Commentary on Political Economy

Thursday 3 September 2020




Twin Peaks of Wonder and Delight

It’s been another weird and wonderful day. In essence, I cannot improve on the end-of-day post from Adam Button on ForexLive, which I will quote in its entirety:

The magical, non-stop rally in stocks continues. The bottom line is this: the pandemic will end in 2021 but easy money policies from central banks and governments won't.

That, and 1.5% margin loans are fueling a remarkable run in stock markets. What's especially incredible is how few dips there are. There was a hiccup today that looked like it could turn into more but even big drops on the Tesla an Apple charts couldn't slow the momentum. New records abound.

  • S&P 500 up 54 points to 3580 (+1.5%)
  • Nasdaq up 116 points to 12056 (+1.0%)
  • DJIA up 454 points to 29100 (+1.6%)

There hasn't been a truly bad day since June.

I agree with all of this. Any number of measures show that this is the most extreme sentiment we have seen in the stock market since the top of the dotcom bubble in 2000. That is becoming the measure of comparison. It is a totally safe bet that there will be a big correction at some point. But any idiot can see that; the point is to work out when that will happen (if you are a trader), or to find something better to invest in now for the long term (if you are an investor). Neither is easy.

So, let’s try to keep things brief for a change. There was an interesting reverse for some of the most exciting and fashionable stocks on Wednesday, notably Apple Inc. and Tesla Inc., but this did nothing to shift the market. More defensive stocks had a better day than usual, but again, nothing that screams a change of direction. One telling comparison with 2000 can be seen in this chart, which compares the Russell 3000 value and growth indexes over the last 25 years. I normalized the chart to equal 100 on the day​ in 2000 when value made its previous low against growth. We know that the bursting of the bubble followed that time:

To save you from squinting at the chart too much, the last “melt-up” phase in 2000 was even greater than the one of the last few months, but the gain since growth stocks briefly lost ground to value in the weeks after the 2016 election is even bigger than in the four years leading up to the top of the internet bubble. Growth has done twice as well as value in that period.

In 2000, rates were low, and the Fed was beginning to raise them. This time around, rates are negligible and there is no chance of their rising for years. In 2000, the economy had been expanding for years; this time it is still clambering out from the hole created by arguably the greatest sudden stop in history. So there are points of difference.​

The similarity counts for more, though. At some point, this will reverse. But, as in 2000, there may well be no clear catalyst for that reversal in advance. And people who stick in value throughout may not feel greatly vindicated in the end. Back then, those who stuck to their guns saw clients pull their money, and wished they had gone with the herd. The same will probably happen this time.​

Stock Splits

A cynic, Oscar Wilde said, knows the price of everything and the value of nothing. Plenty of investors also, allegedly, have difficulty discerning the difference between price and value. That at least seemed to be the best interpretation of the extraordinary goings on in the shares of Apple and Tesla in the last week or so. Both companies had very high share prices after their long rallies. And on Monday, both decided to split their stock. The number of shares in both companies rose, so that while their underlying value was unaffected, the price of each share fell.

This should be a technical operation with no effect on market values. Instead, the market worth of two of the wonders of the age, with all kinds of great news already incorporated in their valuations, surged as they split Monday —​ and then sank​ Wednesday:

On Monday, the two tech titans rose while the rest of the market was sluggish for much of the day; on Wednesday, they fell as the rest of the market climbed. So these are obviously stock-specific effects.​

One response is to say that incidents like this prove markets aren't​ efficient. There shouldn’t have been any move at all. But that is too easy. Most of us knew already that markets are often inefficient. So how can we explain effects like this? I recommend reading this lengthy post from Aswath Damodaran, the guru of stock valuation at New York University’s Stern School of Business.​

He suggests that value and price are different things (which they are) and that different kinds of investors will view that difference differently. Traders only care about price (which is what changed​ Monday), while value investors will look for opportunities when price is below value, in the belief that they will converge. Efficient marketeers​ think it isn't​ possible to identify and take advantage of those differences when they emerge.

He then offers three different kinds of events that can befall a stock. “Value events” actually change the cash flows we should expect a company to produce, while “gap events”​ have no effect on value but might help markets realize that there is a gap and narrow it. Finally a “pricing event”​ on Damodaran’s definition might increase the price of the company, even if it increases the gap with value.

Both stocks have had plenty of value events in recent years, as markets have decided they are likely to produce more cash flows. What happened​ Monday wasn’t such an event.​ This was also not a “gap event.”​ Damodaran mentions spinoffs or stock buybacks as examples of events where companies that believe their stock is underpriced can try to nudge the market back to a fair valuation. Neither can possibly believe that their share price is currently undervalued.​

Instead, this was more of a price event. For a comparison, think of moments when companies change their stock tickers to something more memorable that can be pronounced as one word. It was established a while ago by academics working in behavioral economics that changing a ticker will raise the share price, which is why exchange-traded funds tend to have irritating but memorable ticker symbols. Similarly, a stock split brings in more investors, and creates interest and confusion. Traders, who don't care about the difference between value and price, can dive in and make a killing.​

This is how Damodaran, writing Tuesday, summed up what was going on:

  • If you are an investor, nothing that happened on August 31 should alter your views on the company. In other words, if you believed that Tesla and Apple were (under) over valued on August 30, 2020, you will continue to do so on August 31, notwithstanding the stock splits and the chatter of Tesla becoming part of the S&P 500.​
  • If you believe that one or both of these stocks is under or over valued, and you are hoping that the stock splits will close the gap, I am afraid that you are disappointed. These are among the most widely followed stocks in the world and stock splits are not going to draw new attention or cause neglected details to come to the surface.
  • However, if you are a trader and you play the momentum game, this is your moment of maximum pain and gain. It is conceivable, and perhaps even likely, that the split will keep the momentum going for the near term, and that you can take advantage by buying today and holding for a period. The problem with momentum is that it is fickle and for those who bought the stock expecting the stock split to be their big payday, if the results ​ fall short of expectations, there will be disappointment. If it sounds like I am playing both sides when I say this, I am, and that is one reason I stay on the sidelines as a trader. I am not good at it.

His conclusion looks good. Momentum in these two stocks proved fickle. If you took profits in these two great companies late Tuesday, well done. If not, never mind. If you’ve held either of them for any length of time you’re still sitting on a nice profit. And finally, the incident does at least remind us that while the market isn’t perfectly efficient, it can generally be relied upon to behave as though it is efficient for much of the time. If things get wildly inefficient, it’s a good bet that they will be corrected.

The problem is, as Damodaran said, that trading is difficult. This was a market inefficiency that grew up over a few days, and was largely corrected​ a few days later.​ Inefficiencies that have been brewing for months or years take longer to correct. And timing those changes is difficult. Which is to say that I, like most of us, am not good at it.

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