As one of the original wise men of the financial blogosphere, David Merkel has always been a crucial read for me.
In 2004, he had done a magnificent piece on the fundamentals of market tops for TheStreet.com’s Real Money pay site. Thankfully, Barry excerpted the post for The Big Picture back in 2006 so it exists on the modern web, outside the catacombs. Tom Brakke unearthed it this morning and I got the chills reading it just now – all of the fundamental signs of a top that David discussed nine years ago can be observed in the markets today.
It’s uncanny how things never change. Read this and tell me you don’t see these exact same things playing out as we speak.
Here’s David (via Barry via Tom, lol)…
Item 1: The Investor Base Becomes Momentum-Driven
Valuation is rarely a sufficient reason to be long or short the market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.
You’ll know a market top is probably coming when:
a) The shorts already have been killed. You don’t hear about them anymore. There is general embarrassment over investments in short-only funds.
b) Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.
c) Valuation-sensitive investors who aren’t total-return driven because of a need to justify fees to outside investors accumulate cash. Warren Buffett is an example of this. When Buffett said that he “didn’t get tech,” he did not mean that he didn’t understand technology; he just couldn’t understand how technology companies would earn returns on equity justifying the capital employed on a sustainable basis.
d) The recent past performance of growth managers tends to beat that of value managers. In short, the future prospects of firms become the dominant means of setting market prices.
e) Momentum strategies are self-reinforcing due to an abundance of momentum investors. Once momentum strategies become dominant in a market, the market behaves differently. Actual price volatility increases. Trends tend to maintain themselves over longer periods. Selloffs tend to be short and sharp.
f) Markets driven by momentum favor inexperienced investors. My favorite way that this plays out is on CNBC. I gauge the age, experience and reasoning of the pundits. Near market tops, the pundits tend to be younger, newer and less rigorous. Experienced investors tend to have a greater regard for risk control, and believe in mean-reversion to a degree. Inexperienced investors tend to follow trends. They like to buy stocks that look like they are succeeding and sell those that look like they are failing.
g) Defined benefit pension plans tend to be net sellers of stock. This happens as they rebalance their funds to their target weights.
Item 2: Corporate Behavior
Corporations respond to signals that market participants give. Near market tops, capital is inexpensive, so companies take the opportunity to raise capital.
Here are ways that corporate behaviors change near a market top:
a) The quality of IPOs declines, and the dollar amount increases. By quality, I mean companies that have a sustainable competitive advantage, and that can generate ROE in excess of cost of capital within a reasonable period.
b) Venture capitalists can do no wrong, so lots of money is attracted to venture capital.
c) Meeting the earnings number becomes paramount. What is ignored is balance sheet quality, cash flow from operations, etc.
d) There is a high degree of visible and/or hidden leverage. Unusual securitization and financing techniques proliferate. Off balance sheet liabilities become very common.
e) Cash flow proves insufficient to finance some speculative enterprises and some financial speculators. This occurs late in the game. When some speculative enterprises begin to run out of cash and can’t find anyone to finance them, they become insolvent. This leads to greater scrutiny and a sea change in attitudes for financing of speculative companies.
f) Elements of accounting seem compromised. Large amounts of earnings stem from accruals rather than cash flow from operations.
g) Dividends become less common. Fewer companies pay dividends, and dividends make up a smaller fraction of earnings or free cash flow.
Now of course, we don’t see dividends becoming less common but we do see a much greater emphasis on buybacks. Also, defined benefit pensions are not net sellers of stock – I could argue that they have only just begun to buy, having been ridiculously underweight in the past few years.
But just about everything else on this list is already in full swing. Hard to deny it.
The question, then, is about how long these trends can continue. When and where will this end? History will disappoint you in pursuit of the answer to that question – “Eventually,” it whispers in your ear, smirking all the while.