The constancy and consistency of the move higher is leading many to re-evaluate their fundamental beliefs.
Gone are the 'new normals,' the balance sheet recessionistas, and the perma-bears, and in their place are newly minted momentum 'guys.'
It is easy to rationalize the market, to find data to support a particular contention, and ultimately to justify a position. It is hard to run against the herd, to fight the forces that be, and to be handed a beat down by the market.
It speaks to something deep within us. The acknowledgment that we are wrong.
We are all momentum chasers now! (or, is it Game of Chicken players, or Musical Chairs participants).
Wednesday, February 16, 2011
Friday, February 11, 2011
A Back of the Envelope on the Pullback
I've been concerned that the mega caps haven't participated in the rally, and their playing catch-up will in fact drive the market higher (even as we get a rotation out of smid caps).
Consequently, when you look at the Naz and S&P 500 I'm not expecting them to fall too much. Doing a back of the envelope of the major indexes:
* 50%+ of each index is comprised of stodgy mega-caps trading at an average of about 15x forward earnings (even when you include Apple and Google and Amazon).
* It seems obvious to me that the large caps are undervalued relative to the smid caps. Smid caps are trading at roughly 18x forward earnings (and that might be understating it).
* When the "risk on" trade expires and the "risk off" trade returns, it is easy to see a little pullback and rotation along the following lines. Large cap multiple compression from 15x to 14x (6%-7% decline), smid cap multiple compression from 18x to 15x (16%-17% decline)....translates to a 10% market decline (assuming a 60/40 large cap/smid cap breakdown - in fact the breakdown is closer to 88/12).
In the absence of any serious weakness in earnings (and the economy), it is highly unlikely that we will see much more than a 10% correction, unless PEs were to compress due to some major risk factor.
Consequently, when you look at the Naz and S&P 500 I'm not expecting them to fall too much. Doing a back of the envelope of the major indexes:
* 50%+ of each index is comprised of stodgy mega-caps trading at an average of about 15x forward earnings (even when you include Apple and Google and Amazon).
* It seems obvious to me that the large caps are undervalued relative to the smid caps. Smid caps are trading at roughly 18x forward earnings (and that might be understating it).
* When the "risk on" trade expires and the "risk off" trade returns, it is easy to see a little pullback and rotation along the following lines. Large cap multiple compression from 15x to 14x (6%-7% decline), smid cap multiple compression from 18x to 15x (16%-17% decline)....translates to a 10% market decline (assuming a 60/40 large cap/smid cap breakdown - in fact the breakdown is closer to 88/12).
In the absence of any serious weakness in earnings (and the economy), it is highly unlikely that we will see much more than a 10% correction, unless PEs were to compress due to some major risk factor.
The Slough of Despond
It feels like we are in the slough of despond.
Fighting a market is not a wise thing (least of all on the positive side of the economic/market cycle). Taking your medicine and getting with the game is always easier said than done.
The markets incessant march onward and upward since its August lows is wearing us down. Just "buy the dip" is the mantra of the moment.
I'm thinking we're not far from a nice pullback, and "sell the rip" is probably a better banner.
Doubling down is a very dangerous sport, but can sometimes cover over a multitude of sins.
The courage to be, and the courage of ones convictions are in short supply. But at some point you've got to take a stand.
Fighting a market is not a wise thing (least of all on the positive side of the economic/market cycle). Taking your medicine and getting with the game is always easier said than done.
The markets incessant march onward and upward since its August lows is wearing us down. Just "buy the dip" is the mantra of the moment.
I'm thinking we're not far from a nice pullback, and "sell the rip" is probably a better banner.
Doubling down is a very dangerous sport, but can sometimes cover over a multitude of sins.
The courage to be, and the courage of ones convictions are in short supply. But at some point you've got to take a stand.
Thursday, January 13, 2011
The Problem With Relative Value*
Virtually every asset class looks attractive relative to bonds right now (except for cash**).
And that is the problem when you have an externality like a central bank setting interest rates. That distortion of the supply/demand nexus, sets up an imbalance. In the current case, it is the misallocation of resources within an economy toward risky assets*** (although it is highly ironic that petrified retail investors actually sought out bonds like a giffen good).
Relative value investors (and that is what most are) look at those signals and from them determine that equities, commodities, precious metals, real estate, you name it, are attractive relative to bonds. And they are. The problem is bond yields are at artificially low levels, and when they normalize (a.k.a., go up) those assets that looked attractive relative to bonds previously no longer look as attractive.
Proper analysis of risk assets should incorporate normalized growth, margins, and discount rates into their framework, otherwise they risk falling for the "relative value illusion" and a host of other fallacies (ie. cyclical illusion, history will repeat illusion, et al).
*Actually there are numerous problems associated with relative value analysis, but that is for another day.
