Zeal: Stock Bear Looming?

[bmichaud]

Moore pointed out various times at the low last year that Zeal LLC made some phenomenal calls on the general market -

 

- http://www.zealllc.com/2011/hypsold.htm

- http://www.zealllc.com/2011/fearmgr.htm

- http://www.zealllc.com/2011/bulltech.htm)

 

- so I thought it would be only appropriate to point out when they do in fact turn, which they now have. See here:

 

http://www.zealllc.com/2012/bearloom.htm

 

If in fact Zeal's call is correct, it will be very interesting to see what in fact holds up in such a decline. Will it be a broad-based sell-off such as 2008/2009 or will it be isolated to a particular segment of the market ala 2001/2002 when all the equity capital in the world got sucked into mega caps and tech, leaving small caps drastically undervalued?

 

I would posit that large-cap banks have the potential to be the "small caps" of the next bear market, in so far as they are so egregiously undervalued relative to most other sectors (perhaps nat gas and coal are close?) that investors will almost view them as "safe havens". Perhaps not. Something about holding bank stocks in a bear market doesn't give me a warm and fuzzy feeling.....we shall see.

[Parsad]

Moore pointed out various times at the low last year that Zeal LLC made some phenomenal calls on the general market -

 

- http://www.zealllc.com/2011/hypsold.htm

- http://www.zealllc.com/2011/fearmgr.htm

- http://www.zealllc.com/2011/bulltech.htm)

 

- so I thought it would be only appropriate to point out when they do in fact turn, which they now have. See here:

 

http://www.zealllc.com/2012/bearloom.htm

 

If in fact Zeal's call is correct, it will be very interesting to see what in fact holds up in such a decline. Will it be a broad-based sell-off such as 2008/2009 or will it be isolated to a particular segment of the market ala 2001/2002 when all the equity capital in the world got sucked into mega caps and tech, leaving small caps drastically undervalued?

 

I would posit that large-cap banks have the potential to be the "small caps" of the next bear market, in so far as they are so egregiously undervalued relative to most other sectors (perhaps nat gas and coal are close?) that investors will almost view them as "safe havens". Perhaps not. Something about holding bank stocks in a bear market doesn't give me a warm and fuzzy feeling.....we shall see.

 

There may be a bear market coming and there may not be, but that article was a load of rubbish!  No offense intended, but that was so difficult to read and actually view it with any rational sense.  Cheers!

[bmichaud]

Ironically I like how simple and straight forward their analysis is - the market moves in secular bull and bear cycles, and the current secular bear that began in 2000 isn't finished, particularly considering where general valuations are at the moment. Historically, these valuations are where secular bears BEGIN, let alone are 12 years deep.....

[Parsad]

Ironically I like how simple and straight forward their analysis is - the market moves in secular bull and bear cycles, and the current secular bear that began in 2000 isn't finished, particularly considering where general valuations are at the moment. Historically, these valuations are where secular bears BEGIN, let alone are 12 years deep.....

 

No such thing.  People love trying to find patterns, even if there are none.  What seems like 17 year cycles are just each new generation forgetting what the lessons were from the previous generation.  I think that's why I found a great deal of affinity with Buffett & Graham's rational, intellectual framework.  It just makes complete sense.  Cheers!

[bmichaud]

The actual years of a cycle are merely secondary coincident - what counts is the valuation cycle the market moves in, and with the market at 20x median Schiller we are at levels that typically precede a secular bear. Again ironically, Buffett shut down his hedge fund just several years before a secular bear started with the market near current valuation levels. Yes Buffett's rational is simple, but he is far more complex than he let's on - as are you Sanjeev...didn't you go 50pc cash right at the top this year based on your Spain analysis? ;)

[Parsad]

The actual years of a cycle are merely secondary coincident - what counts is the valuation cycle the market moves in, and with the market at 20x median Schiller we are at levels that typically precede a secular bear. Again ironically, Buffett shut down his hedge fund just several years before a secular bear started with the market near current valuation levels. Yes Buffett's rational is simple, but he is far more complex than he let's on - as are you Sanjeev...didn't you go 50pc cash right at the top this year based on your Spain analysis? ;)

 

Yes Bmi, I agree with all of that.  I don't agree with the technical analysis and attempts at Zeal to quantify 17-year cycles.  This seems to be something that has taken hold of alot of people after Buffett wrote his Fortune article in late 1999.  His comment about the previous 17 years and the next 17 years looking very different, seems to have become fodder for alot of value managers as well as technical analysts.  They've taken his comments out of context and believe that 17-year cycles exist.  Cheers!

[bmichaud]

I hear ya - I actually forgot Buffett said that.

[Packer16]

For the bears, I would refer you to page 131 of Howard Marks book where he lists key factors in determining market sentiment.  Of the 23 facotrs listed only 3 to 5 suggest we are in bull market top territory (primarily the low interest rate ones) and the remaining factors imply we are closer to  bear market bottom territory.  By these indicators, the markets are not in a pending decline mode as was the caes in 2007/8. 

