Classic: The Fundamentals of Market Tops
I wrote the following at RealMoney on 1/13/2004:
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Market Analysis
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Watch out for a momentum-driven investor base.
Companies will take advantage of a topping market by raising cash.
A top in the market is not imminent.
I am basically a fundamentalist in my investing methods, but I do see value in trying to gauge when markets are likely to make a top or bottom out. The methods that I will describe in this column are somewhat vague, but I always have believed that investment is a game that you win by being approximately right. Precision is of secondary importance.
At the end of this column, I will apply my reasoning to the current market to show what concerns exist and why there is reason for optimism.
The Investor Base Becomes Momentum-Driven
Valuation is rarely a sufficient reason to be long or short the market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.
You’ll know a market top is probably coming when:
- The shorts already have been killed. You don’t hear about them anymore. There is general embarrassment over investments in short-only funds.
- Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.
- Valuation-sensitive investors who aren’t total-return driven because of a need to justify fees to outside investors accumulate cash. Warren Buffett is an example of this. When Buffett said that he “didn’t get tech,” he did not mean that he didn’t understand technology; he just couldn’t understand how technology companies would earn returns on equity justifying the capital employed on a sustainable basis.
- The recent past performance of growth managers tends to beat that of value managers. (I am using the terms growth and value in a classic sense here. Growth managers attempt to ascertain the future prospects of firms with little focus on valuation. Value managers attempt to calculate the value of a firm with less credit for future prospects.) In short, the future prospects of firms become the dominant means of setting market prices.
- Momentum strategies are self-reinforcing due to an abundance of momentum investors. Once momentum strategies become dominant in a market, the market behaves differently. Actual price volatility increases. Trends tend to maintain themselves over longer periods. Selloffs tend to be short and sharp.
- Markets driven by momentum favor inexperienced investors. My favorite way that this plays out is on CNBC. I gauge the age, experience and reasoning of the pundits. Near market tops, the pundits tend to be younger, newer and less rigorous. Experienced investors tend to have a greater regard for risk control, and believe in mean-reversion to a degree. Inexperienced investors tend to follow trends. They like to buy stocks that look like they are succeeding and sell those that look like they are failing.
- Defined benefit pension plans tend to be net sellers of stock. This happens as they rebalance their funds to their target weights.
Corporate Behavior
Corporations respond to signals that market participants give. Near market tops, capital is inexpensive, so companies take the opportunity to raise capital.
Here are ways that corporate behaviors change near a market top:
- The quality of IPOs declines, and the dollar amount increases. By quality, I mean companies that have a sustainable competitive advantage, and that can generate ROE in excess of cost of capital within a reasonable period.
- Venture capitalists can do no wrong, so lots of money is attracted to venture capital.
- Meeting the earnings number becomes paramount. What is ignored is balance sheet quality, cash flow from operations, etc.
- There is a high degree of visible and/or hidden leverage. Unusual securitization and financing techniques proliferate. Off balance sheet liabilities become very common.
- Cash flow proves insufficient to finance some speculative enterprises and some financial speculators. This occurs late in the game. When some speculative enterprises begin to run out of cash and can’t find anyone to finance them, they become insolvent. This leads to greater scrutiny and a sea change in attitudes for financing of speculative companies.
- Elements of accounting seem compromised. Large amounts of earnings stem from accruals rather than cash flow from operations.
- Dividends become less common. Fewer companies pay dividends, and dividends make up a smaller fraction of earnings or free cash flow.
In short, cash is the lifeblood of business. During speculative times, watch it like a hawk. No array of accrual entries can ever provide quite the same certainty as cash and other highly liquid assets in a crisis.
Other Gauges
These two factors are more macro than the investor base or corporate behavior but are just as important.
Near a top, the following tends to happen:
- Implied volatility is low and actual volatility is high. When there are many momentum investors in a market, prices get more volatile. At the same time, there can be less demand for hedging via put options, because the market has an aura of inevitability.
- The Federal Reserve withdraws liquidity from the system. The rate of expansion of the Fed’s balance sheet slows. This causes short interest rates to rise, making financing more expensive. As this slows down the economy, speculative ventures get hit hardest. Remember that monetary policy works with a six- to 18-month lag; also, this indicator works in reverse when the Fed adds liquidity to the system.
One final note about my indicators: I have found that different indicators work for market bottoms and tops, so don’t blindly apply these in reverse to try to gauge bottoms.
No Top Now
There are reasons for concern in the present environment. Valuations are getting stretched in some parts of the market. Debt capital is cheap today. There are an increasing number of momentum investors in the market. Making the earnings estimate is once again of high importance. Nonetheless, a top in the market is not imminent, for these reasons:
- The Fed is on hold for now. Liquidity is ample, perhaps too much so.
- Actual price volatility is muted.
- Since all of the accounting scandals of the last few years, many corporations have cleaned up their accounting and become more conservative.
- Cash flow from operations comprises a high proportion of current earnings. More dividends are getting paid.
- Leverage has not declined, but most corporations have succeeded in refinancing themselves in a low interest rate environment.
- Conservative asset managers have not been fired yet.
- Most IPOs don’t seem outlandish.
Not all of the indicators that I put forth have to appear for there to be a market top. A preponderance of them appearing would make me concerned, and that is not the case now.
Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and kept me out of the trouble in 1999 and 2000. I hope that I — and you — can achieve the same with them as we near the next top.
The current market environment is not as favorable as it was a year ago, but there are still some reasonably valued companies with seemingly clean accounting to buy at present. Right now, being long the market is more compelling to me than being flat, much less short.