The most amazing thing about markets to me is that no matter how many previous instances I have, I can never find days that are anywhere near the ones we are currently having. It is moving from x day highs to y day lows with impunity and alacrity and then hanging on the balance scale at the end of day when Zeus decides who will win.
I remember reading a book several years ago about Roger Bannister and his breaking of the four minute mile in 1954. At the time there were any number of physicians who predicted that the record was physically impossible to break; one predicted that Bannister's heart would explode to accomplish such a feat.
I was reminded of this in both watching (and hearing) that, once again, in a seemingly inexorable march of highs (and lows), world records were broken throughout the Olympics in Beijing.
It bears mentioning that the events themselves have changed greatly from year to year: not only in the rise of professional Olympians, undistracted from a training (indeed, a living) regimen by employment, formal education or social duties, but as well in the structure of the events themselves. Engineered swimsuits, deeper pools, vacated end lanes, and other such changes in swimming events alone have contributed to the aforementioned increase of extremes.
So too, I'd hypothesize, in the markets: that the year-over-year outdoing of previous records in extremes have as much, if not more…to do with the character, fragmentation and specialization of market venues; the "democratization" of access to various markets, bringing millions of additional opinions and hundreds of billions more dollars in; the rise of electronic, in particular algorithmic trading; better/faster processing speeds in technology; and the like, *ad infinitum*…than of any intrinsic quality of markets
Thursday, August 28, 2008
Monday, August 18, 2008
Why Stocks May Not Go Down the Drain
BACK IN HIGH-SCHOOL MATH CLASS, ONE OF THE PROBLEMS I hated was this: A bathtub is filling at x gallons per minute, but water is draining at an (x-1) rate. How long before the 60-gallon tub is filled? The math geniuses -- most of whom probably run their own quant shops now -- figured it out relatively quickly, but I struggled. I'd always think, why not plug the drain?
Think of the market as the tank, substitute earnings growth for the water coming in and inflation for water going out, and investors are facing a similar challenge. The inflation rate has a crucial inverse affect on the market's price-to-earnings ratio: Higher inflation depresses P/E multiples, while lower inflation allows P/Es to expand, or the tub to fill, because companies lose less profit to inflated costs.
The latest figures suggest the worst, inflation up and earnings down. Thursday the July inflation estimate was released: up 0.8%, due to rising food, energy, airline and apparel prices, and up 5.6% from the level 12 months ago, for the highest jump in 17 years. Meanwhile, S&P 500 earnings were down about 22% in the second quarter, after falling 16% in the first, with most of that damage in the financials. With a global slowdown under way, the likelihood is that S&P 500 profits will show further quarterly drops, perhaps for the next six to 12 months. In other words, water is entering at a slowing rate, just as it's now draining at an accelerated pace.
But you don't need calculus to know that as bad as inflation is right now, it's likely to subside over the next 12 months, perhaps enough to mitigate the damage from earnings declines. Profits will drop, says Morgan Stanley European strategist Teun Draaisma, but history suggests that falling inflation could help expand P/E multiples enough to cushion the blow, keeping the overall market roughly where it is now. Morgan Stanley expects the U.S. inflation rate to slide to 2.8% by the end of 2009. Commodity prices, which have fallen significantly, will soon be lapping the outsized increases of 2007.
During past recessions in developed markets, he adds, at some point inflation peaked, even as profits still had a long way to fall. "In Europe, for example, in the 16 months beginning December 1974, corporate earnings fell some 40%, but the P/E went to 14 from six, and the market rose about 50%." Before you push the Buy button, Draaisma is looking for a flattish market, not a big rise, because the expected inflation drop won't be as large as those in previous recessions, nor is the current U.S. market P/E, about 14-15 times 2008 earnings estimates, as low as those in past contractions.
And there's a caveat. (There's always a caveat, isn't there?) The strategist sees a "garden variety" recession. A long and deep economic malaise could overwhelm the balm from lower inflation. Now, if we only had a stopper.
Think of the market as the tank, substitute earnings growth for the water coming in and inflation for water going out, and investors are facing a similar challenge. The inflation rate has a crucial inverse affect on the market's price-to-earnings ratio: Higher inflation depresses P/E multiples, while lower inflation allows P/Es to expand, or the tub to fill, because companies lose less profit to inflated costs.
