Commentary on Political Economy

Thursday 20 January 2022


Confessions of a Correction Curmudgeon

The big news from Thursday, emblazoned across the top of and headlined by many of our competitors, is that the​ Nasdaq-100 is “in correction.”​ This is​ in line with the standard definition that a “correction” in an index is any fall from peak to trough of 10% or more. I have no idea where this definition comes from, and I don’t think it’s of any use.​

Here, for reference, is what has happened to the Nasdaq 100 index over the last 13 years. Since​ hitting bottom in March 2009 following​ the Lehman crisis, it’s been quite a run, but one punctuated by 12 corrections. Or, to take the received jargon even more seriously, 10 corrections and two bear markets (declines​ of more than 20%, after the Fed laid out Quantitative Tightening on “autopilot”​ in late 2018, and in​ the pandemic’s first wave in early 2020.)​ Which is strange, really, because it looks more like an uninterrupted bull​ market:

Over that entire period, the Nasdaq 100 has never gone as long as eight months between setting new highs. The two “bear markets” were both reactions towhat appeared to be very alarming events. Markets quickly recovered, in the first case because the Fed backed off, and in the second because it​ made clear that Covid wouldn’t be allowed to damage securities prices. I don’t think either incident​ can be described as a bear market, but just as reaction to news that wasn’t​ all that exaggerated in either case.

So why do I have a problem with saying that a “correction” is any fall of 10%? First, it’s arbitrary. Second, and more importantly, the word implies that afterward,​ the market is​ “correct,”​ that whatever the problem was has been “corrected.”​ That is dangerously misleading.

Looking at the current situation, I drew some lines on the chart to show the clear upward trend before Covid. Even after being “corrected,” the Nasdaq 100 is still above the upper limits of that trend. And if we look at the 200-day moving average, a measure of the long-term trend, we find that the index is now just below it. But it’s dropped below the 200-day moving average several times during the post-2009 bull run and hasn’t stayed there​ for long. So if we’re talking about market trends and trading patterns, it doesn’t look to me as though we’ve corrected anything yet.

Themore natural way to understand the word is that the share price is somehow being “corrected” to come back in line with its fundamentals. If a market can be said to have a correct​ price, it presumably has to do with a measure of fair value. But if that’s what a correction​ is supposed to be, the Nasdaq 100 still looks incorrect.

This chart shows the index’s multiple of forward earnings (as calculated by Bloomberg) and of sales, going back to 2009. A rising trend in sales multiples is perhaps to be expected as industries grow more concentrated and bigger companies become more profitable. But both measures tell the same story. The Nasdaq 100 grew steadily richer in the 10​ years after the crisis, and​ then took a massive step change higher in the aftermath of the Fed’s​ Covid desperations. Neither measure is yet particularly close to its pre-pandemic​ level. If a correction means correcting for fundamental valuation, there is a lot more​ to be done:

So how seriously should we take this “correction?”​ And does it particularly apply to the Nasdaq 100, a large-cap index that includes virtually all the most exciting mega-cap technology companies?

If we compare the Nasdaq 100 with the equal-weighted version of the same index (where each component stock accounts for exactly 1% of the index at the beginning of each year, rather than being weighted for market cap), we discover that the average Nasdaq 100 stock is now no higher than it was last​ February. This chart​ strongly implies​ thatthat the market has been led by the largest companies, and that the correction has further to go:

Looking more broadly across the market, and at the pattern of selling during the day, we discover something more interesting. The following chart is a screenshot, as the graphical software went on strike when I asked it to deal with so much intra-day pricing. It includes a group of indexes that, off the top of my head, seemed to cover a range of U.S. stocks. Everything I looked at was trading upward in the morning and ended up down more than 1% for the day. The pattern for everything from special acquisition companies to​ meme stocks​ (which have had an index devoted to them just in time to track their collapse) through Chinese ADRs, the highly cyclical semiconductor sector, the Russell 2000 small-cap index, the mega-cap FANGs, and boring old real estate and value stocks dropped like a stone in the last hour. Meme stocks had the roughest ride, as we might expect, and real estate had the easiest. The Nasdaq 100 was in the middle of the pack.​

