There was a book written in 2001 by Richard Bernstein titled Navigate the Noise. That certainly seems like an appropriate topic for today’s market. With the rise of algorithmic trading and low liquidity (few ready buyers in volume at current prices), it’s amazing how many sudden, surprising moves happen in the market, punctuated by resets like the mini-crash of last winter (intra-day drop of 20% on December 26th) or the momentum factor algorithm meltdown of the last week or two. How to make sense of it all? What is news and what is knowledge?
No great surprise to regular readers, but I’m fond of scenario analysis. What is the range of possibilities that can happen and how likely are those various possibilities? That method can also be called a Monte Carlo simulation. How well do those possibilities fit in with current pricing in the market? Contrast that with the algorithms, which seem to chase headlines. Mention a potential trade deal enough, and apparently you can approach all-time highs. There’s probably potential for a drinking game in there somewhere… which sometimes seems like how the market is acting.
It’s easy to complain about crazy market moves, but it’s more effective to take what you get and don’t get upset. Facing reality is a lot more useful than pointing at ideology. So what do we have?
Unfortunately, based on market data, this is a situation that can go multiple ways, so there’s no ‘Easy’ button here. First, so I put it out there, October earnings are likely to be bad. The thing is, that’s broadly expected. Thus, guidance may be more important, here. Specifically, we need to pay attention to the potential gap between the expectations for that guidance and what we actually get. For my part, guidance already seems awfully optimistic, so the very common October expectations reset seems like the base case, but it pays to be open-minded.
Past the next quarter is when it really gets interesting. What’s behind that door? I fully expect a tiger, but I can’t rule out the possibility of a lady [Stockton, Frank “The Lady, Or the Tiger?”.] Basically, we’re comping against sufficiently weak year-over-year numbers that I can’t rule out the idea of an improvement starting towards the end of the year.
Don’t get excited, though. I don’t want to get too complicated here, so I’ll keep it fairly simple. It may be possible to create good scenarios, but it’d historically be very uncommon given the current situation. Probably most important is that the market has already largely priced in that good scenario. Thus, if we do get that unlikely but possible good scenario, I wouldn’t expect to get paid very much for that. Let’s look at two examples.
First up is financials. If you are willing to assume that loan loss reserve additions will stay quite low, and that basically everything in the economy continues to chug along OK, then you still end up with an earnings scenario that looks roughly flat. For that, you have to pay a price less than 10% off of all-time highs. Needless to say, that’s a risk/reward scenario that I find difficult to like.
Second is semiconductors. Their business has been pretty terrible for the last three or four quarters. That’s not good, but it also puts out the possibility that next year could show improvement. That would be nice, except again you have the question of the price you have to pay. At roughly the worst price in 2016 you would have paid $75 to buy the semiconductor index (SOXX). Now you would be paying $218, just off of all-time highs. For that price you get an industry that has stubbornly refused to price in factually bad earnings and may see modest improvement if everything manages to work OK. As an aside, the latest data I’ve seen from semiconductor hubs, like South Korea, aren’t at all encouraging, but hey, trade the headlines, so drink up!
So where do you run? The way we work, right now that’s a pretty difficult question. First, to state the implication clearly, while I can’t rule out the possibility that we will see a turnaround party like we saw in 2016, it would be much harder to do this time around. Something would have to drive further growth, and right now all we see is slowing growth. Would a trade deal even be enough? I find the numbers hard to make work. The only light of optimism out there is that it wouldn’t take particularly great numbers to see improvement from the last year or so. From this field position, though, that’s really unlikely, just not impossible.
So what are we doing? In stocks, we’ve been raising cash over the last few weeks. Everything is broadly pretty rich. Defensive sectors have a better range of scenarios, but still aren’t that great. I’m willing to bet we get better opportunities coming up, perhaps surrounding earnings season. In our asset allocation strategy, we started out overweight in equities, and then spent the bulk of the year heavily overweight in long-term Treasurys, but spent August paring down to a market-weighted position. Why? That was a run of historic proportions we’ve seen in Treasurys this year, and while I expect it to continue over time, our tendency is to trim or sell as risk/reward gets worse. Treasurys and some other fixed income instruments are still attractive, and I’ve been adding back to them a little over the last week or so, but given the run of relatively positive macro data we’ve seen of late, they had arguably gotten ahead of themselves. They’re broadly attractive in the long-term, they just got a bit ahead of themselves last month.
Bottom line, while I expect we’re going to see deteriorating data over the next year or so, I can’t guarantee that, so we’re trying to stick to good risk/reward situations. Just as important, the market is currently pricing in very optimistic scenarios. That leads us to generally be cautious. We’ve seen a modest trend of rising volatility since 2017, and I’d expect that to continue as a base case. While that’s a concern, it’s also an opportunity. In this low liquidity environment, we’ve seen that prices can change quite quickly. There’s no reason to expect that to change, so it makes sense to be proactively prepared if you can be. All of the advice above looks pretty useless based on the last two or three weeks, but that time is gone. What you do today prepares you for the future, and that’s why we’re doing what we’ve been doing. Sometimes the best tactic is patience. Patience lets you take advantage of opportunities, and genuinely patient capital is an important commodity in an uncertain, uncomfortable, vacillating market. You have to Navigate the Noise.