Posted by Rob Weigand. The increasingly negative mood on Wall Street provides us with a good learning laboratory. As I’ve written previously, periods of declining stock prices are great times to study investments because they focus our attention. When prices are rising and we’re all getting wealthier, we tend to ask fewer questions. We’re not compelled to figure out how things work as much as we are when our portfolios are declining in value on a near daily basis.
As Pimco’s Bill Gross recently put it: “We have for so long now been willing to be entertained rather than informed, that we more or less accept majority opinion, perpetually shaped by a ratings-obsessed media, at face value” (from the June 2008 Pimco Market Commentary).
This posting will explain why the current market mood turned so negative so quickly. The subtle conspiracy of good news that the financial media has been feeding us has finally exhausted itself. My second choice title for this posting was Harvest of the Hypesters. The hypesters I’m referring to include all those anonymous geniuses and their risk management models who developed the “structured products” that have gummed up the global financial system, but also some “brand name” hypesters that are worth a quick mention.
Number one on this list has to be Ed Yardeni, who has been selling clients on his “Great Global Boom” story since 2003. Ed used to give academics a free subscription to his website and daily emails, which I used to think was quite generous of him. It was helpful to see how he constructed his overall strategy, and I appreciate the years of insightful reading he provided. I became suspicious, however, when he abruptly stopped the subscription. I am now of the opinion that when Ed was broadcasting the Great Global Boom story, he wanted to feed it through as many channels as possible. But when he was about to change his tune to the Great Doom and Gloom story, he didn’t want his about-face visible to the world-at-large.
Another hypester that deserves a quick mention is Jim Cramer, the clown prince of cable TV, who has done more harm to individual investors than anyone in history. The damage inflicted by Cramer stems not so much from his poor stock picking ability, which has been documented by academic research, but more from the “shoot-from-the-hip” approach to “investing” (actually trading) he promotes. Cramer’s advice results in clients trading far too often and generating fees and commissions that make the brokerages wealthier and the clients poorer. Having come of age in investing watching the thoughtful Louis Ruykeyser program for years, I am deeply saddened to see the millions of people who watch Cramer’s idiotic histrionics, and so enthusiastically. Like Ann Coulter, Cramer gets rich simply by acting outrageous at our collective expense.
Abby Joseph Cohen is another Hypester-Hall-Of-Famer who was quietly demoted by Goldman Sachs in late 2007 when her perennially cheery market forecasts outlived their usefulness. For years Ms. Cohen was trotted out in front of the cameras to offer her matronly brand of comfort whenever markets got preoccupied with a bit of bad news. I miss watching her eyes comically dart back and forth as she struggled against the teleprompter while reading the propagnda du jour. Ms. Cohen’s professional persona was a fictional character, created to feed the positive propaganda machine — she was renowned for endearing folksly habits like thiftily riding the bus from Queens to Manhattan every day. In the Grand Theater of the Financial Media Ms. Cohen played the role of the scholarly librarian who “shushed” our fears and comforted us with the same bedtime story every day — markets can only go higher, and if we stay fully invested in equities we will all live happily ever after.
How about a quick mention for Forbes’ Ken Fisher, who in December 2007 published a column informing readers that “we are entering an era of above-average returns.” Well, they say timing is everything. Of course, Fisher has issued this pronouncement regularly for the past decade — despite the fact that it’s been a period of below-average returns, something well-known to every portfolio manager from Boston to Bangla Desh.
As I wind down this rant, let’s not overlook Dylan “The Brawler” Brautigan (“I’ll thrrrrash any man who says a word agin’ these marrrrkets!”) and his merry band of wild-eyed traders on CNBC’s “Fast Money.” (Don’t you just love the guy on the show with the ninja ponytail who never blinks? You know, the samurai options trader.) Or how about Maria-the-Diva Bartiromo, who saves her sultry “come hither” glances only for the most bullish guests. Whoops — almost forgot Larry Kudlow, who’s been touting the “Goldilocks” economy (everything is just right) for months now. Yeah, Larry, everything is just right. I know a few million subprime mortgage holders who would love to throw a bowl of scalding porridge right in your face.
