Persuasion Time

The last few weeks have been rather strange.  It started with a 2% drop in the U.S. stock market on the first trading day of the month.  It picked up more strangeness on the following Thursday when the market fell 10% intraday on reasons still a bit unclear.  The “flash crash” they call it.  It continues today with the market very weak again on, from what I can tell, is no new news.

All the talk of Europe’s problems and the threat of contagion is, in my view, besides the point.  From what I can tell, investors are selling mostly because they want to sell.  It’s as if all the economic progress made from the first part of 2009 was all smoke and mirrors.  Some people may actually believe that – that all the improvement was built on the back of government stimulus that will soon end, spinning us into another recession.

As if on cue, all the doom and gloom gurus, who have been quietly absent from the media’s attention for the last year, are now once again proudly on display, explaining exactly how fragile the situation is, and enumerating all the fun and exciting ways it can become much, much worse.  I know these seem like hard times, but allow me to provide some perspective.

1)      Corporate America is doing fine. U.S. companies have the best balance sheets in decades.  They are sitting on record amounts of cash.  Revenues, profits and cash flow have all surpassed expectations for five consecutive quarters.

2)      Low interest rates are a boon for much of the economy.  The Fed appears committed to keeping rates low for a long time yet.  This helps the car companies, the banks, the housing industry and reduces expenses for every borrower.  It also makes stocks look more attractive relative to bonds.

3)      Stocks are on sale. It’s funny how consumers love anything on sale except stocks.  As the market falls, I begin to see great bargains on many of my favorite companies.  Even if investors have no new cash to invest, these lower prices can allow them to swap into very attractive stocks at cheap levels.

4)      Positives and negatives always co-exist.  Even when the market was rising, the problems the market seems so concerned about right now were there. Never is it the case that only positives or only negatives exist.  Investors are always trying to figure out which forces have the greater influence.  Right now the negatives are winning.  Yet, scores of positive factors exist; they are just being ignored by the market.

5)      The worst case scenario never happens. My worst case view?  North Korean launches nuclear missiles (you doubted they had them??) into Seoul and Tokyo.  Seizing on the mayhem this causes, China invades Russia with 100 million troops.  Responding to this threat, Russia fire off its nukes – unfortunately they are still targeting the U.S.  President Obama, channeling Martin Sheen in “The Dead Zone” fires off our nukes into the heart of Germany, because, well, we’ve beat them twice before.  Anything less than this, I think the market can handle.  Seriously, the stock market has been able to absorb the worst global credit crisis in a generation.  It bounced back from that.  The current fear is unlikely to spread to another crisis of similar magnitude.  Even if it does, it seems logical to me that the market could again rebound from that .

In all reality, I don’t feel fine.  Every day the market shows this kind of volatility affects me in a harsh way.  Yet, I have enough training and experience to know that these days, too, will pass and the market will once again focus on the positives and ignore the negatives.  Until then, I will continue my search for value and seize upon it when I see it.

Well, what I can say?  These are strange times we live in.

The market falls 7.6% in one week (at one point over 9% in one day), and the best the heads of the stock exchanges can say is “we are working on finding a cause for this.”  Last Monday, the market’s actions felt technical – a concerted move by hedge funds and other active traders reacting to a spike in volatility due to concerns in Europe.  I say “technical” because the market went down early in the day and basically stayed at that level to the close.

Thursday’s action was something else entirely.  What exactly, the authorities are still working to discover.  It seems unlikely it was a “fat finger” – someone pushing the “sell a billion” button instead of “sell a million.” The real culprit appears to be the automatic trading systems active traders now use.  High Frequency Traders (HFT) are also being looked at closely to determine what role, if any, this portion of the trading community may have had.

What is HFT?  At the most basic level, it is very short-term trading (measured in milliseconds) driven by sophisticated computer programs which can measure and trade on the slightest inefficiencies in the market.  A few years ago, HFT represented about less than a quarter of the daily trading volume; now that figure is as high as 75%, according to some estimates.  Despite this high volume, HFT traders only represent 2% of the number of traders out there.  HFT proponents argue that their activities make the market more efficient and lower the cost of trading (by narrowing bid/ask spreads).  Critics suggest that they have some kind of “unfair” advantage over other traders.  If last Thursday’s market action was either caused by or exacerbated by HFT, perhaps more scrutiny of this kind of trading may be warranted.

