Tuesday Morning Reads: value investors hoarding cash


Some things I’m reading this morning:

  • Apple:  revenue up & profit margins at the top end of range (MarketWatch)
  • Paul Tudor Jones: U.S. stocks will outperform other equity markets for the remainder of this year (Bloomberg)
  • Value investors hoarding cash (Bloomberg)
  • Cautious optimism on the economy (WP)
  • Poster children for buybacks-trump anything investing (TRB)
  • W.H.O declares Nigeria free of Ebola (NYT)
  • Update on Europe’s Quantitative Easing initiative (Zerohedge)
  • Bill Murray’s words of wisdom (TheDailyBeast)

Repeating the mistakes of Ben Stein?

Who is Ben Stein?  He’s a lawyer, a political commentator, President Nixon’s speechwriter, the economics teacher from Ferris Bueller’s Day Off (click here for a clip of his role) and even a self-proclaimed economist.  He has been so successful at selling himself as an economist that he landed a coveted role writing a weekly column about finance and the economy in the NY Times.  He has since moved on from that assignment, but I have seen him recently talking economics and markets on Fox Business.

Why does this matter?  Because on August 7th in 2007 Ben Stein penned an article in the NY Times titled Chicken Litttle’s Brethren, on the Trading Floor.  You can click the title for the full article or just let me briefly summarize the crux of Stein’s argument:  when the article was written, the subprime mortgage market was experiencing some cracks and the equity markets had sold off some 6% from their highs.  Mr. Stein basically argued that the subprime mortgage market, at only 13% of the total mortgage market,  was too small to cause damage to the broader economy and stock market (“these subprime losses are wildly out of all proportion to the likely damage to the economy from the subprime problems.”).

The rest, as they say, is history.  The S&P 500 peaked a few months later in October of 2007 and proceeded to sell off 60% over the next year and a half.  The problem, as we all know now, was in large part due to the problems with subprime lending.

What’s noteworthy about Mr. Stein’s argument is not that he inaccurately calculated the implosion of the subprime market that was really only just beginning during that summer of 2007.   99.9% of us made a similar mistake.  As Michael Lewis documented so well in his book The Big Short, there were only a handful of people that recognized the impact of the credit problem and actually had the conviction to trade on their belief.  No, what’s striking about Mr. Stein’s argument is how naive it was to dismiss the interconnectedness of financial markets in addition to the emotion/human psychology that drives investors to hit the sell button.  As an “economist” he should have been aware of leverage ratios at banks.  As an actor he should have seen the movie It’s a Wonderful Life with its bank run scene.

Fast forward to today.   Over the weekend “The Trader” column in Barron’s described reasons to dismiss the “wall of worry” in today’s markets.  Ebola, the end to QE, etc.  Well reasoned arguments, for sure, about these concerns.  But here’s what was said about Europe:

“The next worry is deflation in Europe spreading to the rest of the world. First, sustained deflation is not common and Europe isn’t there yet. True, the euro zone is recessionary in some countries and basically is showing no growth as a whole.

‘Yet, how is this different?’ asks Chris Hyzy, chief investment officer of U.S. Trust. The euro-zone economy has shown 1% growth to 1% contraction for the past three years. On the margin, Europe is a negative factor, adds Dan Morris, global investment strategist at TIAA-CREF, but the U.S. isn’t a trade-dependent economy. U.S. exports are about 13% of gross domestic product, half of Germany’s ratio.”

There’s the 13% figure again.  Obviously it’s by coincidence that we see this identical statistic as the one referenced in the aforementioned 2007 article.  But it’s eerily reminiscent of Stein.  What’s really at stake is not the relatively small exposure that the U.S. has to the Eurozone, but how a such a small percentage can metastasize based on fundamental issues (implosion of European banks will impact U.S. banks) and a spreading of fear should the worst happen.

It’s too early to panic.  But there are signs of real risk in the Eurozone as growth continues to slow.  If problems persist, a policy response by the European Central Bank President Draghi will likely stave off any potential disaster for the near term.  However, that response involves convincing 18 European countries–including Germany–to commit to such a response.  At this point, we can’t be overly confident that this will happen, and thus, the Eurozone remains our largest fear for equity markets.

Stock-Market Bargains Abound After Last Week’s Selloff


This weekend’s Barron’s had two bullish articles about the prospects for continued stock market price appreciation.  Below, I’ve copied the introductory paragraphs to the first of those two articles.  The second article eerily reminds me of another optimistic piece written prior to the market rout in the fall of 2008.  I’ll comment on that one in a later post, but for now here is a take that succinctly & reasonably highlights some positive aspects to this current market. 

