– By Fred Dunlap –
Enjoy This Recent Edition of the Dunlap Investment Newsletter.
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“Ladies and Gentlemen, we are backing away from the gate and will be taxiing to the runway. Your seat back tables should be in the upright position and your belongings should be stowed either in the overhead compartment or under the seat in front of you. In the event of a loss of cabin pressure, oxygen masks will drop from the ceiling… Be sure to put your mask on first, before putting one on your Comfort Peacock…
“We will likely experience some turbulence due to expected strong winds. So we will require that all passengers fasten their seat belts and keep them TIGHT for the duration of the flight… All Comfort Dogs, Cats and Hamsters should be strapped in too, unless you have provided them with a suitable crash helmet…”
News Bulletin: “Sales of Comfort Ponies, Dogs and Peacocks are surging in Manhattan. Investors are lined up outside of pet stores, emptying cages as fast as store owners can fill them. Sales of leashes and poop bags are skyrocketing too!”
Yes, anxiety is growing in investor circles after last week’s selloff, and their angst reached a new crescendo today at 3pm when the Dow was down 1600 on the day, recovering somewhat in the last hour to be only down 1175 at the closing bell.
Turbulence has returned to the stock market after taking a snooze for the last 14 months. The Volatility Index is again alive, spiking from insipid levels of 9-10 to a raised level of 18 on Friday afternoon. What did it do today? It spiked to 38.
From reading the last several Newsletters, you know that we expected this to happen–we discussed that “Choppy Waters are Ahead.” And we discussed summoning Santa for a sturdy seat belt.
Does the fact that we predicted this make us special? No. It means that we are rational. It means that we recognize that any (and all) bull markets NEED setbacks like this. These are periods for consolidation, which are the lifeblood to the next leg up in valuations. More on this later…
But first let’s put the last few trading days in perspective.
A Quick Look in the Rear View Mirror
2017 – Markets were up 20+%, causing investors to celebrate by high-fiving and snapping towels in the locker room.
2018 – In the first four weeks of this year, markets soared another 7.5%. But after 26 calendar days of bliss, watching a straight up stock market, last week provided a reminder that stock prices can go down too. In the last six trading sessions, the S&P has fallen 8.2%.
A Point Worth Noting – While you may feel inclined to kick your dog over the recent market decline, keep in mind that the closing prices tonight are only 1% below valuations on 12/31/17. Yes, while I was watching Anderson Cooper spread three minutes of content over four excruciating hours, I was only 1% better off than I am tonight.
Yea, I know. I am rationalizing here. And I know you were falling in love with your net worth on January 26th. But I am trying to provide you some solace…some perspective…and frankly, I like your dog, and I don’t want him to get the boot!
What’s driving the turmoil?
In our 1/3/18 Newsletter (Better Late than Never – “Thanks Santa!”), we discussed that 2018 would be a harder, more mercurial year to achieve investment gains. The first five weeks are testimony to this fact. But why this decline, so close to recent all-time highs? Well, there are some catalysts which are worth mentioning:
- It’s been over 400 days since the last 5% pullback. I know this retreat stings, but we were way overdue for a downward move.
- Wage figures were reported last week (for the month of January), showing an annual increase of 2.9% (year-over-year). For years, politicians have vehemently called for wage increases to be given to John Q. Public. And then we got some! Those being granted by hundreds of corporations, coming in the form of bonuses, pay increases and larger 401(k) contributions. Hooray, right? Gosh, I think so. Nobody would call those crumbs, would they?
- So how did the market respond? It worried that wage increases would lead to product price increases…which would lead to inflation…which might cause the Fed to raise rates faster and farther…which could dampen stock market valuations.
In our 12/8/17 Newsletter (What do I want for Christmas?), I warned that too much stimulus (Tax Reform and an Infrastructure bill) on top of an already-tight labor market might cause a spike in wages in order to attract workers. This week’s market reaction to the jump in annualized wages is a living example of that concern.
Will we see inflation? Or will there be productivity advances, which allow corporations NOT to need to pass additional wage costs on to the consumer (in the form of higher prices on goods)? We will see in the coming months.
What else is going on in the market (that might be the cause of all of this tumult)?
Not much! Things are cool!
