Monthly Archives: March 2013

Stretching Out the Cycle

I’m a big fan of looking at the past in order to put the present into perspective.  In my opinion, the inability to do this well may be a key factor limiting the average person from being a good investor.  Too many people focus only on the present and/or the recent past and then extrapolate the current situation into the future.  This tendency can explain the irrational exuberance of the late 1990s and the morbid pessimism during and following the “Great Recession” of 2008-2009.

It is obvious to most people now that we are in a U.S. equity bull market.  Yet, during each of the corrections the market experienced during 2010, 2011 and 2012, there were many who were quick to “predict” that the bull market was over and that stock prices were “doomed” to revisit the old recession lows.  Much of the “analysis” touted in the media, appears to be little more than extrapolating the current trend, whether it’s up, down or sideways.  Why do people think this way?  One possibility is that many trends will persist for a while.  The likelihood of being “right” goes up when one expects the current trend to continue.  Everyone who likes to hear the sound of his/her own voice will want to be right and to be quoted often in the media.  Going with flow will assure this, at least for a while.

Another possibility for this tendency is that calling inflection points is very difficult.  Think back to how many people you can remember suggesting that October of 2007 was the peak in the stock market.  Naturally, some who had been bearish for a while before then took credit for calling this cyclical peak in the market, but very few actually did.  Ditto for the bottom of stocks prices in early 2009.  Many smart investors were buying stocks in late 2008 and early 2009, but very few of the “expert” commentators were calling the turn when it happened.

I guess this my roundabout way of saying that predicting the future is hard.

But, here is where the past can be helpful in trying to understand what might be coming down the road.  We all know that a typical economic recovery (as measured by the time from the trough in GDP growth to its peak) lasts about 5 years.  We also know that few recoveries are “typical,” and that knowing the average duration only gives us a general guideline for the current cycle.  We also know that U.S. equity bull markets last, on average, a little over 4 years.  Here too, the mean does not define each and every bull market.  Yet, these two historical measures can be helpful in determining where we are now in our cycle.

Near the end of a normal economic expansion, corporate profits and profit margins tend to be high, and tend to peak near a cycle’s end.  Interest rates are usually trending upward as the cycle nears its apex.  Capacity utilization, employment growth and other cyclically measures of economic activity will also show higher than average numbers as the cycle peaks.  Often, we will see banking lending very strong near the end of a business cycle – many times the recovery/expansion will be fueled by this lending.  Inflation is usually trending higher near a cyclical top.  Corporate balance sheets may show more debt and less cash as companies use borrowing as well as their own cash flow to expand their business growth.  More often than not, some kind of excesses in a sector or industry may be obvious near the peak of broad economic cycle (tech in the late 1990s, real estate in 2007-2008, for example)

As equity bull markets mature, they also can show tell-tale signs of their own demise.  Somewhat ironically, stronger-than-trend line economic growth is often a harbinger of the end of a bull market.  Strong profit growth if accompanied with expected higher profit growth can often signal the end of the bull market.  Stock valuations almost always reach their highest levels at the peak of the bull market.  Perhaps the most telling sign of the end of a bull market is sentiment.  In my career, each bull peak was accompanied by widespread enthusiasm of stocks.  Most people you would meet at these peaks were fully invested in stocks and wholeheartedly expected the markets to continue to rise further.  Cash on the sidelines will usually be very low at the peak in stock prices.  As with the economy, some sort of excess may accompany a bull market top (tech and telecom stocks in the late 1990s, for example).

Which of these “typical” cycle-end factors do we see today?

Only a small number.  Corporate profits and margins are high. Sentiment has improved from the bottom.  But mostly everything else suggests anything but a business cycle peak or bull market top.  Debt levels are low and cash levels are high.  Bank lending is tepid.  GDP growth has been below trend most of this recovery.  Employment trends are not robust.  Equity valuations are closer to cycle averages than peaks. The evidence supporting a top in the economy or the U.S. stock market is quite scant.

This leads me to believe that this time around the business cycle and by extension the bull market will be longer than average.  I see very little of the excesses I normally associate with market tops.  The Fed is likely to keep short-term rates low for a long time yet – this should provide some kind of support for the stock market.  We have seen some rotation into stocks by individual investors in recent weeks, but I would submit that sentiment is far from ebullient.

