One of the great texts of the ancient world is Xenophon's Anabasis. It is the story of 10,000 Greek mercenaries enlisted by one of the contenders in a Persian dynastic struggle. They are victorious in battle but their sponsor is slain. Their leaders are then lured into a conference with the opposing commander and murdered. What follows is the remarkable story of a fighting retreat in which they elect new leaders (one of whom is Xenophon) and conduct an orderly and highly disciplined withdrawal over hundreds of miles until they reach the Black Sea. Xenophon's story of disciplined survival without leaders may have suggested to Alexander the Great that a disciplined army of moderate size could conquer Asia. It also stands as a model for investor behavior amidst market chaos in which market leadership has been decapitated.
In the latter stages of most bull markets the generals continue to move ahead while the foot soldiers lag. This was most recently and classically true during the final run-up to the dot com crash in 2000. Everything.com continued toward Alpha Centauri while the rest of the market, and especially small caps, languished. Jesse Livermore commented on this kind of thing anecdotally a century ago, warning that when the leaders of a bull market break down irretrievably, the bull move is over. We cannot quite yet say with certainty that this bull market has been decapitated, but as of Friday April 10 this has become highly probable.
The Generals of this bull movement include (but are not limited to): Tesla (NASDAQ:TSLA), Netflix (NASDAQ:NFLX), Priceline (PCLN), Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB), Linked-In (LNKD), Twitter (NYSE:TWTR), Expedia (NASDAQ:EXPE), TripAdvisor (NASDAQ:TRIP), Gilead (NASDAQ:GILD), the whole iShare Nasdaq Biotech ETF (NASDAQ:IBB), and, yes, Google (NASDAQ:GOOG) (NASDAQ:GOOGL). Some of them are great companies. Some of them will continue to astound and make investors wealthy even if bought at today's prices. Most of them are absurdly priced on all the major measurements of stock value. Some will next appear prominently on value screens for sad, bedraggled losers.
Consider Tesla. It has more than half the market cap of Ford (NYSE:F), about one and half per cent of Ford's sales, and no profits. How many things have to go perfectly for how long to justify that valuation? Are they going to whip not only Ford and other current auto makers but all future challengers? How much of a discount for uncertainty is built into Tesla?
One fact is very clear: no rational investor at this moment is buying Tesla or any of the rest of them for any quality other than price momentum, and without price momentum there is no rationale for buying them at all. The market will be in search of new leaders for the next bull move, most of which will outperform during the corrective phase and take off swiftly when the market again turns up.
Is this assassination of market leaders merely a rotation?
Yes and no, but mainly no. "Rotation" will likely be the major CNBC talking heads' meme as the market unravels (assuming that the current trends continue). It does have a grain of truth. The early evidence of rotation - toward value, value indexes, and especially large and mega cap value - does say a good bit about what is going on in the market and where you might safely park investment cash, particularly if you feel the necessity to be fully invested. It also suggests the disciplines that will help you survive a major correction.
The breakdown of the market leadership is based on a deeper reality: a general unwinding of the operating premise of this bull market. The premise is that money is abundant and the returns on safe investments are so low that an investor is justified in throwing money at lower returns, lower safety, and lower probability of success. For several years it has seemed crazy not to do this. Nothing special has gone wrong with any of the high flyers - certainly nothing that was not going wrong before. The change is in monetary conditions and the attitudes that came with them. The tide of monetary abundance has begun to recede. Risk has become less attractive, and may soon appear a lot less attractive. Insiders and the smart money have begun to take note of this.
So is the turn of the tide good for value stocks? Yes and no; relatively yes, initially yes, absolutely no. Ultimately, of course, yes, because value is the underpinning of all investing. The Value Generals in a major correction will serve as Xenophon and his colleagues in the Anabasis or possibly like Bill Murray in Stripes - good enough, with a little luck, to get you through.
The bottom line is this: when the leaders are taken out and shot, it isn't good news for anybody.
If this is a significant correction, how bad will it get?
Nobody knows a single specific answer to this question. One can assay some probabilities, but any such assessment is personal. Here is mine:
We are five years into a bull market, which is among the longer uninterrupted bulls. We have not had a correction on the scale of a normal annual drawdown for two years. This fact alone argues that a correction at this time is not likely to be unusually shallow. Another argument is that earlier corrections over the past five years have not featured the market leadership - which has been technology, especially social media "technology," and small caps. Small caps are by most measures above the 90th percentile in valuation, as noted recently by Joel Greenblatt, among others. Small caps are going to owe us several years of relative give back from this level, if not now, soon.
Everything is overvalued to some degree, from a slight amount to an absurd amount. The froth stocks look ridiculously overvalued to me. In some cases their price to sales ratios are more like price earnings ratios. The value stalwarts look to be somewhere around the upper end of a fair value band. Nothing looks cheap unless easy money and super low rates are going to persist forever. This is highly unlikely. There is a reasonable chance, however, that the next bull market will emerge while monetary conditions remain roughly what they are today. This suggests a fairly high probability of a correction of intermediate degree - 20-25%. Admittedly, this is more gut than science.
