by Doug Kass
There’s too many of you crying
Brother, brother, brother
There’s far too many of you dying
You know we’ve got to find a way
To bring some lovin’ here today” – Marvin Gaye and Al Cleveland, What’s Going On?
After Renaldo Benson of The Four Tops witnessed police brutality and violence in Berkeley’s People’s Park during a protest held by anti-war activists (hailed as “Bloody Thursday”), he discussed it with songwriter Al Cleveland who wrote “What’s Going On?”:
“‘What is happening here?’ One question led to another. Why are they sending kids so far away from their families overseas? Why are they attacking their own children in the streets?” – Renaldo “Obie” Benson
The Four Tops turned down his request to record the song in the belief that it was “a protest song.” Cleveland next went to Marvin Gaye who was already inspired by social ills committed in the U.S. (“with the world exploding around me, how am I supposed to keep singing love songs?” ) – like the 1965 Watts riots. Gaye revised the song to his liking, retitled it and added melody (“added some things that were more ghetto, more natural, which made it seem like a story than a song … we measured him for the suit and he tailored the hell out of it”).
In 2004, Rolling Stone Magazine ranked “What’s Going on?” as the fourth greatest song of all time.
So, Dougie, what’s going on and what lessons should we learn from 2018?
A Changing Market Structure
“Price is what you pay. Value is what you get.” – Warren Buffett
The markets are ever changing – even the dominant players have their season. But, ultimately, when too many adopt the same strategy (who is left to buy?) and valuations go the extreme, the strategy nearly always implodes.
When I graduated Wharton in 1972 the bank trust departments dominated the markets. Banks concentrated their investments in the “nifty fifty” – a group of large cap growth stocks that became the market darlings of the late 1960s and the early 1970s. They were seen as great companies that became known as “one decision” stocks – stocks (like Avon Products (AVP) , Polaroid and Xerox (XRX) ) that you should buy, no matter how expensive and hold forever (sound familiar?).
In time, there valuations rose to elevated levels (Xerox at 50x, Avon at 65x and Polaroid at 95x earnings.)
Helping to restore the myth that the price you pay does not matter came from an unlikely source, Wharton finance professor Dr. Jeremy Siegel. In his book, Stocks for the Long Run, Siegel demonstrated that the fifty highest-priced stocks on the NYSE had basically matched the performance of the S&P 500 Index. This “demonstrated” that the market was not irrationally pricing those stocks.
The bear market of 1973-4 saw these stocks collapse dramatically in both magnitude and time (not dissimilar to the dot.com bust in mid -2000) and the previously dominant market player – the bank trust department – was replaced by an emerging mutual fund industry.
Fidelity, Putnam (where I worked), Templeton and other mutual fund families quickly became the dominant market players – overtaking JP Morgan (JPM) and Citibank (C) (as it was then called) as the major market player.
Along the way, a new strategy called “Portfolio Insurance” began to take hold. Ultimately, though it was a portfolio, it provided little “insurance” and served to be the catalyst of the October, 1987 massacre in which the markets dove by -21% in one day.
In the next decade, hedge funds (with their spectacular performance records) emerged as the dominant market player. George Soros and others were canonized, appearing on the cover of leading trade journals. But, as their performance deteriorated and the 1997-2000 dot.com boom became a tech wreck in 2000-02, active managers were beginning to replaced with passive exchange traded funds (ETFs) who provided a low-cost, tax-efficient, liquid and diversified vehicle for the retail investor. Soon thereafter, machines (and algos) began to further gain market share from active managers, producing high frequency trading and other quant strategies (e.g., risk parity) that outperformed active managers on a consistent basis.
As previously noted, these strategies and products are generally agnostic to balance sheets, income statements and private market value – that, to myself and others, is a dangerous precedent.
By most estimates ETFs and quants now account for nearly 3/4 of daily average volume. With the quantum rise in the popularity of ETFs and quant strategies we, as I have warned, have run the risk of Portfolio Insurance (Part Deux). It was clear, with the benefit of hindsight, that one of the risks associated with the popularity of passive products is that the market, like in 1968-1972 and again in 1998-2000, placed a small number of stocks in too important portfolio roles representing a disproportionate weighting (with elevated valuations).
The problem today is, like Portfolio Insurance in the mid to late 1980s (which produced a dramatic -21% drawdown in a day), the dominant players (ETFs and the machines and algos) worship at the altar of price momentum (and/or the perception of risk by asset class) – so they tend to “buy high and sell low.”
Regardless of reason (higher interest rates, widening credit spreads, trade disagreements, policy concerns, political uncertainty, etc.) the price momentum began to deteriorate earlier this year. That selling of the most dominant market players began to increase.
Then the fundamentals began to soften as global economic ambiguity increased. Homebuilders reported weak order guidance as market participants ignored the increasing lack of home affordability (as rates and home prices rose rapidly against a lesser rate of wage growth). Semiconductors proved, once again, that they are commodity plays. Former market darling Nvidia (NVDA) proved to be more of a crypto currency play that investors realized. Signposts of peak business data center emerged (as an overbuilt developed almost overnight). Apple (AAPL) whiffed and even Alphabet/Google (GOOGL) and Amazon (AMZN) reported uninspiring third quarter earnings reports. This all occurred amid the emergence of a substantive regulatory threat (to Facebook (FB) in particular) – something I have been very concerned about since mid-2017.