Conclusion: These people are not journalists. They are actors on the stage that’s become our national financial media.
Now, before you criticize me for being biased and not applauding the prescient calls of some of the doom-and-gloom market forecasters, allow me to point out — there are almost none to applaud. You can’t survive in the investments business if you broadcast a cautionary tale in public. You have to save that for the real advice you offer privately to your best clients. Viewers don’t watch as much CNBC and Bloomberg TV when markets are falling and the outlook is gloomy. And advertisers aren’t interested in buying ads on TV stations that focus on bad news — even when bad news is reality.
To better understand how this stream of positively-biased information has been affecting markets, let’s get technical for a moment. Picture a regression equation with stock market returns (on the left-hand side) explained by a set of factors on the right-hand side such as economic growth, inflation and interest rates, consumer spending, the trade deficit, the relative value of currencies, etc. And remember that each of the explanatory factors has a regression coefficient attached to it — the coefficient measures how sensitive stock returns are to each factor. Now here’s the key point — market participants decide, collectively, how much to weight each factor. Even when the news is bad, they can completely ignore it — the market sometimes assigns a negative weight to bad news (think about the way stocks surged in the Fall of 2007 despite horrible news, and rose again in the Spring of 2008 under similar circumstances).
So what’s going on now? Why are stock prices falling every day? People have stopped ignoring reality. There is simply not a shred of good news out there to divert our attention from what’s been going on. Let’s go down the list of what’s on their mind. It’s not a pretty picture.
Remember how we were supposed to be transitioning to a “knowledge economy?” Well, it seems that all the brainpower that’s been concentrated into money management has resulted in the current financial crisis — the worst since the Great Depression. Is it too outrageous to propose that it’s time to consider re-assigning these people to jobs where they can do far less harm? It might be easier to just pay them to stay home for the rest of their lives. All these astrophysicists and aeronautical engineers running hedge funds and investment banks have used their great mathematical sophistication to tie the world’s financial system into an enormously complicated knot. Our rationale for locking people up in Guantanamo was that it would prevent future terrorist attacks. Well, these people have committed terrorist acts on the global financial system and the wealth and prosperity of the United States. Sequestering them on a desert island might create value in the aggregate.
So we’re the world leader in banking and investing and this is where it got us. Great. Well, at least we can fall back on making stuff, right? Whoops, not so fast. At the market close on June 26, CNBC reported that General Motors’ stock is now at a 50-year low. There is a non-zero probability GM will go bankrupt. Detroit has been downsizing jobs for years, a trend that may be radically accelerating in the near future.
When he was circulating his newsletter, Yardeni once quipped, “I’m not giving up on U.S. consumers — every time I’m tempted to turn negative, they bail me out.” The U.S. consumer is in sad shape and unlikely to bail anyone out for quite a while. Households have too much debt, not enough retirement savings, and many have negative equity in their homes, which continue to fall in value. Good thing the tax breaks of the last eight years mainly benefitted the ultra-wealthy.
Well, the only thing that could make all of the above worse would be inflation. And guess what? We’ve got an inflation problem, and world central banks are not coordinated in their approach to fighting it. The European Central Bank is raising rates while the U.S. Fed is sitting tight. News of this drove the U.S. dollar sharply lower, after it had rallied a little in recent weeks. And a weaker dollar just makes the inflation problem worse. Laughably (if you like having jokes played on you), one of the arguments as to why the Fed can wait to act is that we don’t have a “wage-price” spiral as we did in the 1970s. That means that salaries are not keeping up with inflation. Well, that’s great news, isn’t it? The U.S. consumer is not only in a tight spot, but is so worried about being laid off from work that he/she can’t even ask for a fair pay increase any more.
