by Doug Kass, Seabreeze Partners Management
“Tops are a process, bottoms are an event.” –Wall Street adage
Back in July I wrote about the possibility of a market top; that warning “bears” repeating in an updated form and version.
In that column I wrote that tops are a process and bottoms are an event, at least most of the time in the stock market. If you looked at an ice cream cone’s profile, the top is generally rounded and the bottom V-shaped. That is how tops and bottoms often look in the stock market, and I believe the market is forming such a top now.
Consider the following fundamentally based issues and concerns:
* Downside Risk Dwarfs Upside Reward. I base my expected market view on the probabilities associated with five separate (from pessimistic to optimistic) projected outcomes that seize on a forecast of economic and corporate profit growth, inflation, interest rates and valuation. In the past I have suggested that this exercise is a guide and is not intended to be a precise calculation, especially in uncertain times. The averages recently have surpassed my expectations of a top in the trading range by about 120 S&P points, or about 4%. With the S&P 500 Index at 2923 at Friday’s close we are significantly above my calculation of intrinsic value.
* Global Growth Is Less Synchronized . The trajectory of worldwide growth is becoming more ambiguous. I have chronicled extensively the erosion in soft and hard high-frequency data in the U.S., Europe, China and elsewhere, so I won’t clutter this missive with too many charts. But needless to say (and as shown by these charts here and here), with economic surprises moderating from a year ago and in the case of Europe falling to two-year lows, we are likely at “Peak Global Growth” in the current quarter. (The data are even worse in South Korea, Taiwan, Indonesia and Thailand.)
* FAANG’s Dominance Represents an Ever-Present Risk. I have warned that earnings disappointments in the FANG stocks represents an immediate risk to this league-leading sector, and to the markets FANG has become GA! Since I initially wrote this article investors have been clearly rotating out of FANG, reflecting misses in important metrics (subs) and some lower broader guidance ahead. As well, the existential threat of increased regulation and antitrust hostility that I warned about nearly a year ago are now on the front burner.
* Market Structure Is One-Sided and Worrisome. Machines and algos rule the day; they, too, are momentum-based on the same side of the boat. The reality that “buyers live higher and sellers live lower” represents the potentially dangerous condition that investors face in a market dominated by passive investors — a threat I have focused on since early 2017.
* Higher Interest Rates Not Only Produce a More Attractive Risk-Free Rate of Return, They Also Make It Hard for the Private and Public Sectors to Service Debt. And over the last 2 1/2 months short-term interest rates have made a decisive move higher. This also serves to reduce the value of stocks as every dividend discount model incorporates a discount factor based on the current level of interest rates.
* Trade Tensions With China Are Intensifying and Mr. Market Is Improperly Looking Past Marginal Risks. From Goldman Sachs’ David Kostin (h/t Zero Hedge). Remember, as previously discussed, the dispute has buoyed second- and third-quarter U.S. GDP. The benefit soon will be over and a third-quarter economic cliff is possible.
* Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window by Both Political Parties. This has very adverse ramifications , which shortly may be discounted in lower stock prices, especially as it relates to the servicing of debt — a subject I have written about often. Not only are our legislators acting irresponsibly and recklessly, but the Republican Party is now considering more permanent tax cuts. Should economic growth moderate, tax receipts diminish and undisciplined spending continue, stock valuations will likely continue to contract.
* Peak Buybacks. Buybacks continue apace, but look who’s selling. As Grandma Koufax used to say, “Dougie, that’s quite a racket!” If I am correct about the peaking in corporate profits, higher interest rates and slowing economic growth, we shortly will have another rate of change — negative in buybacks.
* China, Europe and the Emerging Market Economic Data All Signal a Slowdown. It’s in the early innings of such a slowdown based on any real-time analysis of the economic data. The rate-of-change slowdown on a trending basis is as clear as day. A rising U.S. dollar and weakening emerging-market economic growth sow the seeds of a possible U.S. dollar funding crisis. This slowdown has not gone unnoticed by investors, as emerging markets have declined absolutely over the summer, materially lagging the strength in the S&P index and the Nasdaq.
* The Orange Swan Has Returned. Again, hastily crafted policy delivered by Twitter that conflates politics is dangerous in a flat and networked world. The return of an untethered Orange Swan is market-unfriendly… brace yourselves as the Supreme Tweeter will likely “Make Economic Uncertainty and Market Volatility Great Again” (#MUVGA) This weekend’s allegations against the Supreme Court nominee likely raises the risks of more volatility and may jeopardize some elements of the administration’s agenda.
* We Are Moving Closer to the November Elections, With Their Uncertainty of Outcome and the Potential For a “Blue Wave.” The current sub-40% approval rating (which is trending lower) for the president is historically a losing proposition for the incumbent. We also may be moving toward some conclusion of the Mueller investigation, creating even more uncertainty.
Bottom Line
“Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.” –Benjamin Graham
The search for value and comparing it to risk taken is, at its core, the marriage of a contrarian streak and a calculator.
While it is important to gauge the possibility that the market may be making an important top, it is even more important to distill, based on reasonable fundamental input, what the market’s reward versus risk is. This calculus trumps everything else that I do in determining market value.
On that front, I continue to believe that downside risk dwarfs upside reward.
Moreover, there is a growing fundamental and technical list of signposts — many highlighted this morning — that the market is starting to look like it is in the process of making a possible, and important, top.
As Columbia University’s Joel Greenblatt wrote:
“There’s a virtuous cycle when people have to defend challenges to their ideas. Any gaps in thinking or analysis become clear pretty quickly when smart people ask good, logical questions. You can’t be a good value investor without being an independent thinker – you’re seeing valuations that the market is not appreciating. But it’s critical that you understand why the market isn’t seeing the value you do. The back and forth that goes on in the investment process helps you get at that.”
I do a lot of back and forth every day in my Diary as I try to communicate my own views, which today seem most contrarian to the consensus and to those who worship at the altar of price momentum!
Copyright © Doug Kass
