Just a quick post to give a mid-quarter view of my main industry rotation model.? The recent moves in the market have knocked many energy sector industries out of the hot zone (red), but any bounce in financials has not knocked them out of the cold zone (green).? I’m still not ready to play in the depositary and credit sensitive financial companies, my insurance exposure is cheap, and earning money with low-ish risks.? That said, this is the type of environment that reveals which insurers have been taking on too much risk with marginal bonds.
industry-ranks-8-21-08
Remember that my industry ranks can be used in two modes: momentum mode (look at the red zone), and value mode (green zone).? I spend most of my time in the green zone, looking at industries where I think pricing power will return.? For me, the red zone is more useful for sale decisions.? When an industry is running hot, I delay selling out in entire, and content myself with trimming positions in order to limit risk when the eventual turn happens.
“It’s not a solvency problem; it’s a liquidity problem.”? So many people say regarding some financial firms that are on the ropes.? I’ve never liked that way of expressing the problem.? Let me explain why.
When does a firm typically default?? When they run out of liquidity.? True, some firms voluntarily file for bankruptcy when they see that their assets are worth less than their liabilities, and don’t see any way out.? Some firms are forced to file for bankruptcy when they trip a debt covenant.? But most firms that find their net worth slouching into, or slouching deeper into negativity don’t file for bankruptcy.? They play for time.
They hold an option with an uncertain expiry date.? When will we run out of cash?? Any way to conserve cash or sell off assets could lengthen the time to expiry, and maybe, just maybe, the economy will turn, or the pricing cycle will turn for the products, or enough other firms will fail, that the remaining liquidity lowers financing rates enough that the company can re-liquefy and survive.
The thing is, a company’s liquidity only becomes an issue when its ability to generate cash flow adequate to service creditors is questionable.? A company can say all it wants, “But we have valuable assets.? We’re not near insolvency!”? Fine.? Sell some of those valuable assets and generate liquidity.? “But it’s a bad market, we don’t want to hit low bids.”? This explains why the solvency as well as liquidity is questioned.? The assets aren’t worth as much as previously imagined.? Perhaps on a fair value basis, during the period of stress, net worth is negative.
Will the banks extend short term loans against unencumbered assets?? Can the firm do a private placement with some prize asset as security? No?? Perhaps the assets are worth considerably less than thought.? A healthy premium of the value of assets over liabilities will almost always be able to attract financing.? But when you are close to the line in a bad environment, any small premium will seem like an illusion to lenders.
So, in a large majority of cases, if there are liquidity problems, it is because there are solvency problems as well.? Here’s one more test: if a firm is suffering from low liquidity, but has valuable assets, why not sell out to another public firm, or go private, and let private equity solve the liquidity problem?? After all, they would like to buy valuable assets at a discount, right?? Right?!
🙁 Well, I would hope so, but during bad periods in the credit cycle, that doesn’t happen often.? So, the way I think is this: most hard liquidity problems are solvency problems, and vice-versa.? They are non-identical twins that don’t stray very far from each other.
Okay, that was theory, now for practice.? Credit sensitive financials have been getting whacked lately, and deservedly so.? Here are the examples:
El-Erian of PIMCO comments on the same phenomenon in an interview with Bloomberg.? (Much more is talked about in the interview.? Bright guy, what can I say?)
Another way of viewing the problem is that bank holding companies are often dependent on dividends from their downstream operating bank subsidiaries.? At this point in time, it is difficult for those subsidiaries to upstream cash to the holding companies.? No surprise then, that many banks are facing higher borrowing costs as they try to roll over maturing bonds.
Since a large amount of recent investment grade corporate debt issuance has been from financial companies, it is no surprise that the spreads on default swap indexes are near recent highs.? To have a truly diversified corporate bond portfolio now, one would have to underweight financials in a significant way.
My examples should confirm to you that insolvency and illiquidity are closely related.? In my investing, I like owning companies that are not playing it too close to the line.? In bad economic environments, the line moves, and companies that thought they could survive can’t.? A warning to all of us who invest, and to those who manage companies: play it safe.? Never take risks that could endanged the franchise, and don’t invest in companies that do so.
Buffett said something to the effect of: “I would rather be approximately right than precisely wrong.”? Everyone should agree with that maxim, but in the business world, many processes don’t work that way.