And that, gentle reader, is why stock prices are falling every day.
You can write to Rob Weigand at email@example.com or find him on the Web at Rob Weigand’s Home Page.
Posted by Rob Weigand. I expect that, in light of the recent sharp declines in the value of U.S. and global equities, the pundits will begin playing their version of the classic game “Where’s Waldo,” except in this case the prized object they seek is the elusive concept known as the “market bottom.” There is a lot riding on their quest. “Market timers” who can call a bottom and direct clients to make aggressive asset allocation changes out of bonds (and other safer assets) and back into equities can earn large excess returns. Even more importantly, these excess returns measure up as alpha (the type of outperformance for which managers can charge hefty performance fees). Let’s take a trip down memory lane and see how far the value of equities have fallen in previous bear markets.
The graph shows that, as far as bear markets go, “we ain’t seen nuthin’ yet” in the 2007-2008 bear. The S&P 500 is only down 13% since its high in July 2007. The bear market declines of the 1930s, 1940s, 1970s and early 2000s were all far worse (-85%, -39%, -40% and -43% respectively). What’s more disturbing to me is, when we look a little longer term, we see that today’s value of the S&P 500 is 10% lower than its high in August 2000. That means we’ve been in a no-gain trading range for 8 years. As the chart shows, this is not uncommon historically. For example, after almost 20 years of gains, stocks meandered around a big trading range from 1961-1972, then rose and fell sharply from 1972-1974.
Why do stocks get mired in low-return trading ranges following big run-ups? Let’s look at the next chart and consider an answer to this question.
Notice that big stock price increases are usually accompanied by expansion of the market P/E ratio (we use a 10-year moving average of earnings in the denominator to smooth out the short-term volatility in earnings — let’s call it the P/E10). In other words, big bull markets are not only driven by increases in corporate earnings and dividends, but also by how much per dollar of earnings investors are willing to pay to own stocks (what the P/E10 ratio measures). In this regard the market P/E10 ratio can be thought of as a measure of investors’ long-term optimism about the future. It only makes sense to pay more to own stocks if you think future earnings will grow faster than they’re growing now.
Unfortunately, the chart shows that investors get more than a little euphoric during these bull market periods, and the market P/E10 ratio eventually reverts to the mean (usually significantly overshooting on the downside), bringing stock values back down with it. In 1929 the market P/E10 hit 32, then bottomed out at 5.6 by 1932. In the extended bull market from 1942-1961, the market P/E10 expanded from 8.5 to 22. One of the reasons stock returns were stuck in a trading range from 1961-1972 is that the P/E10 stayed mainly above 20 from 1961-1969 (similar to today’s high P/E10). In 1974 the market P/E10 bottomed out at 8.3 and stayed low until 1982, when it fell as low as 6.6. These were some pretty bleak years in the stock market. But from 1982-1999 the P/E10 expanded all the way to 44, symptomatic of a phenomenal bubble.
This gives us an interesting framework for understanding what drives bull and bear markets. The best bull market returns have been driven, at least in part, by expansion of the market P/E10 ratio. Unfortunately, as the P/E10 expands, it sucks some of the future expected return out of equities. It used to be the case that expected returns got reset as the P/E10 contracted to ridiculously low values (8 in the 1930s and 6 in the early 1980s). Apparently, it really is “darkest before the dawn” in terms of relative equity valuation. Investors’ despair over the stock market, reflected in super-low P/E10s, sets the stage for future bull runs.