 

Packer

[bmichaud]

I haven't seen the factors, but sentiment is often times mentioned in response to bearish theses. What's interesting about sentiment now is that while individuals are pervasively negative and bearish econ data is in our face on a daily basis, the market remains overvalued - IMO, this is due to ZIRP forcing investors into higher yielding securities, but more likely due to very high profit margins giving the illusion stocks are in fact "cheap" here. Lastly RE sentiment - I'll have to dig up the stat, but if you look at how investors are actually allocating their cash, they are far more bullishly positioned than would be implied by sentiment.

[Packer16]

I think the overvalued thesis is based upon a false premise of mean reverting profit margins.  Mean reverting profit margins is based upon having a supply/demand balance of labor.  Historically, labor supply has been kept in check famine, war or just unproductive ways opreations (i.e. communism).  But none of these check factors is now in play so we have a surplus of labor which will has lead to higher profit margins.  Without these factors in play, I don't see how profit margins will mean revert and thus do not think the market is overvalued.  Just mu 2c.

 

Packer

[Uccmal]

The cycle they are looking at exists but it translates roughly into 17 yr+- secular bulls followed by 12-13 yr. secular bears. 

 

2000-2012/13 - secular bear

1982-2000 - bull

1970/72 - 82 - bear

54/55- 70/72 - bull

etc.

 

Dates are rough.  It has to do with spending/overspending and then retrenchment cycles.  Your birth and the time you entered the workforce has alot to do with how you behave going forward and your investing luck.  Buffett started at the beginning of a secular bull.  Even politicians get credit or bashed for factors in the greater cycle that are out of their control.

 

Corporate balance sheets are filled with cash now.  This will start to be spent on hiring, given back

to shareholders as cash, paid as taxes, etc.  This will trigger the secular bull.  I think we are actually on the cusp of the next bull this summer.  Financials have started to rally, which precedes other stocks in the economic cycle.  The greater tax payments will reduce or constrain government debt.

 

And all of this is irrelevant to my investing except great bargains will be thrown up in turn over the next few years before we enter a long phase of value investing torture like the 1990s when I started.

[bmichaud]

I'm sure it's been discussed somewhere on the board, but I really like Montier's work on profit margins....

Montier_March_2012.pdf

[Packer16]

Montier's data is interesting but it is based upon a time period when many of the constraining factors where in place.  Once they are no longer in place (since early 1990s), the mean increased.  Similar to Grantham's commodities hypothesis.

 

Packer

[petec]

Packer, what constraining factors?  Over the long run the only constraining factor ought to be required returns on equity.  Unless more companies have a sustainable competitive advantage than used to be the case, returns on equity (and therefore, all else equal, margins) ought to be mean reverting as excess returns get competed away.

 

On a related note, has anyone seen data for margins relative to history by sector, rather than for the whole S&P/market? 

[bmichaud]

Packer, what constraining factors?  Over the long run the only constraining factor ought to be required returns on equity.  Unless more companies have a sustainable competitive advantage than used to be the case, returns on equity (and therefore, all else equal, margins) ought to be mean reverting as excess returns get competed away.

 

On a related note, has anyone seen data for margins relative to history by sector, rather than for the whole S&P/market?

 

http://pragcap.com/the-2012-earnings-outlook

 

[Packer16]

The constraining factors which have been historically present are factors which remove large portions of the popluation from the labor market such as famine, disease, war and communism.  These have cause a shortage of labor and thus have caused inflation and revsion to the mean for profit margins.  Since the people cost are such a higher percentage of the products the developed world consumes, when there is surplus labor this component does not cause margins to tighten.  Margins actually expand as automation reduces the need for labor.  The offsetting factor is price competition.  I think what you are seeing is leveling out at a higher margin levels.  Unfortunately, the data to support mean reversion only goes back to the 1920s so the sample we are looking at includes 70 years of the factors present and only 20 years when they were not.

 

Packer

[petec]

Hi Packer.  Do you have data supporting that logic?  Because I'm not sure: OK labour costs ought to be lower now, but in a competitive world that means prices should be lower, not margins higher.  Also, in a world where a big segment of the population was hors de combat as it were, demand and therefore revenues must also have been below potential.

 

I think it is far more likely that margins are being supported by low interest rates, low effective taxes, and vast government spending during a time of aggressive cost cutting.  All of which are temporary.  I think Montier's work shows the impact of government spending on margins very effectively.

 

Another way to think about it.  If we agree that competition will cause returns on equity to trend towards the cost of equity, then the only ways that margins can rise permanently are:

1. Investors permanently raise their RoE requirements.  Possible, but why?

2. One of the other components of RoE falls permanently, necessitating higher margins to get to the same RoE.  Using Dupont, these components are asset turns and gearing.  I see no reason why one of these should have fallen permanently.

3. A higher proportion of companies have a strong moat.  Automating your plant won't raise your margins if everyone else can do it.  Only moats can sustain returns above the cost of capital.  In this world of ever-acccelerating technology, I'm inclined to think moats are getting harder to build, not easier.

 

Personally I think we have lived through a period of anomalously cheap credit and therefore anomalously high demand, which is currently being sustained by high government spending.  That's probably not sustainable and so returns (margins) will fall; if it is sustainable, then companies will develop the confidence to invest in more capacity and then returns (margins) will fall.  When this happens, I have no idea.

 

Just my tuppence.