Take auditing as an example.? I’ve only experienced it as an actuary working in financial reporting, and it amazed me to see the detail work that they went through of checking cash flows (which should be done — how else do we detect fraud?), but with little to no attention on reserving assumptions.? Spending time on the “bigger picture” questions is important, and shouldn’t be neglected.
Or, consider earnings spreadsheets that analysts do.? They can be valuable, but I find it more valuable to look at the broader industry picture to see if an industry as a whole has a favorable economic picture, or, might be close to a turning point.
Then again, I think more like a portfolio manager, and less like an analyst.? That makes me better for some tasks, and not others.? My boss at Provident Mutual taught me the you need to identify the main 2-3 drivers of future profitability, and focus on them, because they will drive 80-90% of the results.? (I call this Cioffi’s Rule.)? If you get the main factors right, you will make more money than most investors.
Sometimes, I get labeled a lightweight because I don’t dig deep on certain issues.? I’m just trying to stay focused on the important issues.? Now, on financial stocks today, I own a bunch of insurers that put me over market weight for financials, but I own no credit-sensitive companies.? Even high-quality names are under stress.? (Consider the rate American Express had to pay to borrow money recently.? And I thought MetLife had it bad.? Ah, to be a corporate bond manager again… there are bargains to be had if one has an adequate balance sheet.)
What we don’t know is a significant factor.? I need to see some significant failures before the financial sector will be interesting.? I’m not investing to be courageous.? I’m here to make money over the cycle on a risk-adjusted basis.? It’s not that I avoid risk, it’s that I avoid taking it when I don’t see that I am paid to take it.
Also, even though my portfolio is concentrated, with 35 almost-equally-weighted companies, I avoid going “socks-and-underwear” (as my Dad would say playing Sheepshead) on any single company.? Even on industries, I try to be measured in my overweight positions.? But the objective is to take risk when you are being paid to do it, and avoid it otherwise.? Focusing is a popular strategy, and those who do well at it do very well.? Those who fail at it fail big.? On average, the strategy of focusing doesn’t of itself add value.
My eight rules help me be approximately right.? That doesn’t mean that I don’t make mistakes.? I make mistakes, and sometimes they are big.? But, my mistakes haven’t been frequent and big.
Consider this as you invest.? Focus on the big factors that affect profitability, and look for positive industry trends that are underdiscounted, and negative industry trends that are overdiscounted.? And, in the process, only buy companies that you know will survive.? More money is lost buying marginal companies than is gained.? Remember the margin of safety concept.? Your first job is not to lose money, so choose wisely.
In value investing, it is imperative that one considers the state of the industry invested in, the balance sheet of the company, and earnings quality.? These are basic concerns for any investor, and all of my failures in investing can be be linked to neglect of one of these three items.
Ben Graham used the phrase “margin of safety.”? Actuaries, even less poetic, use “provision for adverse deviation.”? In either case, the idea is investing in such a way that you won’t get badly hurt if you are wrong.? It handles risk at the security selection level — choose your companies carefully; make sure they are survivors.
Does the industry have pricing power?? Is it under pressure from rising costs?? (Credit losses are a cost for financials.)? Pricing power, and lack thereof, should be considered in valuation decisions.? Are things so bad that companies are going bankrupt?? Perhaps it is time to buy the strongest one in that industry, because it often takes defaults to make pricing power turn.? Fewer competitors means profit margins can rise.
Does the company have a lot of debt?? Is the tangible net worth small relative to the liabilities?? Be careful, because a small negative change in the economics of the business could kick the company over the edge.
Do the earnings come from cash earnings, or do accruals dominate the earnings?? Cash earnings are always higher quality than accrual earnings.? This is one reason why financials almost always trade at a discount, becausethey are a bag of accruals.? Also, with financials, the quality of the accrual entries affects valuations.? Asset managers will have higher valuations than long-tail P&C insurers.? Who knows whether the reserves are right or not?
All that said, it was with sad amusement when I heard on the radio this afternoon that Legg Mason had become the largest shareholder of Freddie Mac.? Is Bill Miller (or Private Capital) doubling down?? He will look like a genius or a fool after this, depending on the outcome.? I think it is foolish, and an willing to say that he doesn’t understand the credit risk in the current environment, and should get advice from someone who gets the current credit crisis better, like me, or Eric Hovde.
Value investors often invest in financial stocks.? That is their undoing in the present market, as earnings and net worth get eaten by credit losses.? But to any value investor that does industry analysis, this was avoidable, because the risk of credit losses to the banks grew as the banks were willing to lend on terms that were loose.