But, all of this is a distraction from what I think is really important now.  Before I comment on the important stuff, let me touch on three important groups of people germane to the discussion of the day:

1)      Journalists.  These folks love to tell stories.  When the market moves up or down, they are supposed to figure out the reasons and the cause and come up with a coherent story which explains the move.  One of my responsibilities at my first job on Wall Street was to write daily market commentary for my colleagues in Tokyo.  Every day I would search the news wires trying to put together the story of the day.  Sometimes “narrowly mixed in light trading” was the best I could do.  Journalists today have tremendous resources available to put together the story of the day, and yet some days, there just may not be a really good reason for why the market does what it does.  However, they still want and need to create and report the story.  My point: the “story” given in the media for any given day’s trading action may not be the whole picture.

2)      Traders. These folks love to make money in the short run.  They measure market trends and will buy and sell in order to capitalize on these trends.  They work for hedge funds, mutual funds, broker-dealers or for themselves.  They use complex computer programs or their “gut feelings.”  The best ones can make money regardless of the direction of the market.  My point: trading is a fine way to make money in the market, but it’s not what I do.  Traders’ opinions about the market are likely to be colored by their time horizon, which can be very short.

3)      Investors. These folks love to make money in the long run.  They measure value and try to buy cheap and sell dear.  Although there are many types of investors, they all share a number of characteristics – they hold investments for a longer time than traders, they usually stay fully invested (as opposed to holding mostly cash), they understand the markets, but may be focused on other things – individual stocks, sectors or countries, and they may care much less about the daily ebb and flow in the markets as do the previous groups. My point: I tend to value the opinions of investors, those folks do what I do and think as I do, over the opinions of other groups.  Part of the challenge of investing these days is sorting through the massive amount of information out there to find the things which really matter.

So, what’s important now?  Fundamentals, that is, those things which ultimately matter to the stock market, do not change quickly.  In my view, Greece is really a digression or distraction from the really important things.  The same goes for the technical glitches from last Thursday.  Corporate earnings, the economy, interest rates and cash on the sidelines are the most important drivers for the market right now and they are all positive.  Amid all the excitement last week, many failed to notice that the US economy added 290,000 jobs in April – something I thought would be a reason to cheer.

Bottom line – I still think that the bull market persists and last week was nothing more than a technical correction and a buying opportunity.  Many smart investors I spoke with last week agree with me and used the weakness to buy stocks.

Or maybe it’s “fear.”  Stock markets around the world took it on the chin today after investors began really worrying about European sovereign debt.  Yes, you might have heard that the European Union had approved a big bailout package for Greece, whose problems are well known, and had concluded (as did I) that Greece and all of its problems was already fully discounted by the markets.  Today’s new twist is the fear of contagion.  This is the “high concept” that one bad apple may indeed spoil the whole bunch.  If Greece can be driven to the brink, this concept muses, why not Spain, Portugal, and others?

Above all else, the stock market fears uncertainty.  Could Greece’s problems spread far, wide and deep?  Maybe.  I am no expert on sovereign debt or the Euro Zone, but I do know that many stocks I really like are now 2—4% cheaper than they were yesterday, without any change in their individual fundamentals.  I also know that corrections within the context of a bull market are normal and actually helpful – they help to prevent the kind of “irrational exuberance” that prevailed in the late 1990s.

This sudden rush of fear reminds me that we are still far away from universal bullishness on the U. S. stock market.  Investor psyches are still tender from the punishment inflicted upon them over the last few years.  Whenever anything negative develops, we tend to move immediately to a “what next?” mentality, as if every negative thing has to be the first of a series of bad events.  In normal times, a correction like we saw today would split opinions somewhere down the middle – half would urge caution and half would view it as a buying opportunity.  The fact that opinions appear to be highly skewed to the caution side this time around tells me that times are not yet “normal” and that much work still needs to be done for investors to fully embrace the new bull market.  That’s one of the key reasons I think it will continue.

My bottom line is that this is a buying opportunity.  I can’t predict that this correction will end in one day; it might last weeks or even months. But I do believe today’s action does not represent anything more than a normal pull back within the context of a bull market.  Time will tell.