A four-week losing streak has sent the Standard & Poor’s 500 index down 6.2%, and stoked investors’ fears of a looming bear market. To many market pros, however, the dip has been like a Halloween horror movie—worth watching but not to be taken too seriously.

In fact, they now see a chance to load up on stocks after such indiscriminate selling. Even after Friday’s 1.3% rally, lots of quality stocks appear to be good buys.

Fundamentally, the market is fairly valued, but not overvalued, and the economic backdrop remains healthy. The U.S. economy looks to be growing at a healthy pace—4.6% in the second quarter and an estimated 3% in the third. Third-quarter earnings are expected to rise 5.1% year to year, according to FactSet. Employment and manufacturing growth reaffirm the trend, and while retail sales slipped 0.3% in September, falling gasoline prices have boosted consumer confidence.

“There’s a disconnect between the sharp market drop and the still-improving fundamentals of the economy and earnings growth,” says Kate Warne, a strategist at Edward Jones.

Trading patterns also indicate confidence in the longer-term outlook for stocks. Investors are paying more to hedge risk now than four months down the road, says Thomas Lee, head of research at Fundstrat. That “inversion of the VIX,” or volatility index, historically has been a sign that the market is nearing a bottom, so long as the economy isn’t in recession.

“Even if I don’t know whether we’ve bottomed, I’d still rather close my eyes and buy,” says Lee.

The S&P 500 traded for 14.6 times forward-four-quarter estimated earnings as of Thursday’s close, according to Yardeni Research. That’s down from 15.5 at the high, and up from 10.2 times at the March 2009 low. Today’s multiple is a slight premium to the 13.8 average multiple since 1978, the first year that data were compiled.

With 10-year Treasury notes yielding near 2%, investors also have more incentive to look to stocks for income, as well as price appreciation. The average S&P 500 stock yields 2%, and 35% of S&P 500 components had a dividend yield greater than the 10-year Treasury yield as of Thursday’s close, according to Lee. That’s twice as many as the long-term average.

The Federal Reserve has begun to hint that, should fundamentals falter, it might delay raising interest rates. The market currently is expecting the central bank to lift rates in mid-2015. A fourth round of quantitative easing, or bond buying by the Fed, can’t be ruled out, either.

“If people realize the world isn’t going to come to an end, you’re going to see them roll back into the market,” Yardeni said.

Investors have dumped shares in some sectors far more than in others. Energy stocks, for instance, have fallen 11% since a Sept. 18 high, and 15% since the start of September. Industrial and materials stocks also have tanked on concerns about a possible global slowdown.

Friday Morning Reads: european stocks rise amid pressure for stimulus


Some things I’m reading this morning:

  • European stocks rise amid pressure for stimulus (Bloomberg)
  • Even oil stocks are surging (BusinessInsider)
  • Morgan Stanley’s revenue doubles, shares up big in pre-market (USAtoday)
  • 5 reasons to worry about deflation (WSJ); see also, Europe is flirting with deflation (BusinessInsider)
  • Calm returns to Wall Street, but Europe remains a worry (DealBook)
  • What markets will (NYT)
  • How to ruin your life (MotleyFool)
  • Wilco to play 6 shows in early December at the Riviera. Tickets go on sale this morning at 10 am (WXRT)

Small caps outperforming large caps–a positive development

small caps vs large caps 10.16.14

Over the recent past we’ve seen significant outperformance in the small cap stocks versus the large caps.  The above chart shows that the Russell 2000 Growth Index (IWO, which is the proxy for small caps) is up 2% versus an almost 3% drop in the SPY (or large cap S&P 500 index) over the past three days.

This might suggest that even the riskier parts of the market (small caps being riskier than large caps on a relative basis) have been beaten down so much and are looking to bottom.

A glimmer of hope and a development to continue to watch closely.

Thursday Morning Reads: why Ebola is behind the selloff


Some things I’m reading this morning:

    • Doug Kass: 7 reasons a recession is more likely than you think (TheStreet)
    • The benchmark 10-year Treasury traded below 2% for the first time since June 2013 (Bloomberg)
    • U.S. oil producers may drill themselves into oblivion (BusinessWeek)
    • Ebola virus disease in West Africa–the first 9 months of the epidemic and forward projections (NewEnglandJournalOfMedicine)
    • Jim Cramer:  why Ebola is behind the selloff (CNBC)
    • Is Wednesday’s market selloff a sign of global slowdown or a correction? (FP)
    • Wall Street might know something the rest of us don’t (NYT)
    • What if there is no tomorrow? (TRB)
    • Which movies to see–& skip–at the 50th Chicago Intl Film Festival (ChicagoReader)

Roller coaster?

dji 10.15.2014

It was an incredible day in the stock market.  The graph above shows today’s price action in the Dow Jones.  Equities sold off hard at the open on some tepid economic reports, continued worries in Europe and a major merger that was called off.  But within an hour, equities recouped about two-thirds of their losses only to descend in a steady and persistent drip down on Ebola scares and a widespread panic.

