Market Musings Blog

January thus far has hit investors hard with a steep stock decline. We hear this decline blamed on China, but that’s not likely. Let’s review the real reasons for why investors are taking so much value away from stocks.

First, the bear market didn’t start in January. As value managers, we are the canary in the coal mine. If we are not doing well, it is likely because valuation in the market is too high, and the market is narrowing around fewer and fewer stocks. This process started some time ago. Institutional Investor has written that it started five years ago. We really noticed it in the last half of 2014. Last year, 75% of S&P 500 stocks closed out the year below their 200 day moving average prices. A substantial majority of stocks were down. The NYSE Composite was off -6.4% and the Russell 2000 sank -5% in 2015. This is a replay of 1999, when the market indices were up strongly, but only because a few tech stocks were still surging, while all around us, the rest of the economy was fraying.

Second, China, the whipping boy for the blame-meisters, has been giving us fits for months. This didn’t start in January, either.

Furthermore, earnings, which actually do count, have been flat for two years, and look to be down to flat again this year.

While we can’t answer the question – why January 4, exactly? – we can say this is the normal progression of a market when values need to adjust downward to account for a variety of uncertainties. Those uncertainties now include: what do crashing oil prices really mean; who will be our next President; when will the Fed stop raising rates; when will earnings start picking up again… It starts with a whomping in some part of the economy where capital misallocation begins to adjust to normalcy – read ‘energy’ – and it proceeds to more benign bystanders – industrials – then it widens to infect everything, including the nine stocks in the S&P 500 that performed well last year.

No one knows how long this will last or how far down stocks will go. It could be over next week, or it could persist for some time. But the whole point is to make stocks cheap enough to tempt buyers again, and someday, that will happen. At some point, even if earnings are not picking up this minute, investors will be tempted by a dividend yield, or by an asset base, or by future earnings.

The very best way to tell when the selling is about to stop is the reaction to news. If a company reports lousy earnings and the stock goes up, we are shifting from ‘bad news is bad and good news is bad’ to ‘good news is good and bad news is good’. When the market is able to overlook today’s bad news, that is a sign it is finally seeing beyond the end of its proverbial nose, into the future, when things will improve.

From our last post, is it risky to buy Exxon at a 52 week low, but after oil prices have fallen 70% and show no signs of recovery?

The answer is: it is a lot less risky than buying the stock at its 52 week high when oil prices are $110 a barrel. It is not risk-less of course, but the lower the price of an asset, the less risky it is to purchase it. For instance, if you were given a gift of Exxon – ie, its price to you was zero – you could not help but make money. You would hardly care where Exxon’s price had been, if you acquired your shares for nothing, which is the ultimate low price.

Investors, however, behave differently. Many investors see stocks that are rising as less risky than stocks that have fallen. This is a behavioral marker of humans: we ‘herd’ together, and if other people like something and bid it up, we feel better joining in.

Another behavior that shows how we feel about risk is reluctance to take losses. Realizing a loss is an admission that you were wrong. But nothing says you have to make back a loss on the same horse that lost for you. Sometimes switching horses is the best move.

Risk mismanagement abounds in the markets; we’ve barely scratched the surface. Yet, the only aspect of your portfolio that you can truly control is its risk. You cannot control return.  Obtaining that return at the lowest possible risk is the Holy Grail.

Risk is slippery, risk is nuanced. Most folks forget the negative side of risk, instead remembering the old saw, ‘the more risk you take, the more return you earn’. Here are some situations that can fool the mind:

• You buy a start up biotechnology company with no earnings and as yet, no product. It goes up 100% in a year. Is this risky? Yes. In this case, the risk paid off in the short term, but you could just have easily lost all your money.
• You buy an early stage technology company with some earnings and two products. It sinks 90% in a year and then goes out of business. Is this risky? Yes. In this case, you took risk, and the portion of the adage above that is never quoted – ‘over time’ – raised its ugly head. You need several risky transactions in a diverse portfolio and a lot of time for that adage to work out. Between first investment and realizing a high return, you will put up with a lot of volatility and some disasters.
• You go in with your brother to build two spec homes in Boulder, CO. It is 2007 and homes in Boulder have gone up a lot in price. Is this risky? Yes, and you are about to lose a lot of money. You will have to wait until at least 2015 to regain most of your investment. If you have to sell before then, you lose money.
• You are one year from retirement and you have 90% of your funds in stocks. You need to live off your portfolio when you retire. None of your stocks pay dividends, but you do have 10% of your assets in bonds. Is this risky? It depends. If you have enough money and can adjust your budget to big market downdrafts, it is not as risky as if you need a fully reliable draw that is on the high side relative to your portfolio size. It IS risky, because you are betting on an unreliable phenomenon – appreciation – to pay your way. But how risky it is, is situational.
• Oil prices are down 66%. Exxon is trading 30% below its 52 week high, at its low for the year. You decide to buy Exxon stock. Is this risky?

The answer to the last scenario is where nuance arises. Exxon didn’t look risky when oil was at $110 a barrel and the stock was at $100 a share. Now, with oil at $37 a barrel and the stock at a 52-week low, it looks risky.  But: is it? Stay tuned for Part III.

The Third Avenue Focused Credit Fund, aka a junk bond mutual fund, moved swiftly to prevent redemptions by transferring the fund’s assets into a liquidating trust today. With the assets locked up, and no cash flows in or out unless at the behest of the fund manager, the manager hopes the underlying junk bonds can be sold in a rational way, rather than at fire sale prices forced by shareholders wanting their money. The fund owns some of the shakier issues available in the market, on the theory that many of these could heal themselves and prove to be more valuable later.

But the market has moved against the fund as the situation in the oil patch begins to spread beyond energy alone.

Unfortunately, the formation of the liquidating trust means shareholders can’t get their money until Third Avenue decides to make sales. So this is what can happen to a mutual fund in a distressed situation. In an extreme situation, if an investor’s whole portfolio was invested in, say, three funds that behaved this way, his money turns out to be locked up.

We are not fans of mutual funds, and this situation just provides more ammunition against these overblown products.

Aside from recognizing this event as an investment risk, it shows how fragile some areas of the economy are. Liquidity has dried up in some assets. Who needs the Fed when you have the markets to make interest rates for shaky credits leap well into double digits? And now, with the Fed actually on the brink of a rate hike, we’ll see who else is naked as the tide goes out.