The latest figures suggest the worst, inflation up and earnings down. Thursday the July inflation estimate was released: up 0.8%, due to rising food, energy, airline and apparel prices, and up 5.6% from the level 12 months ago, for the highest jump in 17 years. Meanwhile, S&P 500 earnings were down about 22% in the second quarter, after falling 16% in the first, with most of that damage in the financials. With a global slowdown under way, the likelihood is that S&P 500 profits will show further quarterly drops, perhaps for the next six to 12 months. In other words, water is entering at a slowing rate, just as it's now draining at an accelerated pace.
But you don't need calculus to know that as bad as inflation is right now, it's likely to subside over the next 12 months, perhaps enough to mitigate the damage from earnings declines. Profits will drop, says Morgan Stanley European strategist Teun Draaisma, but history suggests that falling inflation could help expand P/E multiples enough to cushion the blow, keeping the overall market roughly where it is now. Morgan Stanley expects the U.S. inflation rate to slide to 2.8% by the end of 2009. Commodity prices, which have fallen significantly, will soon be lapping the outsized increases of 2007.
During past recessions in developed markets, he adds, at some point inflation peaked, even as profits still had a long way to fall. "In Europe, for example, in the 16 months beginning December 1974, corporate earnings fell some 40%, but the P/E went to 14 from six, and the market rose about 50%." Before you push the Buy button, Draaisma is looking for a flattish market, not a big rise, because the expected inflation drop won't be as large as those in previous recessions, nor is the current U.S. market P/E, about 14-15 times 2008 earnings estimates, as low as those in past contractions.
And there's a caveat. (There's always a caveat, isn't there?) The strategist sees a "garden variety" recession. A long and deep economic malaise could overwhelm the balm from lower inflation. Now, if we only had a stopper.
Wednesday, August 6, 2008
The End of the Era of US Dominance?
You can read a lot lately about the end of the US dominance era. Many dare to compare the Roman empire with the United States. Examples can be demographics issues with "barbarians" entering the empire as workforce (as opposed to invaders) while the average "citizens" age increases, high military expenses to maintain presence along the borders, big trade deficit as rich consumers help grow poorer neighbors that produce at lower costs. Environment, food, climate change, and energy are additional problems, which are not exclusively "American", but require a global response. Let's leave aside the parallels between Romans and Americans. There are multiple futures ahead with profound implications from the U.S. perspective. The main drivers are related to:
- energy: peak oil and dependence from foreign sources;
- technology: what happens if the technology gap narrows in favor of competitors?;
- demography: older population and immigration issues;
- climate change;
- global governance and geopolitics: failing states and emergence of areas of regional/global power (Asia/resurgence of Russia).
There could be many other drivers, but, in my opinion, the analysis of the implications of the different future scenarios should start from the present situation.
Twenty years after the end of the cold war the US remains the only global power, however, I think that being global in the years past has shown itself to be too expensive for the benefits it gives. The efforts required to maintain a constant (or even increasing) high level of global presence are too high. The main point is that marginal costs are higher than marginal benefits. In summary, if this trend continues, the country could enter a long decline era, where vital resources are wasted to "guard the outposts of the empire" instead of being used to sustain the country's capitalistic and entrepreneurial spirit. Maybe a global strategy should be set aside in favor of a reduced and more focused intervention in specific critical areas and issues. At the same time, concerns about US "strategic competitors", should not be excessive. No country, from China to Russia and each for different reasons, can cultivate the ambition to become a global player for decades to come. The US should manage the comparative advantage in technology, military, innovation potential, financial markets, social development, property rights, education, and so forth, making a better use of its huge resources. The current trend of deficits and debt is not going in this direction. Many consider this trend acceptable and manageable. Actually, my personal opinion is that a continuously weaker currency, higher inflation, increasing private and public debt, a fragile credit system display that the current strategy (with the related cost and budget implications) cannot be sustained much longer. If we look at the stock market, which represents the economy, in the past ten years it has not grown that much. And, if we take into account exchange rates, the situation looks even less satisfactory. The wave of innovation (and source of huge profits) brought by the advent of the information age in the nineties was initiated and "owned" by US technology and US companies. Microsoft, Intel, Oracle, Cisco, Yahoo! and so forth are some examples. The last wave, still ongoing, but limited in its effects, is now represented by Google and Apple. This sector is getting mature and growth appears to be slower with time. In general, the stock market performance reflects a mature economy where growth can be sustained only at the cost of higher inflation. The US needs badly a new wave of innovation. Where is the next wave coming from? Will US companies once again be protagonists? This is what is really crucial in the next decade. Energy dependence is one important aspect, also from the national security perspective, to take into account in this scenario. Is alternative energy going to drive the new technological developments and the needed growth? Biotech? Nanotechnologies? Very difficult to say. Very important, however, is that resources be allocated properly to maintain the intellectual and cultural leadership in the various fields of human and economic interest and not dispersed to support global strategic efforts, which could reveal themselves as unsustainable in the long term.