Late in the afternoon the Dow pared losses to close down 173 points–or 1%.

Is this the capitulation that the market needs?  Probably not, but current conditions are at extreme oversold levels.

More to come later…

Wednesday Morning Reads: so much for rate increases


Some things I’m reading this morning:

  • Stock futures drop on global economy concerns…how about Ebola news? (Reuters)
  • So much for rate increases…(PragCap)
  • B of A posts small profit (MoneyBeat)
  • The sell-off, particularly in bonds, could be relatively violent when it comes (Telegraph)
  • Larry Fink: great time to get back into the market (CNBC)
  • The $11 trillion advantage that shields us from trouble (Bloomberg)
  • Curse of the new Fed chief. Spooked markets test Yellen (MichaelSantolli)
  • What if Tom Brady gets Ebola? (Deadspin)
  • Foo Fighters with Zac Brown cover Ozzy’s ‘War Pigs’ (LettermanShow)

Fear Enters the Market

The S&P 500 dropped another 1.6% yesterday and posted its worst three day slide since November 2011. As the S&P is now down 6.8% from a high set one month ago and holding just over a 1% gain for the year, other equity markets have felt even more pain. The Dow Jones is down 1.5% year-to-date, the Russell 2000 Small Cap Index is down 10% for the year, European stocks (VGK) have shed 12% and Emerging Markets (EEM) stocks are off over 2% for the year.

The Street had become accustomed to calm, slowly rising markets over the past 2 ¾ years. But it was only a few years back where the market had absorbed 15% and 19% downdrafts during the year ultimately ending those years in the green (2010 saw a 13% gain even given the 15% correction while 2011 ended slightly higher even after a 19% correction). Unfortunately, volatility is actually considered the norm in equity markets. There is ample historical evidence showing this. Here’s some:

  • Since 1928, major U.S. equity markets have averaged about three 5% corrections each calendar year;
  • Since 1928, the S&P 500 has averaged about one 10% correction each calendar year.

The fear is now palpable. Half of Nasdaq stocks are off 20% more from their highs, meaning they are already in a bear market. European bourses are getting crushed. The S&P has now pierced its 200-day moving average—an important technical support level. The Chicago Board Options Exchange Volatility Index, a gauge of investor uncertainty otherwise known as the ‘fear index’, rose to a 28-month high on Monday, after surging 46% last week. Given the price action, investors will have to ask if this will be a normal 5-10% correction, a larger 10-20% correction or a full blown start of a bear market. I don’t know for sure. The simple truth is that nobody knows for sure.

Given the uncertainty, however, it is important to attempt to ascertain the cause of the correction. And the truth here, counter to the daily emphatic declarations of direct cause and effect that we read about in the financial press or hear about from the multitude of market pundits on CNBC, it is very difficult to pinpoint any one direct cause.  But, I’ll group the potential causes in three main categories: (1) geopolitical; (2) fundamental; (3) economic growth.

ISIS, Ebola Russia/Ukraine, Ebola, the Middle East, even the disappearance of Rodman’s guy Kim Jon Un are all on the list for the current geopolitical concerns.  There is no question in my mind that some of these are causing real fear in equity markets.  As I pen this update the S&P is up 20 points–for now.  But the second that CNBC cuts to another potential Ebola victim, the S&Ps are sure to drop 20-30 handles in an instant.  I don’t want to minimize the tragic consequences of the disease.  I also don’t want to fully dismiss the potential devastating market impact that this disease could have on equity markets.  But at this point, the geopolitical concerns are only generating short-term emotional fear on the market.

As the always acerbic Josh Brown tweeted out earlier in the year, “I’m going to hold off on investing until the Middle East gets straightened out. – guy in 1967 who died broke”. One who either sells the market or sits on the sidelines due to the emotional fear and market hiccups resulting from these issues risks losing out on future profits.  To the extent possible, we attempt to leave out emotion from the investment process.