Earnings are going up.
Companies are growing.
Consumer confidence is up. Spending the (er, crumbs…) as soon as they get them…
New Non-Manufacturing data spiked this morning (that’s a good thing…).
Is Repatriation going as planned? Yup, corporations are gearing up for share buybacks and dividend increases, with some commencing in only a few weeks.
And let’s not forget that the global economies are still growing. And interest rates are…still low enough…such that bonds can’t yet compete with stocks.
Hell, things are darn good!
So why the Hell are we down 8.2% in the last SIX DAYS??
Because…we shouldn’t have been up 7.5% in the preceding 26 days…
Meet the “Marginal Investor”
Company stocks have millions (or sometimes billions) of shares. But only a small fraction of them trade each day. The shareholders who trade each day are the Marginal Investors, ones which aren’t committed to investing with the company for the long term. The remainder of shares are held by long-term investors, whom I will call Committed Shareholders.
More definitional description please, Freddie Deeeee?
Non-Committed Shareholders (Marginal Investors): these shareholders are either 1. worried that the stock price will go down or are concerned that the stock won’t go much higher, or 2. have made enough $$ at the current price, such that they have met their goal and now decide to exit. They aren’t long-term loyalists to the stock.
Committed Shareholders: these shareholders believe that the stock has greater future potential and, to gain those expected returns, they are committed to remaining long-term owners.
What about new investors? Those who just bought shares? Heck, those are Committed Shareholders–they just paid good money to get into the party. They want gains, and they will be patient to wait for them.
When we get a sell-off like the one this past week, the drop in price is the result of Marginal Investors exiting their positions. They represent the selling volume in any stock. Surprisingly, it doesn’t take that many Marginal Investors to drive a stock’s price down. It just requires an imbalance between supply and demand, where the Marginal Investors outnumber the buying volume. And in the last week, we have had a lack of buyers to offset the volume sold by Marginal Investors.
Removing Marginal Investors is referred to as “Consolidation.”
Consolidation…is a Good Thing! When stocks pull back, it’s actually a healthy development. Why? Because it rids each stock of Non-Committed Shareholders. Get rid of them! We didn’t want them anyway! Heck, they are so bad…they’re traitors! Hey, let’s get a damn FISA Warrant!
But I digress…
Er, back to the discussion…
What does the removal of those Marginal Investors leave behind? A higher concentration of shareholders who are committed to the stock for the longer term. These Committed Shareholders are more resistant to selling their shares.
What does that set the stage for? An imbalance of more buyers vs. fewer sellers, which can/will drive stock valuations higher.
“Consolidation” is a fundamental component to each next bull advance.
What do I love?
I love when stock prices go up. Sure I do.
But I also deeply love when prices stay the same…even if that goes on for a while… Yep, I love a day when a stock I own doesn’t move at all. Why? Because there are still millions of shares being traded, each and every day–and with each traded share, my stock is consolidating to a higher, more pure concentration of Committed Shareholders… A collection of shareholders which removes more Marginal Investors each day… Heck, that happens even without a FISA Warrant…
Yes, I love “sideways-trading days” just as much as days when my stocks advance. Because with consolidation, I know that price advances will eventually come.
Summary
Have I enjoyed the pullback this past week? Perversely, yes… A little bit. Because I appreciate the consolidation process and its impact on future prices.
In early January, I really never got emotionally attached to the surreal gains we witnessed in the first 26 days–they were (in my mind) only a precursor to a necessary pullback, which would serve a valuable purpose–to consolidate Committed Shareholders for the next leg up.
Stay patient this week. Tomorrow morning could be equally tumultuous. The market futures tonight point to as much as another 1000 point drop on the Dow. Will that forecast soften by the opening bell? We will see in the morning.
But my best guess is that we are nearing a pricing bottom. We might see a stabilization tomorrow during the trading day, and, who knows, maybe even a rally to the close? But the bottom line is that “stocks never go straight up or straight down.” And what we are witnessing thus far is actually quite “normal.”
So embrace the process of consolidation. And appreciate the role of the Marginal Investors.
Frankly, I appreciate them even more…after they have left.
Stay thirsty my friends.
Freddie Deeeeeeeeeee