As a value investor, I have been able to avoid the current crisis.? I avoided credit-sensitive financials, and have bought cheap names among industrial stocks.? But that was yesterday, what of tomorrow?? I don’t think the credit crisis is done, and so I urge a conservative posture at present.
Every 100 posts, as WordPress counts, I take a moment out to reflect on my life , my blog, the markets, and more.? My blog is usually a reflection of me as an investor and businessman, but it is not a reflection of me, the whole person.? This is my chance to speak my mind more broadly.? (By the way, it is amusing to be doing post 800 on 08/08/08.)
Hasn’t the market been volatile lately?? I feel like a yo-yo.? Ordinarily my sector rotation methods help my portfolio to be less volatile than the market, but at present my “beta” feels like 1.3.? Now, on the plus side, I am underweight energy for the first time in six years, starting in mid-July, and my energy exposure has a large refining component through Valero and ConocoPhilips. Beyond that, I am in the plus column again for 2008, though returns on Monday could reverse that with ease.
That’s the market.? Only invest what you can afford to lose.
Writing this blog interfaces with the print/online world in a variety of odd ways.? I talk to reporters fairly frequently, and give them a good amount of my time.? So, I want to thank my contacts at the CNN/Money, Fortune, Bloomberg, TheStreet.com, The Wall Street Journal, Business Week, and the Associated Press.? Other interested writers/reporters, e-mail me, and we can talk.
Ordinarily, when I write these posts, I cite those who have driven traffic my way, but right now, my internet connectivity is not cooperating with me.? Instead, I will mention the blogs that are not on my blogroll that I admire: World Beta, Felix Salmon, Information Arbitrage, and Interfluidity.
I remain most grateful to my readers.? I can’t respond to every e-mail, but I do read all of them.? Thanks for taking the time to read my writings.? I enjoy doing it because it gives something back to the broader investment community; retail investors don’t have many friends.
I leave you all with this.? I know my blog is eclectic; I cover a number of issues, and less well than some blogs that are more focused on single issues.? If you have ideas that you want me to write about, please e-mail me.
May the Lord bless you in your endeavors, and grant all of us wisdom in what I expect to be turbulent times in the markets.
A large-ish number of people have asked me to write this piece.? For those with access to RealMoney, I did an article called The Fundamentals of Market Tops.? For those without access, Barry Ritholtz put a large portion of it at his blog.? (I was honored .) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.
So, a number of people came to me and asked if I would write ?The Fundamentals of Market Bottoms.?? Believe me, I have wanted to do so, but some of my pieces at RealMoney were ?labor of love? pieces.? They took time to write, and my editor Gretchen would love them to death.? By the way, if I may say so publicly, the editors at RealMoney (particularly Gretchen) are some of their hidden treasures.? They really made my writing sing.? I like to think that I can write, but I am much better when I am edited.
Okay, before I start this piece, I have to deal with the issue of why equity market tops and bottoms are different.? Tops and bottoms are different primarily because of debt and options investors.? At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.? Option investors get greedy on calls near tops, and give up on or short puts.? Implied volatility is low and stays low.? There is a sense of invincibility for the equity market, and the bond and option markets reflect that.
Bottoms are more jagged, the way corporate bond spreads are near equity market bottoms.? They spike multiple times before the bottom arrives.? Investors similarly grab for puts multiple times before the bottom arrives.? Implied volatility is high and jumpy.
As a friend of mine once said, ?To make a stock go to zero, it has to have a significant slug of debt.?? That is what differentiates tops from bottoms.? At tops, no one cares about debt or balance sheets.? The only insolvencies that happen then are due to fraud.? But at bottoms, the only thing that investors care about is debt or balance sheets.? In many cases, the corporate debt behaves like equity, and the equity is as jumpy as an at-the-money warrant.
I equate bond spreads and option volatility because contingent claims theory views corporate bondholders as having sold a put option to the equityholders.? In other words, the bondholders receive a company when in default, but the equityholders hang onto it in good times.? I described this in greater measure in Changes in Corporate Bonds, Part 1, and Changes in Corporate Bonds, Part 2.
Though this piece is about bottoms, not tops, I am going to use an old CC post of mine on tops to illustrate a point.
Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow?s growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.
As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a 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.
I?m not pounding the table for anyone to short anything here, but I want to point out that the argument for a bubble does not rely on the amount of the price rise, but on the amount and nature of the financing involved. That financing is more extreme today on a balance sheet basis than at any point in modern times. The average maturity of that debt to repricing date is shorter than at any point in modern times.
