Sunday, August 3, 2014

One simplician's view of the market...

As you might imagine---after last week's market action---this weekend brings me greater than the usual volume of investing and trading (two different things btw) opinion articles to consume. I find the technicians particularly fascinating. These are the folks who produce colorfully-lined charts showing trends, support and resistance levels against moving averages, volume, relative strength, breadth and a number of other important (in their views) indicators to assess and draw conclusions from.

I'm not much of a technician, I'm more into the fundamentals: The state of the economy, of corporate balance sheets, of earnings and the like. I pay very close attention to valuation metrics---like, but not only, price to earnings (p/e) ratios---and I plot historical relationships between them and market movements to get a feel for whether stocks are relatively expensive, cheap or fairly valued. Which I suppose (that trend/chart-watching), essentially, makes me a bit of a technician. Honestly, I consider myself a simplition. I gather information and I apply what I believe to be simple common sense.

Not to say that the market, with all its nuance, is the least bit simple to understand. Or that we live in a simple world. Not in the least. I simply see the market for what it is; the place where people buy and sell companies. As with any other transaction, when we're talking stocks, one party sees more value in cash (or what he can purchase with it) versus the stock he presently owns, while the other sees more value in that stock than he does whatever else he might purchase with the cash he presently holds. So the latter hands his cash to the former, and the former hands his shares to the latter. Last Thursday, those who saw value in shares of stock, saw it 300+ Dow points cheaper than where they saw it on Wednesday. It's really that simple.

(Yes, the machine has infiltrated the process. Computer programs set to trade on various signals can occupy either or both sides of a trade. Which, in essence---in that the programs are acting on behalf of their programmers---doesn't alter the dynamic.)

Well, yeah, but we all want to know why. Why, at any given moment, do some folks value cash more than the shares of a given company's stock, and vice versa? Yes, that's where things get complicated. Of course only they can tell you. But, surely---as there are technicians and fundamentalists---different people can see entirely different things when they look at a share of stock.

Some see stocks as commodities in and of themselves. They see ticker symbols that move up, down and sideways in price. They speculate as to where the price of a given symbol is headed, then trade accordingly. Not to suggest that they are entirely oblivious to what the underlying company (or companies [in the case of a diversified investment product]) actually produces, but that's not their focus. They have zero interest in riding a business model to fruition. They're in the market to make money right now. I would call them traders, as opposed to investors. That ain't me, but, hey, more power to em! The market needs liquidity, and traders provide it.

To others, like yours truly, stocks represent ownership in companies. We would be your investors. We're looking to participate in the success of the companies that produce goods and services for a world of consumers. Our portfolios, over time, rise and fall with the business prospects of the companies whose shares we, or the vehicles we invest in, own.

Which brings us to the topic of the day: What, in the opinion of one simplician, are the prospects for the companies whose stocks trade on the world's exchanges in the summer of 2014?

Before I offer up my view, I want to be very clear that my generally positive take on the present prospects for a growing economy and growing company earnings may not translate to a near-term advance in the major averages. For one, in the short-run, the technicals matter (in that lots of folks trade on them). And for another, not all fundamentalists, I'm sure, share my views. Of course that (buyers and sellers) is what makes a market.

As for the U.S.---which is where we'll remain for today---the economy, while not setting records, is clearly picking up. The Purchasing Managers Indices---for both the manufacturing and the service sectors---among other indicators, are showing strong signs that on balance business, both current activity and the forward outlook, is improving. And it's beginning to show up in corporate top-line results, in GDP, in the employment numbers, etc. The thing is, the price of your average share of stock is, in my view, largely discounting recent results already. Meaning, for stocks to move measurably higher, a better economy will have to translate into better corporate results. Which, of course, it should.

So why the recent volatility? Once again, technicals matter (and some charts are looking suspect), and not everyone sees eye to eye on the fundamentals. There is a contingent out there that believes that this bull market has been all about the Fed and what it sees as ultra-easy monetary policy. To it, a growing economy spells the end of easy money, and the end of easy money spells the end of the bull market. While, on its face, that sounds too, well, simple, I could take that one---drill down a bit---and run with it. To make that a plausible position for me, I would not have to concur (which I don't) that the Fed made this bull market, I'd simply have to assume that present stock valuations fully discount all this economy can produce, and that a change in monetary policy (from easy to tight) is a classic sign that the economy is entering its final phase of expansion. Or, as some assert, that nothing can kill a bull market faster than a tight-money Fed. In either case, sympathetic market timers would sell at these presumably peak levels and wait for the coming recession/bear market to open the valuation door to re-entry.

