Market Analysis
The Investor Base Becomes Momentum-Driven
You’ll know a market top is probably coming when:
Here are ways that corporate behaviors change near a market top:
Other Gauges
Near a top, the following tends to happen:
No Top Now
The Investor Base Becomes Momentum-Driven
You’ll know a market top is probably coming when:
- The shorts already have been killed. You don’t hear about them anymore. There is general embarrassment over investments in short-only funds.
- Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.
- Valuation-sensitive investors who aren’t total-return driven because of a need to justify fees to outside investors accumulate cash. Warren Buffett is an example of this. When Buffett said that he “didn’t get tech,” he did not mean that he didn’t understand technology; he just couldn’t understand how technology companies would earn returns on equity justifying the capital employed on a sustainable basis.
- The recent past performance of growth managers tends to beat that of value managers. (I am using the terms growth and value in a classic sense here. Growth managers attempt to ascertain the future prospects of firms with little focus on valuation. Value managers attempt to calculate the value of a firm with less credit for future prospects.) In short, the future prospects of firms become the dominant means of setting market prices.
- Momentum strategies are self-reinforcing due to an abundance of momentum investors. Once momentum strategies become dominant in a market, the market behaves differently. Actual price volatility increases. Trends tend to maintain themselves over longer periods. Selloffs tend to be short and sharp.
- Markets driven by momentum favor inexperienced investors. My favorite way that this plays out is on CNBC. I gauge the age, experience and reasoning of the pundits. Near market tops, the pundits tend to be younger, newer and less rigorous. Experienced investors tend to have a greater regard for risk control, and believe in mean-reversion to a degree. Inexperienced investors tend to follow trends. They like to buy stocks that look like they are succeeding and sell those that look like they are failing.
- Defined benefit pension plans tend to be net sellers of stock. This happens as they rebalance their funds to their target weights.
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Corporate BehaviorHere are ways that corporate behaviors change near a market top:
- The quality of IPOs declines, and the dollar amount increases. By quality, I mean companies that have a sustainable competitive advantage, and that can generate ROE in excess of cost of capital within a reasonable period.
- Venture capitalists can do no wrong, so lots of money is attracted to venture capital.
- Meeting the earnings number becomes paramount. What is ignored is balance sheet quality, cash flow from operations, etc.
- There is a high degree of visible and/or hidden leverage. Unusual securitization and financing techniques proliferate. Off balance sheet liabilities become very common.
- Cash flow proves insufficient to finance some speculative enterprises and some financial speculators. This occurs late in the game. When some speculative enterprises begin to run out of cash and can’t find anyone to finance them, they become insolvent. This leads to greater scrutiny and a sea change in attitudes for financing of speculative companies.
- Elements of accounting seem compromised. Large amounts of earnings stem from accruals rather than cash flow from operations.
- Dividends become less common. Fewer companies pay dividends, and dividends make up a smaller fraction of earnings or free cash flow.
Other Gauges
Near a top, the following tends to happen:
- Implied volatility is low and actual volatility is high. When there are many momentum investors in a market, prices get more volatile. At the same time, there can be less demand for hedging via put options, because the market has an aura of inevitability.
- The Federal Reserve withdraws liquidity from the system. The rate of expansion of the Fed’s balance sheet slows. This causes short interest rates to rise, making financing more expensive. As this slows down the economy, speculative ventures get hit hardest. Remember that monetary policy works with a six- to 18-month lag; also, this indicator works in reverse when the Fed adds liquidity to the system.
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No Top Now
- The Fed is on hold for now. Liquidity is ample, perhaps too much so.
- Actual price volatility is muted.
- Since all of the accounting scandals of the last few years, many corporations have cleaned up their accounting and become more conservative.
- Cash flow from operations comprises a high proportion of current earnings. More dividends are getting paid.
- Leverage has not declined, but most corporations have succeeded in refinancing themselves in a low interest rate environment.
- Conservative asset managers have not been fired yet.
- Most IPOs don’t seem outlandish.