March this year, when the S&P 500 recaptured and surpassed its previous record high of 1565. Is this going to become the next macro growth market – only the third since 1954 – or will history record it as yet another false dawn? This is the key question weighing on our minds as we begin the preparation of our 2014 strategy models.
Growth and Gaps: A Refresher
A macro growth market is one in which broad market indexes, like the S&P 500, surpass a previous record high never to return. Conversely, when the market turns down and fails to reach its previous high, we are in a gap market environment. We call it a “gap market” because, in the context of a long term price index chart, these periods look like gaps in an otherwise upward-sloping trend. The chart below shows a history of growth and gap markets from 1929 to the present:
We see that, in each of the past two gap market environments, there were false dawns. This is when the market manages to recover its losses and set a new record high, only to fall back down and extend the gap market. It happened twice in the ’68-82 environment, in 1973 and in 1981. More recently, the S&P 500 regained all the ground it lost after the 2000 tech bubble collapse, reaching new highs in October 2007. That was the falsest of false dawns. Equities turned down in late ’07 and slid into the cataclysm that was 2008. At its worst, the 2008-09 drawdown took the S&P 500 back to levels last seen in 1996.
In the Mix: Easing and Earnings
Thanks largely to the Fed and the European Central Bank, markets have managed to fend off a handful of curve balls thrown their way on the road to regaining lost ground. Experts may debate the effectiveness of quantitative easing on the real economy of jobs and production, but there is little doubt that it has propped up the values of financial assets. At the same time, corporate earnings have also reached record levels. The robust pace of earnings growth has kept markets from entering bubble territory. We can see this in the following chart, which shows the ten year performance of the S&P 500 price index and its TTM (twelve trailing months) price-to-earnings (P/E) ratio:
While asset prices have advanced steadily over the past several years, strong earnings gains (the denominator of the P/E equation) have kept valuation levels in check. The key question is this: in a world of sluggish GDP growth, can companies continue delivering the results? A key determinant of recent growth has been an increased global footprint by S&P 500. Global growth has slowed, though, including many of the key growth engine markets. Brazil’s real GDP growth in 2012 was under 1%, putting it in the company of the anemic Eurozone economies. With a slowdown in top-line growth, companies will have to continue making the efficiency gains in their cost structures that have been the other key growth factor.
When we make investment decisions we do so around the likelihood of alternative outcomes. We continue to be of the view that the likeliest outcome for 2014 will be a continuation of the growth market trend, albeit with some potential pullbacks along the way. But we remain mindful of the potential for false dawns and the need to be vigilant sentinels of the portfolios under our management.