**But even cash looks attractive if you believe bond rates are going to go up.
***Actually, the misallocation may be less to risky assets, than to risky behavior.
And that is the problem when you have an externality like a central bank setting interest rates. That distortion of the supply/demand nexus, sets up an imbalance. In the current case, it is the misallocation of resources within an economy toward risky assets*** (although it is highly ironic that petrified retail investors actually sought out bonds like a giffen good).
Relative value investors (and that is what most are) look at those signals and from them determine that equities, commodities, precious metals, real estate, you name it, are attractive relative to bonds. And they are. The problem is bond yields are at artificially low levels, and when they normalize (a.k.a., go up) those assets that looked attractive relative to bonds previously no longer look as attractive.
Proper analysis of risk assets should incorporate normalized growth, margins, and discount rates into their framework, otherwise they risk falling for the "relative value illusion" and a host of other fallacies (ie. cyclical illusion, history will repeat illusion, et al).
*Actually there are numerous problems associated with relative value analysis, but that is for another day.
**But even cash looks attractive if you believe bond rates are going to go up.
***Actually, the misallocation may be less to risky assets, than to risky behavior.
Friday, December 31, 2010
Good bye 2010
Good bye 2010. Can't say I am sad to see you go. The beauty of a new year is that it promises something better.
2010 was a classic recovery in the economy and the market. Doom and gloom still resonate, and it probably won't be until blue skies and sunshine return that the piper will next come calling.
Lesson learned. Don't fight the Fed. Easier said than done, when every fiber of your being thinks it an emperor with no clothes.
Here's to 2011, and the hope for conviction.
2010 was a classic recovery in the economy and the market. Doom and gloom still resonate, and it probably won't be until blue skies and sunshine return that the piper will next come calling.
Lesson learned. Don't fight the Fed. Easier said than done, when every fiber of your being thinks it an emperor with no clothes.
Here's to 2011, and the hope for conviction.
Monday, November 8, 2010
All Roads Lead to Inflation
At this point, all roads lead to inflation. This may be strange given that there are strong deflationary forces brought about by the deleveraging from a balance sheet recession still in the system.
But if you take a step back. The Fed is implicitly (if not explicitly) trying to create it. The third world is experiencing it. Risky asset prices are reflecting it. The markets are beginning to come around to it.
We're playing with fire here.
Most historical studies indicate that inflation is generally positive for risky assets, but too much inflation is bad. Hyperinflation is another thing all together, leading to the wipe out of an existing order/system. But even if we don't see hyperinflation, only inflation, there are assets that provide a better store of value than others. What inflation does is force you to do something. You can't just sit there (and especially not at the moment with cash and bond yields so low).
If it true that all roads lead to inflation, then how can investors best preserve their purchasing power? What stores of value will help protect investors against inflation? How should investors best approach this problem? Investors need to take greater risk with their asset allocation. Being fearful and leaving money in cash or bonds is perhaps the worst thing they can do.
But if you take a step back. The Fed is implicitly (if not explicitly) trying to create it. The third world is experiencing it. Risky asset prices are reflecting it. The markets are beginning to come around to it.
We're playing with fire here.
Most historical studies indicate that inflation is generally positive for risky assets, but too much inflation is bad. Hyperinflation is another thing all together, leading to the wipe out of an existing order/system. But even if we don't see hyperinflation, only inflation, there are assets that provide a better store of value than others. What inflation does is force you to do something. You can't just sit there (and especially not at the moment with cash and bond yields so low).
If it true that all roads lead to inflation, then how can investors best preserve their purchasing power? What stores of value will help protect investors against inflation? How should investors best approach this problem? Investors need to take greater risk with their asset allocation. Being fearful and leaving money in cash or bonds is perhaps the worst thing they can do.
Tuesday, November 2, 2010
Why are bond yields so low?
There are myriad reasons why bond yields are so low. I have found it useful to list them so that I have a framework for seeing the various parts and gauging how they change over time. Here is why bond yields are so low:
(1) Relatively low inflation.
(2) Exceptionally low short term rates (controlled by the Fed).
(3) The investor fearful of deflation.
(4) The investor fearful of equities.
(5) The investor who is simply fearful.
(6) Foreign central bank buyer.
(7) Federal Reserve POMO monetization.
(8) The ride-the-yield curve financial institution buyer.
(9) The front-run the Fed speculative buyer.
(10) The momentum buyer.
(1) Relatively low inflation.
(2) Exceptionally low short term rates (controlled by the Fed).
(3) The investor fearful of deflation.
(4) The investor fearful of equities.
(5) The investor who is simply fearful.
(6) Foreign central bank buyer.
(7) Federal Reserve POMO monetization.
(8) The ride-the-yield curve financial institution buyer.
(9) The front-run the Fed speculative buyer.
(10) The momentum buyer.
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