We’re about a decade into an amazing bull run the stock market, with valuations climbing ever higher. I often hear questions on different nuances, almost always of course dealing with the way to earn the quickest or best returns.
In order to understand what drives returns, the most important thing is understanding flow of capital. You need to understand why money is piling into an asset and why you should expect this to continue. This may sound simple or obvious, but most people don’t think of things that way at all – they look too much into the underlying asset or the headline news. Most financial articles you read are nothing but noise – they take the most recent stock move and tie it to a recent headline. This is easy journalism which provides an endless amount of analysis to sell, can sound somewhat convincing at a surface level because it reflects something you’ve already heard and many are talking about, but really tells you nothing about what’s going on beneath the surface.
In order to understand flow of capital, I’ll start by introducing a number of investment strategies. Investing is as much art as science, and there are many ways to play it. Regardless of your strategy however, it takes patience, discipline, and conviction in your approach. I’ll list a few approaches and then brush into my view of things.
Passive investing / ETF’s:
Most funds today are passive rather than active, so I’ll start there. A passive fund, like an ETF, will blindly throw money at a benchmark allocating based on price. If a stock doubles in price, it’s weight in the index effectively doubles, and more money is allocated there as a result. Valuation is thrown out the window, as markets are assumed to be efficient in pricing. Downside protection is thrown out the window, as diversification is assumed to be adequate because you hold all the shares in the index. This strategy is a great way to minimize management fees, as very little oversight or research is required. However, I tend to believe that this strategy going mainstream will simply drive valuation to wilder cycles than ever before. When money piles in over time all seems well, but when this influx halts or reverses it could easily overshoot valuation to the downside. Most investors in this area tend to be momentum driven by nature, and will reallocate away when their gains don’t meet expectations, creating a self-feeding cycle lower.
For active managers, some focus in valuation. This tends to offer more downside protection, as reduced price can generate more interest rather than the reverse. However, there are many so-called “value traps” out there that seem to offer good valuation for years but simply don’t show the gains of momentum stocks leaving you with sub-par investment returns. Please understand though that value investing is by no means a dead end, it just isn’t a panacea – a good value investor should be able to explain not only why valuation metrics are good, but what catalyst is expected to drive valuations higher and approximately when this is expected to play out. Without the why and the when – or the signs to watch for – how can you keep the discipline to hold the investment until it gains? How do you know if it will ever gain?
Technical analysis and investing:
People often see the simplistic side of this approach- “the such and such stock price shows a classic formation which indicates movement to the upside with resistance expected at this price level”. It’s not quite that simple… traders who are successful with this style of investing often focus on a specific market and find what works there. They might look at oil for example and follow a number of indices they find relevant which often include currency fluctuations and trends energy users (like airlines and commercial freight). They also pick a time range that tends to be short term … some are measured in hours, some in days, weeks or months but typically not much longer than that. The big advantage to this approach is that you always have something to work on, and you have relatively steady ways of quantifying your success and value, so many active fund employees invest this way.
The idea here is that you try to find the overall trends in the market and invest accordingly. Is the dollar strengthening, putting pressure on gold an emerging markets? Will bond yields continue to rise or fall and who will gain as this happens? Note that political events can affect this, but it is primarily related to identifying cycles … what type of market are we in, what are the primary drivers, what are the signs that the cycle is shifting, and so on. This is what I’m personally most drawn to, but it has a major drawback … there isn’t always something great to invest in. I like using the ocean as an analogy here… technical and momentum investors try to follow the waves, making something on each one. Value investors pick a few surfers in hopes of finding a good one for the team and trusting him to make it. Macro investors focus on the tides. This can be powerful, but you might have to wait a while before the tides are really moving.
Back to the original question – what drives the markets?
Over the last decade, we have had unprecedented easing of central banks worldwide. The federal reserve is perhaps the most important player, but the amount of easing by the European Central Bank, Bank of Japan, and Central bank of China has been much heavier. The result has been a flood of new money to “invest”, almost like a dam opening up to make the river flow bigger. In addition, capital conditions for global investment have eased like never before.
This has lead to what I like to think of as the “everything bubble”. Housing has effectively become a global investment asset instead of a place for workers to live. Whatever it is that big funds pour money into – stocks, bonds, real estate, etc – have soared while wage inflation stayed low. This has a number of implications including the worldwide political instability we see, but I’m going to focus on markets.
In a sense, the markets now are really simple, but more patience is required than ever which can be excruciating. Essentially, the flood of central bank money has been driving markets ever higher in a way that far outpaces other drivers. Right now it has simply become a story of one ratio: the quantity of money allocated to investments compared to the quantity of available assets to invest in.
Take a quick look at recent events in this area. The Federal Reserve began to tighten in two ways – reducing its balance sheet holdings while increasing interest rates. The US dollar began to strengthen. This put a lot of pressure on emerging markets, so they all had to tighten central bank policy in response. Emerging market assets slumped in value. The BOJ, ECB, and bank of China slowed or stopped their easing measures so that their currencies wouldn’t drop too much. The US dollar is still the worlds biggest reserve currency and the biggest currency for international trade, so these entities cannot just let their currencies slip.
Then the tax cuts went through allowing big international corporations to “re-patriate” their overseas cash holdings without the big tax penalties of the past. This money flooded into stock buybacks and US treasuries. The US market didn’t see a taste of the liquidity drying from the world until mid 2018, but the move was relatively mild (though somewhat larger in the most crazily valued tech names). Markets don’t move in a straight line however, and the low in December was followed by a new wave of money. The Federal Reserve even spoke dovishly in January to help keep valuations high. Worldwide markets aren’t seeing the same gains however, and even gold has been under pressure as money has flowed into US dollar denominated assets.
However, the Federal Reserve is still reducing its balance sheet and other central banks are still waiting before they ease further. Also, the US budget deficit is higher than ever. This that means that the money flow from central banks isn’t raising the level of money allocated to investments, while the amount of investable assets – in the form of US treasuries – is still increasing. That is an outward tide which warns of lower valuations ahead. Be patient my friends and hold more money aside for a time when valuations are better.
How do you know when to stop waiting? Simple. The Federal Reserve will start loosening the floodgates again. Once asset values go down enough to spook the banks and politicians, the Federal Reserve will lower interest rates and then start to increase their asset purchases again.
Don’t try to be clever and front-run this process. The magic is in going with the tides, not anticipating a future move before other investors. Let the Federal Reserve reduce rates to 1% before you become really bullish, otherwise you’re fighting upstream, it’s really that simple – and the patience required will be excruciating.
In the last down cycle back in 2008, I made a big mistake that I don’t want to repeat. Valuations were getting better and I was all in before that crash in fall 2008. I witnessed a massive margin call as the CEO of Chesapeake lost his shares and pushed the stock below $12 a share. I knew this was a crazy good buy but I couldn’t do anything! If I sold my existing holdings it would take a few days before Ameritrade would let me re-invest the money, and even if I had money to transfer in there was a waiting process. A few days later the stock was back over $25. The bottom of the market hit in March 2009 and I couldn’t keep investing because I knew my days of working in my HVAC construction job were numbered. This time I want some money to allocate for crazy bargains if they happen. Also … the central bank turned the market last time just as it will this time. When that happens, if last time is a guide, the US market will pick up first while emerging markets lag for a year or two. Then emerging markets will skyrocket as risk-on once again dominates.
Good luck everyone, and remember- the key to correctly applied patience in investing is to know why you expect a move higher and you give yourself signs to watch for. Without that you’ll be subject to the folly of losing patience prematurely (like I did with emerging markets back in 2010), or blindly being patient in a “value trap” that never seems to go anywhere.