There are some rough patches out there - China's malinvestment and banking problems, potential deflation in Europe, and several geopolitical hot spots with economic implications. Even the U.S. continues to slug through a sad, gray recovery which is very tough on ordinary folks and includes a constant headwind to consumption. I do not see a high probability that any of these things will cause the global financial system to come unstuck, however. We have had two superbears in the last fifteen years with broad (and global) market declines around 50%. In the second one the financial system almost came apart. That may have been enough to rein in risk appetite and reset the world on a more normal course. A crash of some kind is entirely possible, but many crashes are brief events. Mega-bears have longer and wider consequences, and I don't see a clear and likely cause for one. My sense of the probability: fairly low.
What should one do about the likelihood of a significant correction?
The best answer is always: nothing. This is what you should do if you use the basic model of investing in low cost index funds with periodic rebalancing - the John Bogle model, to name its best known advocate. You will already have rebalanced toward your fixed income allocation several times, and a correction of moderate degree should cause you to rebalance back toward stocks at least a time or two.
If you are a trader, with disciplines to follow, you will probably stick to those disciplines until they begin to produce positive setups again. If you are a short seller, well, you need to be smarter than I am, and then you will know what to do. I think, frankly, that the market is going down, and that the froth stocks, the small caps, and Nasdaq will lead to the downside. Short selling, however, is asymmetrical to the negative side in a number of ways. I have a reasonable degree of confidence in my judgment, but much less confidence in my timing. I'll pass on short selling.
What am I doing in my own portfolio?
I myself own stocks rather than index funds. If I felt we were at or near the final cyclical bottom of the secular bear market/trading range since 2000, I would probably put my entire remaining cash reserve into an index fund. For now I like the flexibility and ability to control risk afforded by selected stock positions. I have a large cash position. I own no bonds, none at all.
My stock/cash allocation is such that I feel exactly the same if the market is up 2% or down 2%, up 20% or down 20%, and so on. This indifference is not my preferred posture, but has recently seemed to me the correct posture in a market which is at least somewhat overpriced and supported artificially to some degree by unusual monetary circumstances. I have tried to be positioned to be equally content to have my portfolio continue making modest new highs or to see the market fall sharply enough to deploy more cash.
I have looked at a number of strategies for hedging - buying puts, selling calls, employing collars (combined call writes and put buys) - and none of these strategies produces a satisfactory probability of positive outcome. Neither does outright sale of all or part of a position. Part of this calculation resides in the fact that more than half the value of stocks held in taxable accounts consists of embedded capital gains. The best candidates for option strategies are probably industrials like Parker Hannifin (NYSE:PH) and Dover (NYSE:DOV), both of which of which are now priced in what I feel is a border area between fair value and overpriced. They remain excellent, growing companies, however, and there is a reasonable chance that the next major bull market will be accompanied by the kind of real economic recovery that supports faster growth in industrials. I haven't ruled out selling calls against my positions at some point, but I am reluctant to do so at the current price.
The positive asymmetry of holding positions in well-managed, dividend-growing companies is a persuasive argument for sitting with your winners and letting a large cash reserve serve as your defense. This is particularly true of my largest position, Berkshire Hathaway (NYSE:BRK.B), which has the nice asymmetry of accretive buybacks at 1.2 times book to truncate the downside. It is also true for energy investments like Chevron (NYSE:CVX), Exxon (NYSE:XOM), and National Oilwell Varco (NYSE:NOV), which remain relatively cheap (though perking up recently) and where the risk assessment has less to do with price and immediate earnings than with an assessment of future pressures on carbon-based energy. I'm keeping them. I'm also keeping Wells Fargo (NYSE:WFC), Chubb (NYSE:CB), and Travelers (NYSE:TRV) for similar reasons, all of them reasonably cheap whatever their recent price actions. I have a mental note to seriously consider adding to each of these positions in the event the market suffers a decline in excess of 20%. If the market falls considerably more than that, I'll throw the last of my reserves into an S&P index fund.
The short answer for what I am doing in my portfolio at this moment: nothing. I don't know quite what I would do if I held a bunch of the market leaders. I suppose that if I had a tax loss, I would sell them; if I had a taxable profit, I would think about it for four or five minutes and then sell them. The only one I might talk myself out of selling is Google.
History suggests the strong probability that the demolition of the market leaders is bad news for themselves, their owners, their sectors, and to a lesser degree the market as a whole. Value stocks are likely to get through a correction with less damage, but an investor should not kid herself that the current market action is primarily a rotation. The next large upward push of the market is likely to have a different theme and a new set of leaders - possibly leaders associated at last with a fundamental economic expansion. The path to safety lies in cold, rational, disciplined action, or, ideally, inaction. Think of Xenophon's 10,000 leaderless Greek mercenaries and survive to fight another day.
Disclosure: I am long BRK.B, WFC, CB, TRV, PH, DOV, XOM, CVX, NOV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.