Where do we find the answers to the questions we ponder? Do we simply have to look around to find the answers in some book, computer file, Wall Street opinion, Fed pronouncement or media pundit? Or do we have to turn inward and ponder the questions ourselves to find the answers? According to Bob Dylan, understanding where we might find the answers was pretty much the point of his song Blowin’ In The Wind:
“There ain’t too much I can say about this song except that the answer is blowing in the wind. It ain’t in no book or movie or TV show or discussion group. Man, it’s in the wind – and it’s blowing in the wind. Too many of these hip people are telling me where the answer is but oh I won’t believe that. I still say it’s in the wind and just like a restless piece of paper it’s got to come down some …But the only trouble is that no one picks up the answer when it comes down so not too many people get to see and know . . . and then it flies away.”
Bob Dylan was 21 when he said that – pretty wise words from a 21 year old. I think those words are especially true for the stock market, because as people come to believe something it gets priced in. If ‘everyone’ believes that rates are going higher then maybe they will go higher and maybe they won’t, but you can be pretty sure that the market has priced that in as everyone acts on the shared wisdom. Thus, the ‘hip’ experts may tell you with confidence what will happen, because they have the answer. But what they’ve really told you is how they’ve acted – they’re taking actions to take advantage of rates going up. Want to join them? You’ll have to get in line behind them- they’re already there.
Here’s a good, concrete stock market example (with thanks to Bartley Madden in his book Value Creation Thinking.) In 1960, 3M Corporation (MMM) was a very highly regarded manufacturing company. They were quite effective, and continued to be through 2014. During that time period, investors would have been rewarded with a return matching the S&P 500. Wait, if it was such a great company, shouldn’t returns have been higher? Unfortunately, no. Those initial high expectations created premium pricing. Their great performance matched the premium expectations, so net there was no benefit to shareholders over the S&P 500. The company did exactly what experts thought, so there was no upside surprise.
Where does the market go from here? I think with markets you have to be aware of expectations. Are they getting better or worse, and what does that imply? Essentially what would have to happen that will make people reassess things more positively than does the current shared wisdom? That’s why we spend a lot of time looking at what people have called ‘sad’ stocks. Sad stocks are ones that people are currently down on, and that gives us a nice starting ground for research – it’s much easier to beat low expectations than high expectations.
It’s also useful to look at stocks and markets with this lens where the picture we are given doesn’t really make much sense. Apple (AAPL) is a great company, but the stock has been up about 24% in the first quarter this year. Why? It’s not earnings. In the last three months estimates for the first quarter, next quarter, and the year are down. Could it be excitement over the promise of new projects? You don’t see that from analysts – the last four ratings changes I see are downgrades, and the last upgrade was July of last year. Maybe initial expectations of investors were too low, so the leak down in analysts’ estimates is no big deal? You can probably slice and dice that to create a debate, but on a TTM (Trailing Twelve Months) basis, over the last five years AAPL’s average P/E was 13.48 and its 2017 starting P/E was 14.14, so it’s not obvious.
Why could this be happening? First, noise happens. The market is not a clockwork-type machine, however much we may wish so. But what else could be going on? One thought is that markets have been seeing record inflows in passive funds. Apple is the biggest stock in the US and the biggest stock in the Nasdaq. If something like the S&P 500 or the Nasdaq index gets bought, Apple gets the largest share of that purchase. Thus, there has been a large marginal buyer of Apple who is buying not because of anything that’s intrinsic to Apple, but because it’s the largest slice of a pie that they want to own.
Remember 2000? Everyone was happy, inflows were strong, particularly to tech, and Cisco (CSCO) was king. Shares were over $80 in March of that year, and are currently almost $34. I’m not saying you can make direct comparisons here – CSCO was a fairly young, growing, and unstable company then and the ultimate fair valuation was hard to know (though $80 seemed awfully expensive.) My point is more general in nature. You have a long-running uptrend. Under reflexivity, this can go on for a longer time than may be rational. In 2000, Cisco’s earnings growth slowed sharply, then turned negative. Some people adapted quickly, selling around the top. That wasn’t very many people. Many more sold after the stock had been cut in half the following year. This year, Apple’s earnings estimates are getting worse while the stock continues to climb. The stock has seen an influx of buyers who see a bright past and assume a bright future.
Is this a situation where you want to get in line behind those who have “the answer”? Do you want to get behind Dylan’s hip people?
Things change rapidly in the market. Marginal buyers can change quickly, particularly if they seem to be chasing performance. What happens if that performance disappears? Does the marginal buyer turn into a marginal seller?
It’s hard to say with certainty, but there are some interesting thoughts to point out. One is how well consumer confidence is coincident with the stock market. Some trumpeted the great consumer confidence numbers last week. When was the last time it peaked? 2007. The last time it was higher? 2000. Is that encouraging? I suppose you could hope consumer confidence continues to rise, so there’s no peak yet. Interesting thought with multiple possibilities. Thanks to Peter Atwater, he figured out that Gallup issues a more frequent but less followed confidence poll that foreshadows the more popular CRB (Commodity Research Bureau) poll. The Gallup confidence poll has turned down, as of the latest reading, perhaps coincident with Congressional failure on healthcare reform. Maybe things can turn back up again, but right now confidence is at 16 year highs and the leading confidence indicator has turned down.
I don’t want to exhaustively go through concerns, as there are always concerns; it’s just a question of how well they are priced in. The only other consideration I want to cite is leading (mostly sentiment) data versus lagging (mostly quantitative) data. A lot has been made of leading data, like manufacturing and service surveys, turning up. That’s totally fair. In a normal cycle, that’s what you should look for first – that’s why it’s called leading data. Contrast this, though, with lagging data, which is commonly quantitative information like financial and employment data. Why look at lagging data at all? Because while leading data can be noisy and potentially lead you astray, lagging data tends to move slowly and not lead you dramatically astray.
There are two points I’d make about lagging data right now. First, it has never really turned down – both financial data and particularly employment data have never really turned down. That’s nice, but it also means there’s probably a limit to how much it can follow leading data up. Second, there have been some signs of stress in the data. While I think it’s generally fair to call employment strong, first, that’s something that happens at the end of an economic cycle, and second about a third of the data is starting to indicate employment is beginning to struggle. That’s even more the case with financial data. We’ve seen big booms in student debt, auto debt, and property debt, and all three of those data points are showing signs of stress, with delinquencies on the rise. (Arguably a fourth debt growth sector has been energy debt, which is also showing stress.)
What, if anything, can hit this Teflon market? In 2000 I personally thought there was an identifiable problem- stock unlocks in the tech sector would create more supply than the market could handle. 2008 was tougher to pinpoint. There were identifiable problems in 2006 (not fully identified by me, to be honest.) They got worse in 2007 and really cracked in 2008. Was there one thing to hang your hat on? I think that’s a lot easier to do in retrospect than it was at the time, and I don’t think it’s even that easy to do in retrospect. While you may be able to see the underlying risk conditions, you can’t as easily pinpoint the trigger point where those conditions impact the market. I feel the same way about the present situation. One thing I will point out is that expectations have become pretty high, and those high expectations seem to be coming under pressure. Will it take much to create a change in expectations at this point? I guess the answer is blowin’ in the wind.