- energy: peak oil and dependence from foreign sources;
- technology: what happens if the technology gap narrows in favor of competitors?;
- demography: older population and immigration issues;
- climate change;
- global governance and geopolitics: failing states and emergence of areas of regional/global power (Asia/resurgence of Russia).
There could be many other drivers, but, in my opinion, the analysis of the implications of the different future scenarios should start from the present situation.
Twenty years after the end of the cold war the US remains the only global power, however, I think that being global in the years past has shown itself to be too expensive for the benefits it gives. The efforts required to maintain a constant (or even increasing) high level of global presence are too high. The main point is that marginal costs are higher than marginal benefits. In summary, if this trend continues, the country could enter a long decline era, where vital resources are wasted to "guard the outposts of the empire" instead of being used to sustain the country's capitalistic and entrepreneurial spirit. Maybe a global strategy should be set aside in favor of a reduced and more focused intervention in specific critical areas and issues. At the same time, concerns about US "strategic competitors", should not be excessive. No country, from China to Russia and each for different reasons, can cultivate the ambition to become a global player for decades to come. The US should manage the comparative advantage in technology, military, innovation potential, financial markets, social development, property rights, education, and so forth, making a better use of its huge resources. The current trend of deficits and debt is not going in this direction. Many consider this trend acceptable and manageable. Actually, my personal opinion is that a continuously weaker currency, higher inflation, increasing private and public debt, a fragile credit system display that the current strategy (with the related cost and budget implications) cannot be sustained much longer. If we look at the stock market, which represents the economy, in the past ten years it has not grown that much. And, if we take into account exchange rates, the situation looks even less satisfactory. The wave of innovation (and source of huge profits) brought by the advent of the information age in the nineties was initiated and "owned" by US technology and US companies. Microsoft, Intel, Oracle, Cisco, Yahoo! and so forth are some examples. The last wave, still ongoing, but limited in its effects, is now represented by Google and Apple. This sector is getting mature and growth appears to be slower with time. In general, the stock market performance reflects a mature economy where growth can be sustained only at the cost of higher inflation. The US needs badly a new wave of innovation. Where is the next wave coming from? Will US companies once again be protagonists? This is what is really crucial in the next decade. Energy dependence is one important aspect, also from the national security perspective, to take into account in this scenario. Is alternative energy going to drive the new technological developments and the needed growth? Biotech? Nanotechnologies? Very difficult to say. Very important, however, is that resources be allocated properly to maintain the intellectual and cultural leadership in the various fields of human and economic interest and not dispersed to support global strategic efforts, which could reveal themselves as unsustainable in the long term.
Friday, August 1, 2008
Ten Basic Laws
1. The trend is your friend
2. Don't confuse brains with a bull market
3. 50% of the movement in a stock is due to the overall market, 30% to the industry group, and 20% of the fundamentals of the company.
4. 80% of the research budget of a Wall Street brokerage firm is devoted to fundamental analysis.
5. Sellside analysts make more money than buyside analysts.
6. The problem in trendfollowing is determining when trends start and when they end.
7. The market can stay irrational far longer than you can stay solvent.
8. The more available information is, the less useful it is.
9. Figures lie and liars figure.
10. When you sit down to a poker game, look around the table to find the pigeons. If you can't find any, you're the pigeon.
2. Don't confuse brains with a bull market
3. 50% of the movement in a stock is due to the overall market, 30% to the industry group, and 20% of the fundamentals of the company.
4. 80% of the research budget of a Wall Street brokerage firm is devoted to fundamental analysis.
5. Sellside analysts make more money than buyside analysts.
6. The problem in trendfollowing is determining when trends start and when they end.
7. The market can stay irrational far longer than you can stay solvent.
8. The more available information is, the less useful it is.
9. Figures lie and liars figure.
10. When you sit down to a poker game, look around the table to find the pigeons. If you can't find any, you're the pigeon.
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