This article was sent to members via email December 25. That email can be accessed via the link that follows this article.
By Brian Nelson, CFA
What a beautiful time of the year. I’m writing to you from Gatlinburg, Tennessee, in the beautiful Smoky Mountains. I know it’s easy to have anxiety about the markets, but please be sure to find time to spend with friends and family this holiday season. Money, we can make more of. Time, we cannot. May you and yours have a blessed holiday season.
Christmas Eve was another market rout. Secretary Treasury Steven Mnuchin tried to ease the market’s concerns by ensuring that the biggest of the banks had sufficient liquidity. This is textbook policy in the midst of a steep market decline that can lead to a crisis, but we think the move wasn’t so much about the banks as it was about something much more serious. Here’s the reason behind the Treasury Secretary’s actions, in his own words:
“In my opinion, market structure has led to a lot more volatility. Part of this is a combination of the market presence of high-frequency traders combined with the Volcker rule.”
The proliferation of a “buy at any price mentality” as in indexing coupled with quantitative styles based on ambiguous and impractical data (almost all of them) are the cause of this volatility. The structure of today’s market is one in which there are more investors not focusing on value than focusing on value, and those that are focusing on value really don’t know how to calculate value. We are in a unique time of market structure where the closest comp may very well be the pre-1940 stock market before the dawn of the value-conscious era of investing.
Behavioralists will say that the market is irrational while efficient market theorists will say that we’re factoring in a recession. The question posed today is not whether the markets are inefficient or efficient but rather if we have the tools to prevent a market that spirals completely out of control as a result of price-agnostic trading. Based on the Treasury Secretary’s preemptive action Sunday, my evaluation of the situation is that the government does not believe it has the tools to curb the next market crisis. Unfortunately, we cannot use the tools that cured the last crisis to cure the next crisis.
The markets are facing the first generation of investors that believe indexing and thematic ETFs are investing and not speculation. When this market moves against key strategies, the limits of arbitrage will be tested, and the “smart money” may not be able to fix this time.Surely, we cannot still believe that buying anything at any price and investing based on backward-looking ambiguous and impractical data is a good idea. Most of what advisors and investors have been “taught” could start to work against them in a big way, and this is my biggest worry.
It’s easy to blame the Fed. It’s easy to blame US-China trade relations. It’s easy to blame a Treasury Secretary that knows the risks. It’s easy to blame the President because it’s popular. But it’s price-agnostic trading (indexing, quant). What concerns me most is that this market could very well spin out of control. If a strong, net-cash-rich, free-cash-flow generating powerhouse such as Facebook could be down ~30% this year, there’s no telling what the market could do to itself during 2019.
Remember — There are two parts to investing: 1) estimated fair value via enterprise valuation, and 2) likelihood of price-to-estimated fair value convergence via technical/momentum. Anything else may be just speculation or gambling. Let’s keep focusing on intrinsic value estimation and evaluating the likelihood of price-to-fair value estimate convergence. This is what investing is all about.
Link to original email: http://campaign.r20.constantcontact.com/render?m=1110817109903&ca=e1319c74-414a-4050-a27a-85ffb549d0e4
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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.