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The Big Picture

January 1, 2017

OK, so the end of 2016 has rolled around, and its time to reflect on ‘The Big Picture’. Where are we? Where are we going? Broad questions but let’s restrict the subject to the equity markets, in particular the US market; What’s really been happening in the US stock market and where is it going in 2017? Even more important (for me that is), what have I been doing with my investments and what am I going to do in the new year?

First of all, let me say I have absolutely no idea where the markets will go in 2017, just as I had no idea where they were going in 2016 at the end of 2015, and so on and so forth. The only thing that I COULD have correctly predicted at the beginning of last year was that I WOULDN’T be able to predict what was going to happen. And that’s exactly what came to pass! We had the energy-induced market swoon at the end of 2015/beginning of 2016, then the Brexit swoon in June then the Trump post-election rally. Who wudda thunk?? The only thing I can say for sure is that market valuations are at the high-end of historical averages… they were last year at this time and they are, even more so, this year. So I can unequivocally state that the market will go down at some future point in time and, most likely, regress to the mean. In my lifetime?? who knows. Lets just say that I think forecasting the next move in the market is a waste of time.

So if forecasting the direction of the markets in 2017 is out, I can at least try to understand what happened to the markets in 2016. My observation on this is simply that ‘the market is a fickle creature’; it goes down when it should go up and up when it should go down, or so at least it seems so to me. With oil prices going down, the equity markets should have gone up; lower energy costs should mean lower industrial production and transportation costs and thus higher corporate profit margins, lower heating and transportation costs for consumers and thus more disposable income to be spent. But no, that’s not how it went. Lower oil prices dragged DOWN the US equity markets! (well, we can’t really be sure that’s what dragged down the markets, but the markets did go down around that time, so it’s not unreasonable to assume….). Then we had the Brexit vote that nobody anticipated and the ensuing downdraft in markets across the pond had a dampening effect on US markets. Totally unexpected! And now we’ve had this wild post-election Trump rally! Before the election pundits were saying the market would fall off a cliff if Trump was elected.. but on the day after the election a strange thing happened; the market went up. So the market forecasters changed their tune and affirmed that the Trump election was GOOD for the economy and thus the market because he is a businessman and will reduce regulation, increase military spending, increase infrastructure spending, reduce taxes, etc. I’m not so sure they were right before, or are right now for that matter. I don’t see how a heavily indebted nation is going to both cut taxes and increase military and infrastructure spending; even deep cuts in entitlement programs (social security? Medicare? welfare?) could hardly be large enough to counterbalance that increased spending. Then there is the issue of the impending impact of increasing interest rates on our national debt… But who am I to judge forecast?

With the market passing favorable judgement on the yet-to-be-installed new administration and the first rate hike in years, bank stock prices have climbed precipitously. A bit too fast in my opinion so I have finally sold my Bank of America warrants as they have tripled in price since last summer. After this sale my overall exposure to the market is less than 50%, i.e. cash is greater than 50%, even with the several small additions to my portfolio this Fall. This is not so say that I am taking a macro view and structuring my portfolio accordingly. No, it’s just that I haven’t spent much time trying to uncover undervalued shares, and what time I have spent has been anything but successful. Sometimes the best thing to do is just sit on your thumbs if you aren’t quite sure… But, if I could find some interesting net-nets or even low P/E and P/B opportunities I wouldn’t really care about overall market valuations. The point is, I just can’t find much of interest to purchase. In September/October I did add a small position in New York REIT (NYRT) when the shares were trading toward the bottom of their annual range. This is a liquidation situation where both the upside and downside are limited; it is more of a parking place for funds for which I can find no better opportunity. More recently I picked up a small starter position in (SPRT) as a special ‘turnaround’ situation (thank you, Shadow Stocks!). No slam dunk, mind you. but enough overall positive characteristics to make it a small position in a diversified portfolio (which mine is not at the moment).

So the first part of my New Year’s resolution is to spend more time focused on stock analysis, and, given the overvaluations in the market, focus on small cap special situations. Perhaps I can uncover some gems for the portfolio despite whatever gyrations the market may take. The second part is to get more invested because market timing just doesn’t work; YOU JUST DON’T KNOW WHAT CRAZY MR. MARKET WILL DO.

In addition to the relatively high valuations in the market I do have another concern; the growth of index funds and their impact on the overall market. The fellows of Horizon Kinetics have written about this more at length and with greater insight than I ever could.  I just wonder if this won’t be the catalyst to nudge the market into regressing back to the mean. Taking the current index fund growth trend to its (il)logical extreme, if 95%, 97% or even 99% of US equities were held through index funds, who would be determining the value of individual stocks and thus the composition and level of the indexes? that 5% or 3% or 1% that actually owned the individual company shares? So isn’t the real US equity market getting smaller and smaller, rather than larger and larger? And isn’t market size the single most important factor in making pricing efficient? Index funds re-weight in response to changes in market capitalization of the components of the index they mimic. Thus if shares of GM go down more than the overall market, index funds have to sell some portion of their GM holdings. So all it takes is one guy deciding he needs money for a new truck and selling a million GM shares in a low market-volume context to send the GM share price down. Well, of course, its more likely that some rogue trading system sells 100 million shares, but that’s just an extension of this argument. Furthermore, index funds that use heuristics (using a subset of stocks to mimic an index) create more imbalance as share price movements are magnified or demagnified based on the relationship between the subset and the true index.

Could it be like the proverbial butterfly flapping its wings off the coast of Africa and starting a hurricane in the Caribbean? Prices changes magnified because so much of trading will be program trading? It’s not just black-box program trading that destabilizes the equity markets, as we have seen, but perhaps even more, index fund ‘program trading’ as retail investors move more and more into index funds.

Is there any kind of investment opportunity created by this? I don’t really know. The only thing I can think of is focusing on stocks not in the indexes (micro and small caps), focusing on situations indexers don’t participate in (spinoffs, exchange offers, etc), and simply not being afraid to hold cash. Perhaps we’ll see if this is even a factor when the next big selloff finally comes.

note: edited 1/2/17

  1. I think the way you are viewing index funds is incorrect? When a stock price declines, they already hold it, so their weightings automatically update due to the decline in price. They don’t have to sell unless the stock declines so much that it moves outside the mandate of the index. The other time they sell is when they get redemptions.

    Isn’t the opportunity on the margins of the new additions and subtractions from major indices.

    • Yes, you’re right. I didn’t think that through very well. I was really trying to make a point about funds that use heuristics, not the large broad-based funds whose composition is exactly that of the indexes. So, for example, an index fund that holds shares in 200 of the S&P 500 companies that ‘mimics’ the S&P 500 because those 200 companies comprise 80% of the stock market capitalization of the index. Or sector funds that use 10 or 15 stocks to ‘mimic’ a sector when there are really 50 or more stocks in that sector. So relatively larger cap stocks may be over-represented and relatively smaller cap stocks under-represented in these indexes, thus creating imbalances when one stock increases or decreases substantially relative to the overall market (index).

  2. Extremely impressed with your writing skills

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