That?s why I think the hot coastal markets are bubblettes. My position hasn?t changed since I wrote my original piece.
Position: none
I had a shorter way of saying it: Bubbles pop when cash flow is insufficient to finance them.? But what of market bottoms?? What is financing like at market bottoms?
The Investor Base Becomes Fundamentally-Driven
1) Now, by fundamentally-driven, I don?t mean that you are just going to read lots of articles telling how cheap certain companies are. There will be a lot of articles telling you to stay away from all stocks because of the negative macroeconomic environment, and, they will be shrill.
2) Fundamental investors are quiet, and valuation-oriented.? They start quietly buying shares when prices fall beneath their threshold levels, coming up to full positions at prices that they think are bargains for any environment.
3) But at the bottom, even long-term fundamental investors are questioning their sanity.? Investors with short time horizons have long since left the scene, and investor with intermediate time horizons are selling.? In one sense investors with short time horizons tend to predominate at tops, and investors with long time horizons dominate at bottoms.
4) The market pays a lot of attention to shorts, attributing to them powers far beyond the capital that they control.
5) Managers that ignored credit quality have gotten killed, or at least, their asset under management are much reduced.
6) At bottoms, you can take a lot of well financed companies private, and make a lot of money in the process, but no one will offer financing then.? M&A volumes are small.
7) Long-term fundamental investors who have the freedom to go to cash begin deploying cash into equities, at least, those few that haven?t morphed into permabears.
8 ) Value managers tend to outperform growth managers at bottoms, though in today?s context, where financials are doing so badly, I would expect growth managers to do better than value managers.
9) On CNBC, and other media outlets, you tend to hear from the ?adults? more often.? By adults, I mean those who say ?You should have seen this coming.? Our nation has been irresponsible, yada, yada, yada.?? When you get used to seeing the faces of David Tice and James Grant, we are likely near a bottom.? The ?chrome dome count? shows more older investors on the tube is another sign of a bottom.
10) Defined benefit plans are net buyers of stock, as they rebalance to their target weights for equities.
11) Value investors find no lack of promising ideas, only a lack of capital.
12) Well-capitalized investors that rarely borrow, do so to take advantage of bargains.? They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.
13) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot ? e.g. money market funds, collectibles, gold, real estate ? they chase the next trend in search of easy money.
14) Short interest reaches high levels; interest in hedged strategies reaches manic levels.
Changes in Corporate Behavior
1) Primary IPOs don?t get done, and what few that get done are only the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.
2) Private equity holds onto their deals longer, because the IPO exit door is shut.? Raising new money is hard; returns are low.
3) There are more earnings disappointments, and guidance goes lower for the future.? The bottom is close when disappointments hit, and the stock barely reacts, as if the market were saying ?So what else is new??
4) Leverage reduces, and companies begin talking about how strong their balance sheets are.? Weaker companies talk about how they will make it, and that their banks are on board, committing credit, waiving covenants, etc.? The weakest die.? Default rates spike during a market bottom, and only when prescient investors note that the amount of companies with questionable credit has declined to an amount that no longer poses systemic risk, does the market as a whole start to rally.
5) Accounting tends to get cleaned up, and operating earnings become closer to net earnings.? As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.
6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.
7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.
8 ) High quality companies keep buying back stock, not aggresssively, but persistently.
Other Indicators
1) Implied volatility is high, as is actual volatility. Investors are pulling their hair, biting their tongues, and retreating from the market. The market gets scared easily, and it is not hard to make the market go up or down a lot.
2)The Fed adds liquidity to the system, and the response is sluggish at best.? By the time the bottom comes, the yield curve has a strong positive slope.
No Bottom Yet
There are some reasons for optimism in the present environment.? Shorts are feared.? Value investors are seeing more and more ideas that are intriguing.? Credit-sensitive names have been hurt.? The yield curve has a positive slope.? Short interest is pretty high.? But a bottom is not with us yet, for the following reasons:
Implied volatility is low.
Corporate defaults are not at crisis levels yet.
Housing prices still have further to fall.
Bear markets have duration, and this one has been pretty short so far.
Leverage hasn?t decreased much.? In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
The Fed is not adding liquidity to the system.
I don?t sense true panic among investors yet.? Not enough neophytes have left the game.
Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, 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 in the game in 2001-2002. I hope that I ? and you ? can achieve the same with them as we near the next bottom.
For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough.? Exacerbating that will be all of the neophyte shorts that have piled on in this bear market.? This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more).? There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals.? In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company ? it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.
As for asset allocators, time to begin edging back into equities, but I would still be below target weight.
The current market environment is not as overvalued as it was a year ago, and there are some reasonably valued companies with seemingly clean accounting to buy at present.? That said, long investors must be willing to endure pain for a while longer, and take defensive measures in terms of the quality of companies that they buy, as well as the industries in question.? Long only investors must play defense here, and there will be a reward when the bottom comes.
12) Value investors find no lack of promising ideas, only a lack of capital.
13) Well-capitalized investors that rarely borrow, do so to take advantage of bargains.? They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.
14) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot — e.g. money market funds, collectibles, gold, real estate — they chase the next trend in search of easy money.
15) Short interest reaches high levels; interest in hedged strategies reaches manic levels.
Changes in Corporate Behavior
1) Primary IPOs don’t get done, and what few that get done are only the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.
2) Private equity holds onto their deals longer, because the IPO exit door is shut.? Raising new money is hard; returns are low.
3) There are more earnings disappointments, and guidance goes lower for the future.? The bottom is close when disappointments hit, and the stock barely reacts, as if the market were saying “So what else is new?”
4) Leverage reduces, and companies begin talking about how strong their balance sheets are.? Weaker companies talk about how they will make it, and that their banks are on board, committing credit, waiving covenants, etc.? The weakest die.? Default rates spike during a market bottom, and only when prescient investors note that the amount of companies with questionable credit has declined to an amount that no longer poses systemic risk, does the market as a whole start to rally.
5) Accounting tends to get cleaned up, and operating earnings become closer to net earnings.? As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.
6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.
7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.
Other Indicators
1) Implied volatility is high, as is actual volatility. Investors are pulling their hair, biting their tongues, and retreating from the market. The market gets scared easily, and it is not hard to make the market go up or down a lot.
2)The Fed adds liquidity to the system, and the response is sluggish at best.? By the time the bottom comes, the yield curve has a strong positive slope.
No Bottom Yet
There are some reasons for optimism in the present environment.? Shorts are feared.? Value investors are seeing more and more ideas that are intriguing.? Credit-sensitive names have been hurt.? The yield curve has a positive slope.? Short interest is pretty high.? But a bottom is not with us yet, for the following reasons:
Implied volatility is low.
Corporate defaults are not at crisis levels yet.
Housing prices still have further to fall.
Bear markets have duration, and this one has been pretty short so far.
Leverage hasn’t decreased much.? In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
The Fed is not adding liquidity to the system.
I don’t sense true panic among investors yet.? Not enough neophytes have left the game.
Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, 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 in the game in 2001-2002. I hope that I — and you — can achieve the same with them as we near the next bottom.
For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough.? Exacerbating that will be all of the neophyte shorts that have piled on in this bear market.? This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more).? There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals.? In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company — it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.
As for asset allocators, time to begin edging back into equities, but I would still be below target weight.
The current market environment is not as overvalued as it was a year ago, and there are some reasonably valued companies with seemingly clean accounting to buy at present.? That said, long investors must be willing to endure pain for a while longer, and take defensive measures in terms of the quality of companies that they buy, as well as the industries in question.? Long only investors must play defense here, and there will be a reward when the bottom comes.
=-=-=-=-=-=-=-==-=-=-=-=-=
That’s all for this post.? After comments are in, I will reformat the piece as one post and republish it.
Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow’s growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.
As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a 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.
I’m not pounding the table for anyone to short anything here, but I want to point out that the argument for a bubble does not rely on the amount of the price rise, but on the amount and nature of the financing involved. That financing is more extreme today on a balance sheet basis than at any point in modern times. The average maturity of that debt to repricing date is shorter than at any point in modern times.
That’s why I think the hot coastal markets are bubblettes. My position hasn’t changed since I wrote my original piece.
Position: none
I had a shorter way of saying it: Bubbles pop when cash flow is insufficient to finance them.? But what of market bottoms?? What is financing like at market bottoms?
The Investor Base Becomes Fundamentally-Driven
1) Now, by fundamentally-driven, I don’t mean that you are just going to read lots of articles telling how cheap certain companies are. There will be a lot of articles telling you to stay away from all stocks because of the negative macroeconomic environment, and, they will be shrill.
