Return Of The Melt-Up?
Muscle memory is a powerful thing. And in the context of an equities market where the proverbial tail often wags the dog, it can be Pavlovian and self-fulfilling.
During this month's modest swoon for an equity market that spent most of 2023 reclaiming lost ground, Nomura's Charlie McElligott was keen to remind investors that volatility expansions have to be "fed," lest they should collapse under the weight of their own implied expectations.
That's just a sophisticated-sounding way of saying th
Uh, I thought that stocks were rising because of improving earnings expectations. That’s what the text books say right?
This market has just become a casino, detached from reality. But that IS our reality.
It just astonishes me that so many investors and commentators still cling to outdated notions such as that earnings and valuations actually matter.
Thank you. I cede the pulpit.
I think earnings and valuations matter, just not as much as fundamentalists would like over shorter periods, and “short” feels “long” when you’re losing.
It also seems to depend on cap, sector, and industry. The non-fundamental type of investor gets excited about some names but not with others.
For example, about two years ago I looked at insurers, possibly the most boring industry ever, but I figured insurance is a non-discretionary purchase (I was bearish on the economy, silly me) and rising yields would drive higher investment income (while investors might disregard mark-to-market losses since insurers tend to own shorter duration and hold to maturity). I bought two names, one has been very good (has stomped the S&P 500) and the other has been meh (outperformed in 2022 but has lagged in 2023). Both are high quality names, but the good one has grown earnings far faster than the meh one and that was able to matter, because it’s such a boring industry. My failure to anticipate the meh name’s meh earnings is, sadly, another story.
I recently refreshed on the insurers, and while I’m less positive on the group now (yield pickup mostly done, lots of premium increases already in the numbers) there are still some interesting names and I’m fairly confident that it’s still a deeply boring industry. After all, their earnings calls barely mention “AI” – how exciting can such companies be?
Sir
I always enjoy your comments. I had two thoughts here. First, insurance is probably boring but it serves as the solid granite foundation of Buffett’s empire. Second, there are many kinds of insurance and they are all financially different. The life insurance/annuity industry is built on asset-liability matching supported by precise underwriting. For example, parts of my monthly annuity checks from TIAA are based on 9%+ assets to which they were matched when the premiums were deposited. Life insurance investments tend to be more tightly regulated and safer than for other types of insurance. Casualty insurance is a whole different animal. Roughly half of the premium income collected is used to pay claims, while the other half goes into reserves, invested to bolster future costs. This part is essentially a huge diversified investment/hedge fund which, if owned like those in BRK, is a giant cash machine. Health insurance is mostly a mess, but it is a hybrid form of casualty coverage. Fast changing healthcare costs make it hard for companies to keep up. I’ve always wondered how much of healthcare costs are from the service and how much results from rising HC insurance premiums. Underwriting in this business is tricky so many reserve pots tend to be used to cushion unexpected costs. There is also reinsurance, another BRK staple, marine insurance (my favorite), pure liability insurance, and others. Quality in an issue throughout all of these, as is size and the nature of a firm’s environment. I own PRU at present. I have owned AFLAC which is decent and a different sort of animal. The problem with this one has been its dependency on its huge presence in Japan. Currency fluctuations often hampered returns and I finally sold it. One other point here is regulation. To my knowledge there is still no significant federal regulation of insurance. For most of this business the states are in charge. As I was taught, NY has the most restrictive regulation and companies wishing to do business in NY have to abide by these regulations across their business, making NY effectively the national regulator.
Thank you ! Your knowledge of insurance is much deeper than mine. In general, I am avoiding exposure to personal lines (social/cost inflation, regulatory risk), health insurance (ditto), life insurance (too boring even for me, underwriting errors have long tails, and annuity exposure). I’m generally favoring commercial lines and re-insurance. My original insurance buys were ACGL and CB. This year, added Tokio Marine (yield pickup and premium hikes barely starting). Now interested in other reinsurance names. Very angry to have missed mortgage insurers (in retrospect, an obvious buy once we saw housing market was going into stasis rather than collapse). Also angry missed the brokers.
Anyway, old coots like me have no choice but to stick to our unfashionable knitting and try to find the lumpy names that want to wear our
dowdy garments. I’m not going to turn myself into a ODTE trader or whatever.
If we are now a casino, and I am not altogether arguing against that, what is the end game?
My sense is that we are back in 1987, when newfangled and leveraged ways to play the market (portfolio insurance then, 0DTE, etc. now) attained wide acceptance. Then outflows into money market funds due to rising yields validated the market as less attractive to the more risk-adverse. Also rising margin debt. We are seeing the same today.
People forget that all market trading strategies imply liquidity in that you can get out at close to the last quote because there is someone on the other side of the trade.
When there is no on the other side of the trade, look out below.
Good point on continuous liquidity. In fact, options pricing models, like Black-Sholes, were based on that assumption. Plus it was assumed that prices did not gap so you had liquidity at every price point as you moved from 80 to 100 for example. (80, 81 82 etc.) How realistic was that? Often enough markets gap from 80 to 100 with no prices in between.
