Beyond The Headlines
Buy the dip, don’t buy the dip?
Are catch-phrases, always right?
The investment profession is full of terse advice like “Buy low, sell high,” “Sell in May and go away,” and – especially relevant now, “Buy the dip.” Here at Sicart we appreciate the wisdom in the first adage. We can see how the second one makes sense, especially if you have big summer vacation plans. However, with the last one, we have a bit of problem.
A bell, a dog, and a Russian scientist
The Pavlovian response, also known as classical conditioning, refers to a training procedure originally devised by the Russian physiologist Ivan Pavlov. Working with dogs, he paired a biologically potent stimulus (food) with a neutral stimulus (a bell or a ticking metronome to be exact). The dogs quickly learned to associate food with the sound, and began to salivate whether or not they were fed.
“Buy the dip” — it’s time to buy, another rally is coming – that’s been our conditioned response for decades now.
However, scientists following up on Pavlov’s work have found that a conditioned response is relatively impermanent. Should ours be as well?
Time to unlearn?
Each time the market has dropped in the last 40 years, it rebounded quickly, no matter what had brought it down. This pattern helped strengthen the argument in favor of indiscriminate passive investing and led some to discredit active investing.
Why was that the case? Over the years, significant market corrections were diligently followed by lower interest rates and more accommodating policies intended to prop up the economy. The smaller corrections were seen as brief pauses, with renewed optimism fueling the next leg of a bull market.
The bell rings… and it’s time buy more again! Or is it?
Fundamentals don’t matter, do they?
We consider ourselves contrarian long-term investors. We constantly seek out bargains, and we don’t mind waiting few years to get the return we want. This is the kind of prudent behavior known to shoppers world-wide; we just do it in the stock market.
The fundamentals drive our process because over time, stocks trade in line with the earnings. As a company’s earnings go up, its stock price increases. Everything else is perception, sometimes making what should be cheap stocks expensive. In an ideal scenario, we like to see a cheap stock with improving fundamentals and recovering valuations. Then we get paid both for the earnings, and the multiple expansion.
But sometimes an individual stock price or the overall market decouples from the trends of fundamentals. Then it’s anyone’s guess where it will head to next. Lately the trend has been upward, and usually that lasts much longer than reason would suggest.
We’ve left the fundamentals behind
The Shiller PE (cyclically adjusted 10-year price-to-earnings) ratio for the S&P 500 recently reached 31.5x. Its 120-year range is 5-45x, with 15-25x being the most common level in that period.
Between 1980 and 2000 this metric increased from 5x to almost 45x: interesting to me because that period coincided with my growth from a toddler to my current height of over six feet! (Almost a perfect correlation, as I’m sure quant-oriented investors would notice.)
I stopped growing, and Shiller’s PE fell from 45x to 15x over the next 8 years. The following decade didn’t bring a new Great Depression with the PE’s drop to 5x as some feared, but quite the opposite, a miraculous rise from 15x to 30x+. (No correlation here with my weight or height.)
If there was a correlation between valuations and anything else, it was the interest rates. The 10-year treasury rate fell from 15% to 2%, only to start rising more recently. That’s an unprecedented tailwind for all asset prices.
When the rates dropped to the ground, and the PE seesawed from 15x to 30x, the market somehow lost touch with the fundamentals. We do know that rates can be forced all the way to zero, and investors can be scared into assets with negative yields (some eurozone markets are a vivid contemporary example). Still, the PE will only climb until the gravitational pull brings it back to where it historically belongs.
Up and down we go
After a post-election rally and diminished volatility last year, we are up against something “new and fresh.” However, I was recently told that there are only 7 plots in all forms of tales, legends, books and movies over the last few thousand years human history; they just repeat again and again.
True also for the financial markets, only there is really just one story. Cheap markets become expensive only to become cheap again. The characters change but the plot is the same.
After a January rally with record in-flows of new money to equities, February brought a sharp turn. The last two months gave us many days with 3%-4% market swings as well as big intraday swings. We are quickly getting used to them. However, the down days outnumber the up days. As a result, the US equity market and most major international indices are down about 10% from recent highs.
Usually under these conditions the majority would scream, “Buy!” — but it is a fading scream today.
Peculiar rally, even stranger sell-off?
The rally lasting from the 2016 elections through January was driven by renewed optimism about economic growth, lower taxes, and a more favorable business environment.
What we notice is that the fundamentals didn’t drive the market up, and it’s not the fundamentals that are bringing it down (just yet).
If you have read our earlier posts, you’ll know that we’ve been waiting for a meaningful correction for a while. We believe that the disconnect between price and value always eventually ends because fundamentals drive the markets in the long run.
History shows, though, that it’s not the fundamentals that fuel the last leg of a bull market or end it. Bernard Baruch, a legendary investor who lived through the Roaring 1920s and profited from the 1929 market crash by going against the crowd, called this phenomenon “the end of the continuity of thought.”
Change of heart
After witnessing celebrations of the post-election rally, we are now seeing a growing list of worries: inflation fears, trade war concerns, Amazon’s battle of tweets, and Facebook’s debacle. None of these are fundamental in nature. They might affect the fundamentals in the long run, but for now they mostly harm market sentiment.
Amazon’s and Facebook’s stories embody most of the themes that paved the way for this bull market’s grand finale and its abrupt end: US presidential elections, FAANG rally, and an insatiable appetite for growth.
Look out, it might rain!
When bad weather is forecast, everyone grabs an umbrella. When we see that the market is out of sync with the fundamentals, and that optimism might be turning to healthy skepticism, the reaction is not so simple. Here are few decisions we’ve made:
1) we are holding more cash than usual, keeping it available to use when things get interesting;
2) we regularly review our holdings and cut those whose prices we believe to be the most out of touch with reality;
3) we add to the highest conviction stocks that have started to appear in some pockets of opportunity;
4) we select some market protection, namely precious metals (gold specifically) and some inverse ETFs that go up when certain asset classes go down.
THE BELL RANG!
May is around the corner. Maybe it is a good time to “sell and go away” as in the adage we began with. Nevertheless, we caution against “buying the dip.” Being unusually picky may keep investors out of trouble until the markets eventually catch up with the fundamentals – as they always do, in the end.
This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.