THREE FACTORS MOST ARE MISSING
John Coates was a Wall Street trader who worked for Goldman Sachs, Merrill Lynch and Deutsche Bank. What he experienced and observed as a trader lead him to study the effects of risk taking on the human body, not just our minds. He became a neuroscientist and published his findings in the book The Hour Between Dog and Wolf: how risk-taking transforms us, body and mind.
He writes, “Financial traders are influenced by what is going on in their bodies as well as in the markets. Two steroid hormones – testosterone and cortisol – come out in force during the excesses of bull and bear markets. Testosterone, ‘the molecule of irrational exuberance’, is released into the body during moments of competition, risk-taking and triumph. In animals, this leads to something called the ‘winner effect.’ A male that wins one battle goes in to the next one primed
with higher levels of testosterone, helping him to win again. Eventually, though, confidence becomes cockiness. The animal starts more fights and experiences higher rates of mortality.” Coates thinks one answer, “is to change the chemical make-up of trading floors by hiring more older men, and especially women. Their bodies release far less testosterone. Women have the same levels of cortisol as men, but their stress response is triggered less by competitive failures and far
more by problems in their personal lives. That makes them more resilient when the markets turn against them.”
This unique research shows us that investors and money managers do not just have to deal with emotions. We also have to try to counteract the physiological changes in our body that our emotions produce. This makes it very challenging to have a realistic, unbiased view of the markets at major market tops and bottoms. Our emotions and our body is driving us to become more optimistic as markets move higher and more pessimistic as markets decline.
This is precisely why recent Investment Updates have pointed out extremely accurate indicators that show investors what is going on in the markets. If we can focus on relying on market indicators instead of looking at corporate information, economic statistics and expert opinions, we can focus on being realistic instead of being optimistic or pessimistic. If we can take our emotions out of the decisionmaking process by analyzing how others are acting in the markets, we can have a real advantage over most others who do not have the discipline or knowledge about what is going on in their minds and bodies. This is true especially of younger men who man many trading floors and do not have the experience or understanding of how easy it is to be so wrong at major market tops and bottoms.
Many accept the fact that emotions affect our decision-making. However, most are missing the fact that what goes on in our bodies just compounds the problem at market extremes. This is the first factor most are missing. As mentioned before, my solution for how to counteract these influences is to follow tools that have no human input which have proven to be reliable in the past, just like a pilot trains to rely on instruments when there is little or no visibility.
Another factor I find few are talking about what is really driving markets higher. Many say it is higher corporate earnings or more confidence in the economy since Donald Trump was elected. However, if one looks at where money is coming from to be invested in U.S. stocks, it is clear that most of the buying since 2009 has come from companies buying back shares in their own company.
The chart below from the Federal Reserve Board and S&P shows us the sources of buying and selling over the last eight years. A major change the media focuses on is how money is moving out of managed funds like mutual funds in order to be invested in exchange traded funds (ETFs). (An ETF typically holds a pre-determined basket of stocks so a manager is not required.)
When markets are strong, investors do not see the need for a manager, so this could be a sign that investors are becoming too complacent. However, you can see that Net Buybacks or corporate buybacks have dwarfed all other sources of buying. This is happening for two reasons. First, with interest rates so low, pension funds are desperate to earn a rate of interest on the portion of funds they are required to invest in bonds/fixed income investments. Second, corporations are always searching for ways to increase their earnings. In addition, corporate executives are driven to improve the earnings of the companies they manage so they can earn higher bonuses or increase their income.
Consequently, corporations are selling bonds to pension funds and using the proceeds to buy back their own shares, in effect taking them out of the market place. This is how it works. If a company earns a return of 8% a year on invested capital and can sell bonds that pay 3%, they are making and extra 5% per year. If the company can increase earnings on part of it’s capital by 5%, shareholders and corporate executives all benefit. If all a pension plan can earn on a 10 year U.S.
government bond is 2.25%, and a corporate bond pays 3%, they are increasing their return by 33%. Therefore, companies are selling bonds to eager pension fund investors and using the funds to buy back their own shares.