I draw two tentative conclusions. First, this selloff was above all indiscriminate. It has all the hallmarks of a top-down move to get out of equities. Second, the collapse into the close suggests miserable sentiment. Faced with an up market after a couple of tough days, people could have delighted that “buy the dip” was in force, and jumped on the bandwagon. Instead, they​ decided this was an​ opportunity to get out.​

To add a thoroughly unscientific and statistically invalid observation, Thursday’s trading pattern looks exactly like a typical session from the summer of 2007​ as the sub-prime crisis was beginning to send the first shock waves through the stock market. This was when the terms “risk-on” and “risk-off” came into vogue. Many investors watched the market​ and decided near the close, depending on their view of the horrors unfolding in credit, whether to buy the dip or cut their losses. Big changes of direction in the last hour, with no obvious news to trigger them, became a fact of life. I remember this vividly as I was working for a British newspaper at the time, and the deadline was 5 p.m. in the New York afternoon. Day after day and week after week, market reports that were ready with everything except the closing prices by 3 p.m. needed to be torn up and rewritten.​

So, whether or not what has just happened has corrected anything, the way the stock market is behaving does suggest elevated anxiety.

Looking more granularly, two stars of​ the work-from-home era suffered something that looks a lot like a correction. Netflix Inc., the leading provider of streaming video, published results after the market closed. The company​ wasn’t as optimistic about future subscription growth as shareholders had hoped. The result in thin post-market trading was a fall of 20%. I’ve incorporated the after-market closing price in the chart below —​ there is every chance that it won’t​ stand up after a day’s trading Friday, but the strength of the reaction says something about the way that sentiment is shifting:

Netflix prospered during the pandemic for obvious reasons. As valuations are supposed to reflect future and not past earnings, the extent of its rally was always odd. Did people really think that we would all spend so much time watching Netflix after the pandemic? Investors also seemed to miss an important distinction between Netflix and the other big FANG stocks —​ its lack of what Warren Buffett would call a wide economic moat. The internet platform companies all dominate particular spaces, and it would be prohibitively difficult to enter and challenge them. Netflix got off to a great start in the streaming battle, but it has plenty of deep-pocketed rivals.​ Competition has intensified as the pandemic continued. If the price move of the last two months represents a grasp that Netflix shouldn’t be treated as the eternally dominant streaming player whose viewership will forever​ grow at the same pace that it did during the pandemic, I’d say that was a correction.​

The​ other big corporate story Thursday was​ Peloton Interactive Inc., whose high-tech exercise bikes proved so popular during the months of isolation. The​ news was that Peloton was stopping production of the bikes due to falling demand. As a result, remarkably, the company’s stock is now lower than it was at the beginning of 2020:

I haven’t made a close study, but at first blush this looks as though it could be an overreaction. Do people think that the prospects for futureearnings now, after the pandemic tu­rned Peloton​ into a household name, are lower than they were before the great surge in demand in 20­20?

The bottom line for both Netflix and Pel­oton is that they can meaningfully be sa­id to have “correcte­d” after the noise of the pandemic promp­ted people to adopt unrealistic expectat­ions. It doesn’t mean their prices are now correct, but they make a lot more sen­se than they did.

Where does all this leave us? Attempting to time the market is a mug’s game, and I make no pretense to be any good at it. Valuation doesn’t help with timing, but it does give an in­dication of the scale of the downside, which for the biggest companies in the Na­sdaq is still great. But if I had to bet, I would say that there is a great​ amo­unt of Covid-era spe­culation still embed­ded in prices. It​ arose because of the huge amounts of liqu­idity unleashed to deal with the pandemi­c. If there’s​ no mo­re new liquidity from the central bank, or if it’s​ actively reduced (still big ifs), then the Nasdaq 100 (in particular, but many other U.S. stocks as well) has a lot further to fall. A process to co­rrect a lot of excess is now under way.​

For a much more conf­ident and aggressive argument of the same point, see the lat­est missive from GMO­’s Jeremy Grantham,​ entitled Let the Wild Rumpus Begin. And​ bear in mind that some really good corporate earnings, or​ softer inflati­on data that suggest​ central banks don’t need to be so aggr­essive, could easily make everything look much rosier. It mi­ght eve

No comments:

Post a Comment