To justify that position, I'd start with this graph showing total U.S. GDP (green) along with the total value of the U.S. stock market (yellow) (sadly, the Bloomberg data on total market cap doesn't go very far back). Notice how the total value of all U.S. stocks has quickly caught up to the total output of the U.S. economy:    Click on any of the following graphs to enlarge...

photo (1)

Then this graph showing how, historically, raising the Fed Funds Rate (white) has tended to precede economic (yellow) contractions:

photo (2)

Then this one showing how the stock market (yellow) tends to follow the economy (green):

photo (3)

I'd then conclude (although I could offer yet more visual support)  that history virtually assures that this bull market, if it isn't kaput already, is on its very last leg.

Well, not so fast. Remember what I said about corporate results, meaning earnings. Take a look at this graph which shows how earnings (blue) for S&P 500 stocks exploded off the 2009 bottom and ran at a faster pace than the index (yellow) for the next couple of years. The index, of late, has simply been catching up to where earnings suggest it should be:

photo (4)

Now take a look at this historical S&P 500 price to earnings graph. Notice how the present 17ish level is by no historical means anything to loose sleep over:

photo (5)

And this one showing the relationship between GDP growth (yellow) and corporate earnings (blue). See the strong correlation?

photo (6)

So what should we expect from earnings if the economy continues to expand from here? That's right, we should expect them to rise as well. Now look again at the graph fourth from the top. See what history says happens to stock prices when corporate earnings are on the rise?

And, lastly (but I could show more), here's one that charts the S&P 500 (yellow) against the 10-year treasury yield index (white). Not much, historically-speaking, to worry about when interest rates begin rising (although, as I've cautioned of late, I have a sneaking suspicion that this time around---given the Fed's extended easy policy---the stock market may not initially follow the pattern of those lines presented on this last chart). 

photo (7)

Hmm... I guess we should conclude that this bull market---intermittent volatility notwithstanding---has yet to even catch its stride.

Well, not so fast. In the fall of 2007, before the great fall of the stock market, I could have shown you plenty of graphs suggesting that stocks weren't nearly in bubble territory. Ah, yes, but the bubble wasn't in the stock market, it was in real estate. And upon its bursting, earnings plummeted and took the stock market with them. However, today, the U.S. real estate market---while having definitely improved---is still struggling to gain some traction. Plus---while the sentiment indicators lean toward bullishness---the tell-tale euphoria (recall what folks were doing with their home equity back then) that often proceeds big blow offs seems nowhere in sight.

So what about bonds? While not everyone agrees, I do see bonds as a big fat bubble. The good news is that while not everyone agrees, lots of folks do, and it's seldom the punch you see coming that knocks you on your butt.

This all (I know it was a lot) brings me to my simple, yet all important, point: The fact that I can offer up real data suggesting that the market is a-ok at these levels is nice, for I know you sometimes worry about this stuff. But there's no guarantee---as I stated above---that this time around this data spells higher highs for stocks. Or, as is always the case, that some black swan (unforeseen happening) can't swoop down and---without a whisper of a warning---take the market with it.

When it's all said and done---all my charting and analyzing notwithstanding---here's why I sleep like a baby:

A husband and wife (clients) stopped by last week to discuss whether they should pay cash or finance a brand new pickup at zero interest. With permission, here's a snippet from the email that inspired our meeting:
My daughter is in the process of purchasing a house in the Sacramento area and of course, she wants me to install tile on the kitchen floor and wood flooring in other parts of the house. I was originally planning on purchasing a pickup in a year or two, however, it looks as if my plans just got accelerated.

Yes, the husband's retired and has discovered all sorts of hidden talents, and time, for his family to exploit. And he gladly accommodates.

His daughter I suspect submitted her request through some miracle of wireless technology that she and Dad both possess. Technology that will seem utterly outdated in short order. Son in law will drool over his wife's pop's new truck and tell her he's got to get one of those. Daughter, if she's anything like her folks, will remind hubby that they just bought a new house (in need of remodeling) that'll be housing a future youngin or two, and that they need to start thinking about college for him/her/them and saving for their own retirement. Nevertheless, hubby will someday negotiate himself into that new truck and, in the meantime, they'll not want for the latest technological innovations that'll organize their lives (nor will all the folks responsible for bringing Pop's truck, their home, the remodeling materials, the takeout lunches for Pop, the gas that'll get him to and around Sacramento, etc., etc., etc., to market). While their savings will provide growing capital for the companies that produce the goods and services they and billions of others, the world over, will utilize in the years to come.

I, the simplician, simply want to own those companies as they (the good ones) forever innovate and grow with their customers. The inevitable, and unavoidable, ups and downs simply reflect the market's growing and pruning of those enterprises---and our expectations---along the way...

1 comment:

  1. […] thinking the best I can do for today is direct you to my blog post from Sunday (it speaks a little to the technicals and a lot to the fundamentals). If you haven’t taken […]