Now here’s the problem — during the 2000-2002 bear market, the market P/E10 never fully corrected. Despite a 43% decline in stock values over this period, at the market bottom the P/E10 remained high, at 21. The current market P/E10 ratio is stuck in a range (25-29) that’s higher than we’ve ever seen (the long-term average is about 15). This means that the stock market might suffer from a dual problem. In addition to going nowhere for 8 years, the stock market has still not finished repricing equities to have the sort of long-term expected returns that get people profoundly excited about owning stocks. When you hear people like George Soros and Jeremy Grantham say that we are in the midst of the greatest global bubble of all time (real estate, commodities, US and global equities), this is what they’re talking about. The value of all investable assets is higher, relative to fundamentals, than ever before — which means that the expected returns for these asset classes are lower than ever before. And all this is playing out just as investors are reawakening to the harsh reality of what a risky world it is. Thus risk is getting re-priced into the value of US and global equities (and real estate, with commodities likely to follow), and prices will keep falling until investors believe the risk premia are sufficiently enticing to warrant a new wave of buying.
Now, all this does not mean that we are NOT at the market bottom — but it does mean that there’s not much (rational) upside from here, either. In conclusion, let’s take a peek at an experiment I’ve been keeping track of for several years now. It’s not a very scientific one, but I’m sure you’ll agree that it’s interesting. In the chart below, I’ve overlayed graphs of the Nikkei 225 leading up to and following the Japan bubble of the 1980s with the S&P 500 leading up to and following the US stock market bubble of 2000 (in logarithms so that percentage changes in the indexes are visually comparable). Notice any similarities? The point is, based on this chart and the ones above, it would not be unprecedented for post-bubble economies to earn crummy, below-average returns for 10-20 years following the unwinding of bubbles. And we’ve got bubbles that aren’t even close to being fully unwound yet. Lots to think about there.
Posted by Rob Weigand. Well, at least the Royal Bank of Scotland’s prediction for a global market crash passes the Revelations 3:15-16 test (which abhors those who cling to wishy-washy opinions and advises that we take a strong stand, one way or another). In case you missed it, on June 18, 2008 RBS issued an advisory calling for a 20% crash in the S&P 500 accompanied by significant global contagion. Their thesis is based on economic weakness, runaway inflation and an impotent Fed, who is apparently reluctant to join the ECB and raise rates to combat global inflation.
You can check out the report on CNBC at the following link.
Not surprisingly, this has gotten me thinking. First of all — can it really be the case that the “strategists” running the world’s elite financial institutions are just waking up to all the negative factors that have been weighing on markets for the past year? You know, things like the overleveraged U.S. consumer dealing with $4 a gallon gasoline and declines in the value of residential real estate; high energy costs putting a drag on the general cost of doing business, paticularly global transportation (FedEx reported disappointing earnings today, which is troubling, because global growth depends on a robust shipping infrastructure); bubbles yet to pop in commodities and emerging market stocks; and a banking/credit creation system that remains extremely reluctant to finance any sort of deal, even high-quality ones. Apparently the answer to this question is yes — these deep thinkers could not work through the math of all this until it hit them right between the eyes. Perhaps they are finally “getting the memo.”
My second thought is, why should we listen to RBS (or Merrill, or Lehman, or any of them)? Collectively, the world’s investment banks have lost almost half a trillion dollars in the credit crisis, with more steep losses to come. If they weren’t thinking clearly when they were building all those sophisticated risk management models (that turned out to be useless), why should we believe they’re thinking clearly now?
Third on my list is the old rule of contrarian sentiment, and one of my favorite stock market terms, capitulation (read more on capitulation at CNBC.com). I love that word. Regarding sentiment, research shows a strong inverse relation between overall stock market sentiment and future returns. In other words, when the majority of professional opinion is unusually bearish, future returns tend to be better than average, and when opinion gets unusually bullish, markets tend to correct downward. How negative is current market sentiment? Well, for example, Thomson/Reuters reports that short interest (volume of shares sold short) on the NYSE is currently at its all-time high (story available at the following link). Perversely, history tells us that all of this negative sentiment can be interpreted as a positive sign.
