The Market Needs to Rise Again before It Peaks by A. Michael Lipper, CFA
Last week’s post hinted that this week I would discuss where are we on the track to a major peak, an issue that I have been concerned about for some time.
History suggests that those who use a crystal ball to predict the future are often forced to eat crushed glass. I certainly doubt most people’s ability to predict the future with any accuracy. I do not claim any special powers or intelligence. What I do believe is useful is to cogitate about what can happen in the future aside from a mere extrapolation of a current trend.
The negative consequences of a peak
The way people write about the large losses suffered from major declines is at worst wrong and at best incomplete. There are two missing pieces. The first is what families talk about in terms of foreclosed leveraged loans which transfers property; that is, the family farm or business.
For me, the second loss (which is both more difficult to measure and much more important in the end) is the loss of opportunity to make very cheap purchases of property, businesses, and securities. In the past, purchases made in distressed periods have yielded capital appreciation of three to one hundred times original capital.
Throughout recorded history, burnt investors, often hurt by intellectual or legal frauds, swear “never again.” They won’t believe in any positive view of the future. We are already seeing investors, particularly younger investors, pulling back. With this so-called risk revulsion as a prospect, I am focused on a track to be wary of the next market peak.
Peaks change the way individuals participate in markets
A sharp, narrowly focused big rally that will dramatically change the individual participation in the market is almost a requirement for a generational peak. Peaks need to suck in all or almost all available capital. They do this on the basis that, despite an immediate strong upsurge, further large price gains are a certainty. We have not yet had this precursor, but we could be setting it up, starting with this week.
After 205 trading days without so much as a 5% general correction, we did get one by early February. This last week saw a relatively low-volume rally that regained almost all of the decline.
The gain in the week was impressive — perhaps impressive enough for people to extrapolate that 2014 could produce the kinds of remarkable gains that 2013 did. (Our own private financial services fund, as well as some others, performed very well. We have warned our holders that this type of gain is not expected to be repeated again in the near future.)
The role of volatility and dispersion
How could we put up some spectacular numbers that would excite people to override their natural caution?
The answer is in two technical market words, volatility and dispersion. The mathematical definition of volatility deals with the amount of price movement that is different than some trend line. The popular press tends to only refer to volatility on the downside. The kind of exciting upside market price movement that will need to occur to suck lots of money into the market will not be called volatility, but genius.
What will cause this kind of movement? That will be dispersion.
The market is moving away from the high correlation market that took almost all stock prices down five years ago. What is happening now is that the relatively little volume being transacted today is away from the large secure stocks even though one could make the case that large caps and their supposedly large liquidity is the safest place for institutional investors today who are conscious of the age of the current bull market run.
We are seeing most of the volume being done in social media-related securities widely defined. (In some cases these are the reborn “TMT” names: technology, media, and telecommunications.) Just contemplate that Apple* has a market capitalization exceeding Exxon. Listen up at your next cocktail party when the conversation moves from “Bridgegate” to the stock market, count the number of times Apple, Google*, Twitter, and Facebook are brought up relative to Exxon.
Then, judge by looking at the outer ring around the conversation and guess what they will be buying and selling soon. One of the reasons individual stocks can skyrocket is an increasing number of insistent buyers are overwhelming the market with buy market orders, not terribly concerned about the going-in price because the rewards will be so large.
This kind of action can, and to some degree is, happening in selected currency, commodity, and bond markets that are deemed to be professional arenas. These can be reinforcing a bullish stock market. For example, much has been written about the smaller-than-normal interest rate spread between high quality and high interest paying paper. One of the reasons Moody’s* went to a new high this week was the increase in high yield offerings expected in both the United States and Europe, which will require credit ratings. And this is where the reinforcement to the equity market comes into the picture. Moody’s recognizes that historically low expected default rates will make high yield (low quality) bonds more attractive for purchase. Whether these new bonds are part of a refinancing scheme that lowers interest rates and extends maturities or are totally new to the bond market, the mere successful offerings in the bond market tend to make the issuers’ stock price rise. This kind of reaction has penalized high quality stock funds compared to those which invest in lower quality or marginal companies.
Markets collapse not because of immediate economic conditions but because of rumors or news of unexpected occurrences; for example, the assassination of the Archduke Franz Ferdinand, which was the proximate cause of the beginning of World War I.
Clearly I do not know what event will cause a market decline after a meteoric rise. But I have a possible one to think about. The present Chinese dynasty is very conscious of collapses of prior dynasties; they also think in longer terms than most of the world’s political leaders and even some far-sighted military leaders. China is building for periods far beyond the current expected terms of office. They want to restore China’s place in the world to number one.
Along the route a lot can go wrong unexpectedly. Some problem dealing with China in rumor or reality could be the equivalent of that relatively minor shot in the decaying days of the Austro-Hungarian Empire.
What are the sorts of unexpected things you think could cause some future collapse or you don’t think there will ever again be a major collapse? Please let me know.
*Stocks owned by me personally, by the private financial services fund I manage, or both.
This was previously published on Inside Investing at the CFA Institute.
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A. Michael Lipper is a CFA charterholder