The most important fundamental indicator—the stock market’s valuation which is defined as the price we pay for a dollar’s worth of earnings—shows the market to be only slightly overvalued.  Fears about an inflated market are being mostly perpetuated by a high Shiller Cyclically Adjsuted Price-to-earnings ratio.  I’ve addressed the blatant weakness of this metric in the past and it’s probably time I revisit it with another blog post.  But for now, any reasonable investor looking at traditional valuation metrics could only conclude that markets are only slightly overvalued–which is a good thing. And with interest rates still at all-time lows, this is an even better thing.

Economic growth
As I’d agree that the recent equity price volatility does include some degree of geopolitical and valuation fears (whether legitimate or not), it’s the fear of economic growth—both domestic and abroad—that has me most concerned.  Small-cap stocks—proxies for credit conditions and risk appetites—have been under pressure since late summer, prior to the recent drubbing in all types of equities. This has been a somewhat troubling development because these stocks are often thought of as canaries in a coal mine.  When lower they are theoretically indicating a slowing of future domestic (only domestic because these stocks aren’t multinational in nature) economic growth. So, it had been advisable to pare exposure to the small caps.  We did this where there was a need. But diversification purposes require us to have some exposure to these stocks. Furthermore, the Fed’s transition to a tighter monetary policy (i.e. raising interest rates) often times causes short-term dislocations in markets.  With the realization that the Fed might tighten rates as early as Spring ’15 came a natural knee jerk sell off in equities.  Those equities that are sold tend to be the ones that have appreciated the most. This can continue, but it’s mostly a short term phenomenon, which leads us to be a bit more optimistic about the small cap sell off and less of a contributor to long run worries about the domestic economy or stock market.

We’re less optimistic about last week’s developments in Europe.  Gavyn Davies of the Financial Times describes it as such, “Financial markets caught a nasty chill last week, when extremely weak activity data from Germany coincided with fears that the ECB could not overcome Bundesbank opposition to more aggressive quantitative easing. Then the IMF reported that there is a 40 per cent probability of a recession in the euro area within 12 months, along with a 30 per cent chance of outright deflation. Markets fear that policy makers in the euro area are once again losing control over their weakening economy.

Since markets often sniff out impending trouble before economists do, there is, as Martin Wolf warns, no room whatever for complacency. But, so far, the blip in global risk assets hardly registers on the Richter scale.  Nor is there much evidence from published data of a major slowdown in global GDP growth up to now.”

Davies continues in the piece (which you can read here) to debunk the risk of the Eurozone causing a global recession using sound and thoughtful analysis. However, what is discounted in this analysis is the shockwaves that can be caused by a lack of confidence due to another recession & a seemingly impotent central bank.  We’ve seen massive amounts of selling in the past due in similar conditions.  Therefore, I’m more concerned about the impact of Europe both on European equities and equities of all geographies (including domestic).

We always maintain an exposure to European equities in client accounts. This is prudent from a diversification standpoint.  And earlier this year we slightly increased exposure as we were hoping to see either higher growth in the Eurozone or for the European Central Bank (ECB) to commit to an aggressive Quantitative Easing-like stimulus if this growth could not be achieved.  It appears that growth, at least for the time being, is stalling and that the ECB will have a very difficult time corralling the necessary countries to add similar stimulus that the U.S. Fed enacted several years ago. These developments are concerning.

What to do now
Remember, at this point the S&P is about flat for the year even after a 7% correction.  These corrections are normal.  But it is also true that the complexion of the market has certainly changed. The uptrend and “buy the dip” mentality has been broken.  As I previously mentioned, nobody knows for sure where the market will bottom out.  In our view, it is time to get more defensive in the face of this recent uncertainty.  We have been reducing equity exposure to Europe and small cap stocks.  Extra cash is sitting on the sidelines waiting to be deployed.

At the same time, we’re about to enter a very favorable season for stock performance and market prices are now clearly oversold.  Valuations are still reasonable (more on this in a future blog post) and interest rates are ridiculously low (even if they go up dramatically from here).  Furthermore, the Fed isn’t completely out of the game.  Federal Reserve Vice Chairman Stanley Fischer said the other day, “If foreign growth is weaker than anticipated, the consequences for the U.S. economy could lead the Fed to remove accommodation more slowly than otherwise.”

Investors who have aggressively timed markets over the last 6 years (and throughout investment history) have sacrificed future profits.  We prefer to maintain a more defensive positioning in times of great uncertainty, but still maintain healthy investment levels appropriate for a client’s risk profile.

Please write or call if you should have any questions.