One of my favorite equity market strategists, Liz Ann Sonders, published this wonderful graphic:


Where do you think we are now in the cycle?  I think maybe just above the “optimism” line.  We still have three E’s to go before we can call the bull market over – here’s to the coming Enthusiasm, Exhilaration and Euphoria!

So how much longer can the bull market last?  I’m not sure (I don’t make predictions, remember?), but I think that anyone who hears someone say that “stocks are expensive” or that “another crash is coming around the corning”  should take a look at the important data (as I suggest above) and draw your own conclusions.  The “best” time to lighten up on stocks is when everyone you meet is telling you to buy them.  I don’t think we’re there yet…

How Picking a New Pope is Like Picking Stocks

The historic resignation of Benedict XVI is certainly newsworthy.  Something that hasn’t happened in 600 years usually is.  Now the cardinals have gathered at the Vatican to select the next global leader of the Roman Catholic Church, the world’s largest Christian Church.

I am not an expert on this, but as I read about it, I was fascinated by the details of the selection process.  As I learned more about the process, I was struck by the many challenges facing those who must make this decision, and by the ramifications this choice will have on the church, if not the entire world.

As I pondered on this, I realized that most people would not view this process akin to picking a stock.  Clearly, the selection of a new pope has global important far beyond anything stock pickers might do, nonetheless, I found a few points of similarity and contrast worth exploring a bit.

Selection by Committee.  The new pope will be chosen by a committee, the College of Cardinals.  Although committees often receive much criticism (the old joke that a camel is a horse as crafted by a committee is but one example…), I suspect they do well in this kind of big decision.  A committee, especially one made up of diverse individuals, can bring a breadth of experience that can make the collective decision much smarter than any one member of the committee might make.  Most places where I’ve worked used a committee to discuss the particulars of stock selection.  This kind of committee work is sometimes more time consuming than working by oneself, but the outcomes, in my experience are usually smarter than the decision of one person.

Following Proper Procedure.  The cardinals will be required to gather in Rome and follow strict guidelines for picking the new pope.  The details are too numerous for the scope of my note today, but a couple caught my eye:  1) No recording devices of any kind are permitted in the discussions.  2) The ballots for each vote are hard written in secret but tallied in public.  3) It’s considered bad form for a cardinal to vote for himself.  In the investment decision process it’s very good to have some kind of procedure to follow.  Too many people tend to select a stock based on a media report, comments from a well-intended friend or neighbor, or (horrors!) from somebody trying hard to sell them something.  There are many valid investment styles, but to be a successful investor requires one to learn, understand and follow the procedures associated with that investment style.  My process in simple terms starts with a screening process to find stocks which look attractive simply by the numbers, then uses qualitative analysis to determine the attractiveness of the stock (some stocks which look good simply by the numbers can be horrible investments…), then looks long and hard at the stock’s valuation, then a dash of technical analysis and then the final decision.

Deliberation.  I suspect that many outsiders would love to be a fly on the wall during the discussions which attend the selection of a new pope.  I’m sure that the cardinals, in trying to find the “right” person who will lead the church over the next several years, consider many factors, including age, health, race, nationality, geography, etc.  In picking a stock, I look at a large number of factors such as cash flow, valuation, profitability, quality of management, insider transactions, sentiment, size and so forth.  I will also consider how the new stock might fit into the portfolio I am managing.  Well-constructed portfolios do not simply contain my “favorite” stocks. Balance, diversification, and risk measures are as important to a portfolio as is the attractiveness of any one stock.

Final Decision.  The new pope will be selected with a 2/3 majority of the votes.  Each time the votes are cast and tabulated, the paper ballots used for voting are tied together and burned in a special stove which sends out smoke from the Sistine Chapel.  Black smoke indicates an inconclusive decision and that more deliberation and voting will be needed.  When a final decision is reached, the smoke from the chimney will be white, signaling to the world, a new pope has been chosen.  Whenever I approach a new stock, I really hope that the decision will be easy.  Most often, however, my initial feeling is mixed – some good, some bad, some questions remain.  I will then go back, dig up more data, ponder a bit more, discuss the issues with my colleagues and try to reach a final conclusion.  There is a great deal of satisfaction and relief in those “aha” moments when the conclusion is obvious.  Alas, my final decision on stock picking never approaches the drama of a puff of white smoke – I just buy the stock and look forward to good things in the future…