Recently dips are no longer bought (machines and algos don’t play that game and who beyond them is left to buy, save the company buybacks?) and the selling has escalated.
While as Byron Wien says, “Disasters have a way of not happening,” I am fearful of a repeat of the machine-induced market loss of October, 1987 in a backdrop of soft fundamentals and still too much optimism.
“Only when the tide goes out do you discover who’s been swimming naked.” – Warren Buffett
I can’t overstate how important it is to understand and learn from market cycles and history.
Howard Marks writes in Mastering the Market Cycle:
The superior investor is attentive to cycles. He takes note of whether past patterns seem to be repeating, gains a sense for where we stand in the various cycles that matter and knows those things have implications for his actions. This allows him to make helpful judgments about cycles and where we stand in them. Specifically:
- Are we close to the beginning of an upswing, or in the late stages?
- If a particular cycle has been rising for a while, has it gone so far that we’re now in dangerous territory?
- Does investors’ behavior suggest they’re being driven by greed or by fear?
- Do they seem appropriately risk-averse or foolishly risk-tolerant?
- Is the market overheated (and overpriced) or is it frigid (and thus cheap) because of what’s been going on cyclically?
- Taken together, does our current position in the cycle imply that we should emphasize defensiveness or aggressiveness?
As I wrote in “Swimming Naked:”
Bear markets and steep corrections reveal the bad actors.
The recent market schmeissing has uncovered these market Fugazzis. I have in the past (and in today’s opening missive) hit these bad actors hard because of the damage they deliver. But, like Warren Buffett, I prefer to criticize by category and not by the individual. We should learn from this reveal in order to better navigate the market’s noise going forward:
* Corporate managements who never met an outlook they didn’t like. In my more than four decades I have interviewed hundreds of managements and observed, in the business media, thousands more. I can not recall one management in my career who had negative observations about his/her company’s secular growth prospects. To paraphrase the Oracle of Omaha again, “corporate managements often lie like ministers of finance on the eve of devaluation.” [Treat their incessant optimism, in the future, with skepticism. Watch what they do (e.g., insider buys) not what they say.]
* Business media moderators who have no skin in the game and are quick to criticize when an investment professional makes an investor boner – reminding me of a wonderful (and oft repeated) quote by Mickey Mantle, “I never knew the game of baseball was so easy until I entered the broadcasting booth.” (There are plenty of value added moderators on the three main business channels, but turn off the channel when these bad actors appear.)
* “Talking heads”– guests who parade in the media – and too often make smug observations and confident market forecasts. Like the bandleader Johnny Mercer they emphasize the positives… but deemphasize or “sweep under the carpet” the negatives, in an attempt to gain viewership, raise their assets under management and/or sell you a service. (Don’t fall for their gambit.)
* The “special sauce” guys who have a special formula to beat Mr. Market. The most venomous are the “unusual call activity” crowd – a constant diet of which will end most up in the poor house. Most have little skin in the game. But, importantly, their consistent failure to memorialize the results of their recommendations is testimony to the mug’s game they use as a “hook” to snare the unsuspecting. I have contempt and little respect for those that show the “rolls” of their winners and too often ignore their trades that go to zero (e.g. out of the money calls bought on (ROKU) , (SQ) , (AAPL) , (TSLA) , (NFLX) , (GS) and many other high beta stocks of that ilk that have recently collapsed). (There is no special sauce. I give these players – with limited accountability and selective disclosure – no respect at all – for basically trying to deceive the individual investor.)
* “Long only” investors who rationalize poor performance in a steep market decline to their “charter” and take credit for good performance in a broad market advance. (They will reappear in the next up cycle – ignore them and remember ‘what they have learned from history is that they haven’t learned from history.’)
* The hedge fund community that is again, despite a sky-high fee structure, underperforming the S&P Index.
* Leveraged players who dramatically underperform when the tide goes out and exhibit superior returns when the tide comes in. (They mostly will be entirely wiped out and typically will never reappear – as they have likely changed careers.)
* Market strategists who parade in the business media, like self professed investment icons, when the going is good – only to disappear at the end/close of every Bull Market when the seas get rough. (They, too, will return in the next cycle but hide your children and your portfolios from them.)
We must learn from this history in order to avoid making the same mistakes in the next investment cycle!
The changing market structure and dominance of new market players (that are agnostic to fundamentals) that has evolved over the last decade is eerily reminiscent to past cycles (in particular Portfolio Insurance in October, 1987).
History demonstrates that a changing (from positive to negative) narrative surrounding the technology industry (in fundamentals and in the current case of added regulatory threats) often produces an influential and negative market inflection point.
What also points to additional market vulnerability is the age of the economic and market cycles – by historic standards (as Lee Cooperman discussed at my country club on Sunday evening). As well, a tipping point in monetary policy is a new cycle development – serving to reducing liquidity and increase volatility. (It took two years but real interest rates are now about to turn positive as the Fed’s balance sheet is shrinking).
I remain in a net short exposure.