Strong negative sentiment is related to the idea of capitulation, which says that, in a bear market (and this is definitely a bear), we have to have several waves of cathartic selling before we can find the bottom and set the stage for a future bull market (and yes, there will be a bull market in our future, it just may be a long way off). Investors capitulate in the sense that they surrender to the overwhelmingly negative market sentiment and everyone just sells, sells, sells. Old-time technical analysts believe that true market bottoms require a few waves of capitulative selling. I would propose that every time the Dow dips below 12,000 (which has occurred 3-4 times in the past 12 months) we are in “capitulation country.”
So it looks like more rough going ahead before markets right themselves. The market hates uncertainty, and there are too many unresolved questions standing in the way of a bull market. Foremost among these are Will banks ever feel like lending money again? and How can the global economy grow robustly and fight inflation at the same time? (Answer: it can’t, but history shows that the long-term effects of inflation are worse than the short-term effects of recession — the U.S. Fed is playing a dangerous game by refusing to take a tough stand on inflation.)
I think it’s going to get more interesting (on the downside) before we can breathe easy. The next bull market will begin after the market overshoots fair value on the downside, which has not occurred yet. Given all the risks out there, a level of 12,000 on the Dow translates into a risk premium that is just barely necessary to get investors interested in owning equities again. Investors won’t rush back into equities until they perceive a profound bargain, probably around Dow 11,700 (or a little lower).
Looking for a silver lining, it’s a great time to study investments. This is the most rational markets have been in the eight years since the great U.S. stock market bubble began its extended unraveling (eventually finding a bottom at Dow 7,700 in November 2002). All the classic themes are playing out, just as the Warren Buffet/take-the-long-view-of-things investment philsophy says they should. Read The Wall Street Journal and watch a little CNBC every day. There is no better investments education than living through a protracted bear market. It’s even better if you’ve got some wealth at risk and are suffering some losses. These experiences are great for focusing your attention.
Posted by Rob Weigand. Let’s think about last Friday’s absurd 3.25% drop in U.S. stock markets. Markets were allegedly spooked by:
1.) a sharp rise in unemployment — to 5.5%, only 0.5% above the traditional definition of “full employment”;
2.) comments from Israel that a military strike against Iran’s nuclear facilities was inevitable; and
3.) a large increase in the price of oil . . . back to where it was a week ago.
Are we supposed to believe that the market was so stunned by these events — events one would think were not all that difficult to anticipate — that stock values had to drop by 3.25%? Actually, no.
What we’re witnessing, with yesterday’s market mania of +1.5% and today’s market depression of -3.25%, is the result of what’s known as momentum trading. When the idea of a momentum trade is forming in a trader’s head it sounds something like this: “Stocks are going up (down) today; I think I’ll buy (sell) some, too.”
You may have noticed that, in the last year in particular, markets have had a strong tendency to start out in one direction (positive or negative) and continue in that direction all day, whether up or down. This tells us that momentum trading has been particularly popular over the past year. In the face of all the volatility and uncertainty, and with bubbles popping faster than a bag of Orville Redenbacher in a high-powered microwave, this is what we pay our investment advisors to do — think deep thoughts like “I think I’ll do what everyone else is doing today. And tomorrow. And the next day. And again and again, as long as these supersized paychecks keep coming.”
I’m curious how others view momentum trading. Do you think this is what professional investors pitch to pensions and endowments when they’re trying to get new assets under management? Pension: So, tell us about your best strategy for beating the market. Manager: Well, when the market appears to be running strongly in a certain direction, we try to time some short-term trades to get in and out before the trend reverses. (Note that market timing, or strategic exposure to beta-returns, does measure as alpha, or active outperformance.)
Maybe it’s just me, but I don’t think too many conversations like that actually take place. But somebody is buying and selling all these stocks and contributing to all that momentum. Trying to earn alpha. In a way they probably don’t want to explain to clients.
I’m looking for a moderate rebound in U.S. equities, as early as Monday June 9, but certainly by the end of the week. Unless oil really does go all the way to $150 a barrel. Then, it’s time to duck and cover.