2) Fundamental investors are quiet, and valuation-oriented.? They start quietly buying shares when prices fall beneath their threshold levels, coming up to full positions at prices that they think are bargains for any environment.
3) But at the bottom, even long-term fundamental investors are questioning their sanity.? Investors with short time horizons have long since left the scene, and investor with intermediate time horizons are selling.? In one sense investors with short time horizons tend to predominate at tops, and investors with long time horizons dominate at bottoms.
4) The market pays a lot of attention to shorts, attributing to them powers far beyond the capital that they control.
5) Managers that ignored credit quality have gotten killed, or at least, their asset under management are much reduced.
6) At bottoms, you can take a lot of well financed companies private, and make a lot of money in the process, but no one will offer financing then.? M&A volumes are small.
7) Long-term fundamental investors who have the freedom to go to cash begin deploying cash into equities, at least, those few that haven’t morphed into permabears.
8) Value managers tend to outperform growth managers at bottoms, though in today’s context, where financials are doing so badly, I would expect growth managers to do better than value managers.
9) On CNBC, and other media outlets, you tend to hear from the “adults” more often.? By adults, I mean those who say “You should have seen this coming.? Our nation has been irresponsible, yada, yada, yada.”? When you get used to seeing the faces of David Tice and James Grant, we are likely near a bottom.? The “chrome dome count” shows more older investors on the tube is another sign of a bottom.
10) High quality companies keep buying back stock, not aggresssively, but persistently.
11) Defined benefit plans are net buyers of stock, as they rebalance to their target weights for equities.
I will try to complete this piece this week.? There should be one more part, and I will publish it all as one unit.
1) How to control your emotions when the market is nuts?? Develop a checklist, or at least a strategy that makes you re-evaluate the fundamentals, rather than buying/selling indiscriminately.
2) What, one standard for revenue recognition?? Impossible! Great!? Revenue recognition is probably the most important issue in accounting, and whatever comes out of this will be important to investors.? (If the standard is bad, value investors that watch the quality of earnings will gain additional advantages.)
4) Tom Graff is a bright guy, and I respect him.? He disagrees with my view on buying agency mortgage backed securities.? He is worth a read.
5) Dark supply.? There are many people who want to sell homes who have them off the market now waiting for better prices.? There are investors buying properties hoping to flip them.? These are reasons I don’t expect housing prices to come back quickly.
6) When I read this piece on Countrywide, I was not surprised by the existence of special deals, but only by their extent.
7) HEL and HELOC experience will continue to decline.? Face it, on most home equity loans in trouble, the losses will be 100%.? This will only burn out one year after the bottom in housing prices.
June was a good month for me, but in the middle of June, it felt like something was shifting in the markets, and it was showing up in my portfolio.? Then, July hit me like a ton of bricks.? The market was down, but I was way down.
Now, I have a number of disciplines that help me on average and over time as I manage equity money.? That doesn’t eliminate the “pit in the stomach” when nothing seems to be working.? It does give me something to do about it, though.? Evaluate poor performers (“what, down so much on no news!”), do some rebalancing trades (“ugh, cash is shrinking… will I have to move into concentration mode as I did in 2002?), and search for errors in my macro views (“why do I have so much cyclicality in the portfolio?”).
My performance versus the market as a whole tends to streak.? There are several reasons for that:
The portfolio has a value tilt.
Market capitalizations are smaller than the S&P 500.
I concentrate the industries that I invest in.
I turn over my portfolio more slowly than most investors.
But, as of Wednesday, as the market bounced back, my portfolio did even better.? I’m behind the S&P 500 by less than a percent now.? But this is what puzzles me here: ordinarily, I expect to outperform more in bear markets than in bull markets, but it seems to be flipped here.
I am overweighted in financials — though all of them are insurers, and none in the financial guarantee business.? Given all of the basket and ETF trading that goes on today, maybe my insurance names are getting dragged along with the banks.? In the short run, that can persist, but eventually industry performance emerges in stock prices.? That’s my best explanation for now.
Away from that, I did a rebalancing sale on YRC Worldwide today.? First rebalancing sale in a while.? Trucking is a volatile industry.? Then again, in cyclical industries, it is always a question of value over the cycle.? The stocks move more than the industry prospects do, so if you resist trends with companies strong enough to survive the cycle, you will make money in the long run.
Full disclosure: long YRCW, and many insurers? (full portfolio available at Stockpickr.com)
.) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.