Things like this have happened before and they all seem to fall apart when the party goes on too long. This is the pattern of a normal credit cycle. Right now, the bonds pension funds are buying, are of reasonable quality. What usually occurs is that bond buyers reach for a higher return once all the good quality credit has been purchased. Most recently, this happened before the Financial Crisis with asset back securities. The investments worked until financial institutions started giving a mortgage to anyone with the only criteria being that they had a pulse. Then, it all unravelled. Charlie Munger said, “I do not think you can trust bankers to control themselves. They are like heroin addicts.” Pension fund managers may not be able to control themselves in the future either if the history of credit cycles repeat.
If we know what is driving stock prices higher, we can know what to look out for. We can watch for signs of lower and lower quality credit being sold.
This is one of the reasons why stock prices have been so resilient in the last year. Corporations are holding this cash and just waiting to invest it. As a result, buying seems to come in whenever there is a slight dip.
Of course, the past shows us that markets will not always rise steadily due to this buying. The S&P 500 fell as 15% from the high in January and February 2016 when oil prices collapsed. This shows that corporate buyers will sometimes step aside during times of uncertainty when there is a sell-off.
The second factor or significant influence most are missing is how much of a factor corporate buybacks are driving stock markets higher. (If you have seen any research on this topic please send it to me.) This is likely to continue over the long-term until the credit cycles matures, which will likely coincide with the inversion of the yield curve. Remember, the inverted yield curve is the simplest and most reliable indicator of a U.S. economic recession in the next 12 months.
When the U.S. economy is in a recession, U.S. stock prices decline 85% of the time. It is as simple as that. While corporate buybacks should continue for some time, there can still be shorter-term market sell-offs.
The third factor most are missing is one you are likely all familiar with. Nevertheless, repetition can be helpful to drive home the point and keep us alert so we can remain vigilant. The third factor is the 80% rise in oil prices over the
12-month period from January/February 2015 to January/February 2016. Ever since 1970, the S&P 500 has declined by 20% or more within 18 months after oil prices have increased 80% or more in the previous 12 months. It has now been
three months since the increase in oil prices hit this warning level. At this time, there are few of the warning signs typically seen before a market sell-off. The most serious market sell-offs since 1980 have all occurred in earnest after Labour
Day. Therefore, if history repeats, it may be appropriate to reduce equity exposure during the summer. Either way, I am now on high alert, looking over my shoulder both ways for early warning signs of a potential bear market.
This chart from the NASDAQ show the 80% rise in oil prices from January/February 2016 to January/February 2017.
There is often a celebration of life when someone passes away. I recently had a minor special occasion and decided to have my own celebration of life while I am still alive.
In Vancouver, people brag that you can snow ski in the morning and golf in the afternoon. So rather than just talking about it, I did my own version of that. I went snowmobiling in world class conditions at the Coquihalla in the morning. Then I
went to a local tulip festival with my wife, two daughters and five grandchildren that live locally in the afternoon. After that I took my jetski down the majestic, historic Harrison River for the final part of my day in the early evening.
However, I was able to participate in another activity I could not plan for. On my way back up the river to Harrison Hot Springs on my Seadoo, a Search and Rescue call was issued for a rollover of a side-by-side ATV on the Harrison East
Road. By the time I got back to the boat launch, the crew from my team was already on the way so I assisted the fire department in setting up a safe and secure landing zone for the medi-vac helicopter and paramedics that were flying in from Vancouver. One person was seriously injured and one had minor injuries.
After that, I stopped on the way home to get a mocha frappuccino and got home at 10:00 pm. What a day of enjoying nature around us, spending time with loved ones and helping those in need. I consider myself a most fortunate man! Thank you for your continued trust and confidence too! Please see photos of that day on the following pages. Have a great weekend!