Climbing A Wall Of Cliches
From Nick Colas of ConvergEx
Climbing A Wall Of Cliches
If clichés reflect overly common (if therefore unappreciated) wisdom, then we finally have a good explanation for why risk assets continue to rally. No, there are actually not “More buyers than sellers” – money flows are negative over the last month for both U.S. equity mutual funds and ETFs. And forget about investors “Downgrading on valuation” as stocks climb higher and higher; truth be told, that’s not even really a thing (unless you work on the sell side). Nope, this is a “Flight to quality”, “don’t fight the Fed”, “never short a dull market” environment with “easy comps” from a long rough winter. Want to call a top somewhere around here? Remember that “Markets discount events 6 months in the future.” A “Santa Claus rally” in June? That would fit the one cliché we know is actually the market’s True North: it will do exactly what hurts the most “Smart” investors. And that would be to rally further as the doomsayers double down and the timid cling to their bonds and cash.
“You don’t want to live in a world where the Federal Reserve can’t move stock markets.” That is one of the most important observations I have heard in this business, and it came from a grizzled old veteran some 15 years ago. The venue was one of those interminable “Idea dinners” and we young pups had been sniping about the whole “Follow the Fed” approach to equity analysis. The old lion eventually swatted away our objections with his simple observation. And he was exactly right. If the Fed can’t move markets with its balance sheet and a little time, then you might as well hit up Youtube/Google for “How to skin a squirrel” and “bartering for surplus ammo”.
So how did the famous phrase “Don’t fight the Fed” become such a derided and devalued cliché? The short answer is that many overused phrases are still true. That’s why they end up so often repeated in the first place. Don’t play with matches. Don’t run with scissors. Cross at the green, not in between (that’s a little 1970s NYC cliché trivia there). All good guidance, but over time and with repetition even the catchiest phrases turn from useful aphorism to forgettable, time wasting, and moldy word play.
Wall Street phrases are especially susceptible to the reverse metamorphosis of swan-to-duckling. For all its supposed sophistication, finance is still anchored in oral traditions more than most 21st century occupations. In what other industry does a leading light go by the moniker “Oracle of…”? After all, the original Oracle sat in Delphi, believed in the pantheon of Greek gods, and anchored her (yep, the Oracle was a young woman) cultural identity to the stories of the blind and illiterate Homer. The modern one dispenses comforting wisdom anchored in a native optimism about human innovation and faith in capital markets.
Now, there are a lot of Wall Street clichés that feel distinctly flimsier than the overarching power of central banks. Consider the following in the context of current market action:
- “More buyers than sellers.” I suspect this must have come from a time when the New York Stock Exchange was the only game in town and $2 brokers crowded around various posts to make trades. Five buyers in the crowd and only two sellers meant the stock in question was probably going higher. In the end, however, there can only be one of each for a specific trade.
The most interesting aspect of the move higher for U.S stocks in the past month is that it comes on the back of large scale outflows of capital from both U.S. listed exchange traded funds (negative $8 billion) and mutual funds (negative $9.5 billion). There are, at least by this count, more sellers than buyers. And yet prices rise. Sellers may be sellers, but they aren’t particularly anxious to part with the holdings.
- “Flight to quality”. I suppose the opposite is the “Dash for trash”, which typically comes early in a market cycle. Once economic conditions begin to improve those companies which were closest to death’s door invariably rally the hardest. Not only do their fundamental stories improve, but they can access capital markets to fix balance sheets ravaged by the preceding downturn. Later in the cycle (like now), investors look for Teflon names just in case the next downturn is just around the corner. Back in the 1970s, corporate procurement managers used to say “You’ll never get fired for buying from IBM” as an excuse to go with that company’s products. Same goes now for stocks. If the global economy is going to weaken, which company will do better: the large multinational or the plucky third tier player?
- “Easy comps”. This one has a raft of near substitutes, but at its essence the concept is simple. The investing world looks at everything on a year over year basis, to remove factors such as the seasonality of demand to the vagaries of corporate expense accruals. If a company blows a quarter it is a whole year before we see it again, when it shows as a comparison point to the newly reported period. The same goes for same store sales comparisons and other industry benchmarks. And, of course, a bad report this year makes for an easier comparison next year.
With the lousy weather of Q1 2014, we essentially have the “Mother of all” (Iraqi cliché, I believe) easy comps now. Not only should we be able to accelerate economic growth in 2014 due to pent up demand, but Q1 2015 should be a layup for a 4-5% growth rate since the comparison is dead easy. We’ll see how that turns out, but never underestimate the power of the “Easy comp’ cliché. You are seeing its effect right now.
- “Downgrade on Valuation”. This is a popular catch phrase among Wall Street analysts, but it doesn’t mean what you think it means. In point of fact valuation is a remarkably slippery topic. It suffers extensively from noisy chatter in the oral history of markets. We try to parse past cycles and what investors who are long dead might have paid for similar stocks in similar situations, adjusted for things like interest rates and long term growth rates. While all this analysis may be comforting, it does little to help us understand what is moving stocks today. And tomorrow.
Market valuation is probably the single most talked about objection to U.S. stocks at the moment. Given the sensitivity to bubbles from the 2000 and 2007/2008 experiences, that’s natural. But language is powerful in this debate, so let’s recast the discussion. What if I told you that U.S. large stocks are 3.3% more expensive than they were at the end of last year? And that small cap stocks (we’ll use the Russell 2000 here) are actually 2% cheaper than in December 2013? Those are the year to date returns for each asset class, and their modest moves are much less scary than calling “Bubble” in a crowded market. After all, if we are in a “Bubble”, it is proving to be made of steel rather than soap film.
But here is why valuation is really a red herring of a discussion: math is not an investment edge. That’s not a cliché; it’s the most important thing to remember about anything in capital markets. Everyone has a calculator on their phone. Division is one of the four basic functions, and literacy rates among investors are essentially 100%. So don’t mistake the ability to do long division with the help of a machine for anything useful. It isn’t.
Now, here is the real call: “Downgrading our view of the market because there is simply no way we avoid a recession in the back half of 2014. We’ll be lucky to avoid a deflationary spiral after that, and corporate earnings will be down 10-15% in 2015 despites the supposed “Easy comps” of Q1 2014.”
If this is your scenario – and long rates on bonds certainly support it – then you are right to be bearish. The trouble is that you are ignoring the observation with which we started this note. Do you want to live in a world where +$3 trillion of central bank liquidity can’t spark some economic growth? And even if you do, is worrying over an equity portfolio really the best use of your time? And don’t think that bonds will bail you out if this all comes to pass. Deflation does funny things to government and corporate finances, as existing bonds and future deficits/CapEx spending must be repaid with declining tax/revenues in future years. Just ask Japan.
In the end, there is one cliché I trust more than any other: “The market will tend to do what hurts the most ‘Smart’ investors.” There is some logic behind that – just look back and see how many smart people where short U.S. Treasuries in December and long small cap stocks. Or long emerging markets. Once the smart money figures something out, the trade is over. I hear enough worry over U.S. stocks to make me think that the smart money is cautious. ETF money flows seem to confirm that sentiment. That caution may end up being right. But probably not just yet.
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