As readers of my blog and followers of my Newsletter know, I am no fan of this rally. I feel it will soon come to a bad end. This, though, has not kept the Newsletter from being 60% invested, as I write.
In times like these, the ever lurking schizophrenia comes to the fore. The market is schizophrenic in both senses of the word: it seems to have lost contact with the economy, and it manifests the usual contradictory bipolar behavior.
Perhaps not surprisingly, the market forces its nature onto investors and traders so that they, too, become schizophrenic (not necessarily medically so). Take my statement, that I don’t like the rally but am 60% invested. That's definitely bipolar. After all, what can be more schizophrenic than demand and supply at the same price?
It helps that many of us have to test trading systems continually, thus coming face to face with that messy process called the scientific method. The Method is itself schizophrenic – first keep an open mind and try and find relationships between data series; then, when you think you’ve seen something, subject it to rigorous statistical testing and try to disprove it. So traders are surrounded by bipolarity all the time and had better get used to it.
As to the current state of play, there seem to me to be too many bulls too soon.
SPY closed at $68.11 on March 9th and is $91.41 as I wrote this, up 34%, in just two months.
My main concern is that the market is moving up (1) too rapidly, (2) on news which is merely good and that only if compared to what came before, (3) our metrics are shaky, (4) we are reading too much into the metrics, and (4) too many people have a stake in the financial and housing sectors, all desirous of sucking in good new money.
Shaky metrics? Like what’s the P/E ratio of the S&P 500? (See, for example, Prof Jeremy Siegel’s debate on how best to calculate a P/E ratio for the index.)
Reading too much into them? Like, in such turbulence, how can we trust bank accounting? And what are profits if, at the same time, they need a “capital buffer”?
I am not a value investor but having started out studying the fundamentals, I still follow value investors closely because I cannot overcome the discipline’s appeal.
At Ivey School of Business, they set up The Ben Graham Centre for Value Investing and on the website posted interviews and lectures by leading value investors including Warren Buffett, Walter Schloss, Seth Klarman and others.
One of the contributors is Kim Shannon of Sionna Investment Managers here in Toronto and she discusses, in the second half of her lecture, what happened in previous bear markets to P/E ratios after each successive bear attack and how, eventually, markets ended up at single digit P/Es.
Single digit P/E and an average sustainable dividend yield of more than 5% or 6% is the solid ground the bull needs to gain traction. Otherwise, unless there are major developments, the ground is too mushy.
Many of the more erudite economists I have followed recently believe that deflation is a greater danger than inflation, principally due to excess capacity and the sluggish velocity of money induced by deleveraging.
The market, on the other hand, seems to be thinking of all the newly created money seeking a place. Many advisers speak of the huge amounts in money funds, ready to spill into equities and commodities.
I used to think that inflation is unlikely to be a threat for some time. Now, I am having second thoughts:
As I said, SPY increased 34% in two months. XLB, the basic materials sector, is anticipating much improved profitability since it is up 44%. During this same period of time, since March 9th, light crude oil increased by 20%. DBC, the DB Commodity Tracking Index Fund, is up 11%.
I don’t want to read too much into these price movements, but I am a little surprised at how quick commodity prices reacted to the perceived good times. Maybe it is going to be inflation after all.
Note: inflation is good for commodities, but not necessarily good for equities. See Warren Buffett’s "How Inflation Swindles the Equity Investor”, which appeared in Fortune in 1977.
DISCLOSURE: I have a long position in XLB. No position in SPY, DBC.