I wonder if newer models have learned to overcome that spurious assumption?
But I was referring to the volatility-driven models that our dear leader has informed us about here. The quantities they push around dwarf flows from individual and plain old-fashioned fund managers by giant multiples. Like 20 times larger.
My problem with B-S was that lognormal doesn’t actually describe security behavior but since they wanted an analytical solution they used it.
Appreciate the conversation, guys. I’m starting to feel queasy about the economic state of affairs. I’m concerned not just what’s happening in foreground, but also what’s happening in the background.
We have inflation. The Fed is managing it. I have reasonable confidence in the actions they’ve taken. They seem to be on a path that’s rational and can reasonably be expected to succeed over time. But the timing is what raises questions for me. It doesn’t help my concerns that I saw a Charlie Munger video yesterday in which he proselytizes about the inevitable effects of the Congress printing money, drawing comparisons with Japan and the Weimar Republic after WWI. Believe I had seen this video earlier. It’s not a recently produced document. But the idea of Congress printing money and living beyond our means just goes against me, and it’s a cause of inflation.
We tell ourselves that we know how to manage this economy. But it’s a squirrelly critter and it has teeth. I don’t like the idea of trying to tame it. And we cannot act like the problem will go away by itself. It will inevitably bite us, triggered by variables in the wild that operate apart from Fed control. The other day I commented on a brewing property crisis in mid-sized cities, as noted in the Washington Post two days ago.
As we discussed earlier this week (in Americans Have No Idea What’s Going On), human beings do not exercise higher consciousness, but are mostly caught up in themselves. They can cross the street safely, but they are not necessarily tuned into broader risks in the economy. I’m thinking of the volume of money at the top of the economy that blissfully carries on with spending patterns in daily life, willfully ignorant of Fed actions and unaffected by the risks in the economy. And as I noted in that same Heisenberg post linked above, there are significant property default and loss risks in mid-sized US cities.
Other variables out in the wild that I’m thinking about include the sputtering world economy. I don’t keep statistics on it, but I keep hearing Europe is in a recession. At the same time Russia is exercising its influence on the politics of countries in Africa, without any assertions of opposition from the west. Of course, Russian politics and its economy are spinning out of control, which is not entirely an unexpected outcome of the war in Ukraine. It remains to be seen how the issues in Russia will end and resolve. It doesn’t look good.
China’s economy is out of control, in part due to their own problem with money printing. China also rattles its sabers in regard to asserting its power in Taiwan, which would probably provide a boost the Chinese economy, though at great cost, if Xi could pull off an actual takeover of the island. Then, of course, the war in Ukraine is not stopping anytime soon. But at the same time, it’s a good thing that the US is firming up its relationships with western pacific countries, like Australia, New Zealand, Japan, South Korea, the Philippines, Papua New Guinea, etal. So there’s that. But prospects don’t look bright for the future. It’s looking a little bit like 1938.
Of course, like any investor, I want to see the US economy find its footing and get back on track. Hell, I want to retire and I want a nest egg. But we’re all aging. The world population will eventually recede. And I reckon the diminishing population will negatively impact the overall strength and veracity of the US economy, not to mention Europe, Asia, and the Americas. It may be a while before it hits the fan. But with a less than potent economy and the possibility of a property crisis in the offing in mid-sized US cities, the future isn’t looking so brilliant and glorious, or even stable.
even though it may not seem so, there is a method to the market madness. read as much as you can about markets, especially the ones you are most interested in. make sure you read a wide variety of viewpoints, even things that seem ridiculous to you. and then think deeply about it. There is so much good information available, and lots of really bad as well. But you will figure it out. it takes years and hard work, just like it does to become an expert in any field. There really are no short cuts. sure one can get lucky for a while, but it won’t last.
If we’re being honest (which we never are), all you need is a Jack Bogle book and a Vanguard index fund. There are no “experts” on markets. That’s like saying “I’m an expert on human behavior.” You’re an expert right up until someone does something totally unexpected that has no explanation whatsoever. Also, no, you shouldn’t “read viewpoints that seem ridiculous to you,” unless your job is to write satire. If it’s ridiculous, reading it makes you ridiculous too.
Walt, isn’t saying that we are never honest, itself an honest statement?
Aren’t I clever… (Hello my name is Vannest and I’m a recovering intellectual).
Well, as a clinical psychologist I’m supposed to be an expert on human behavior – or at least the subset that represents my scope of practice.
What I observe is that humans behaving badly, if it wasn’t so destructive, would be boring it’s so predictable. That’s been going on since time immemorial. It’s when humans do something altruistic that is interesting about us.
What I also observe is that there are ALWAYS a reason why a human does something. It is NEVER random. The reason, though, is usually not rational (i.e. based on logical thinking rather than emotion). That’s why people pay me to listen to and talk with them. They do things that, while understandable, are not rational.