Small Cap Stocks

As I’ve noted in the past, Markets obey a basic rule: they reverse after extremes. The basic reason for this is that extremes demand action from various interested parties, which ignites a major shift/change in the Market that ultimately changes fundamentals, pricing and the supply/demand picture. So I was pleasantly surprised to read today that home buying is now at a 13-year low.

The Mortgage Bankers Association noted that:

“Sales of new homes plunged nearly 33 percent in May, however, to the lowest since record keeping began in the early 1960s and existing home sales unexpectedly fell 2.2 percent. A double-dip recession is a growing concern.”

So is the lowest new home sales on record a sign that a reversal is near?

Of course, I don’t have a clue as to the timing (note: I’m taking a beating on my recent ZIPR investment), but my guess is that residential real estate after years of decline is finally facing a major extreme and will reverse. It’s nearly impossible to imagine that a change will occur when extremes and pessimism reign supreme, but there always is a change and reversal at some point. My guess is something radical, albeit rational, will be implemented soon to maintain a “floor” in real estate. Undoubtedly, on a more immediate basis, the homebuyer tax credit will be extended and renewed.

It’s also interesting to note, that in general, humans are followers as opposed to leaders. This is why nearly everyone sells at the bottom and buys at the top. So when significant social trends, that still represent value, reach a record low, the odds are high that a bottom has been reached.

Even though I’m invested heavily in the stock market, deep down I’m rooting for a massive correction as we’re experiencing now. The reason is because the stock market is apparently the only language that the President, his economic team, and the rest of the government understand.

If people are unemployed, can’t pay their mortgages, can’t afford healthcare, nobody cares. Heaven forbid the US government should run a deficit or reign in corporate fraud in order to help its citizens. But, woe onto us if the stock market drops a few thousand points. Suddenly, we’re in crisis mode and the sky is falling.

So perhaps the best thing that can happen for the country now, and the stock market in the long-term, is a massive correction. That should shake the President/Government up a bit, and perhaps jolt him to begin action on truly reforming the “real” economy, instead of sending trillions to the fake economy on Wall Street. Forcing banks to restructure debt on deeply flawed residential housing loans would be a good start. Ultimately, if the real economy is on solid ground, the stock market will be able to make progress on a sustained basis.

What’s interesting about the current deficit debate, is that the same set of Republican pushing to eliminate social programs in order to reduce the deficit, are the same people clamoring for lower taxes. Enlightened people, of course, understand that both large deficits and tax policies have zero effect on the fiscal strength of the US Government (remember the government prints the money, and is never really in “debt” to anyone). Nevertheless, if you are going to preach money myths like deficit reduction, as the Republicans are, you might as well at least pretend to be consistent. If you care about eliminating social programs in the name of deficit reduction, you need to also favor higher taxes, which would, if you buy into the deficit myth, do wonders to reduce the deficit. To favor one policy over the other, indicates complete hypocrisy or worse signals a more sinister motive behind the push to abandon those in financial trouble via deficit reduction.

The other day I had an interesting back and forth with a colleague of mine about the target price for a recent stock recommendation I posted on this site.

While I argued for a higher price target based upon my future cash-flow expectations and a lower discount to the standard industry multiple, he presented a case for lower future cash-flow and a larger discount to the industry multiple.

Who was right? At this point, both of us and neither of us. The argument proves the fact that in the Markets there is no way to prove or better yet disprove (ala Popper’s Falsifiability concept) any valuation proposition, and so all valuation propositions are inherently false and meaningless.

Since the entire art of valuation rests upon future cash-flow expectations and subjective terminal multiples based upon discount rates, the entire process can be characterized as a great folly.

The folly is two-fold:

1. The future is unknowable, especially for outside investors. While a range of cash-flow projections seems reasonable, the probability of each case is open to interpretation and yields vastly different valuation targets. There is no way to prove any case, since you can’t prove or disprove the future.

2. Assigning multiples and applying discount rates is entirely subjective. Small differences can lead enormous pricing differences. Moreover, in an era of 0% interest rates, it is irrational use any sort of discounting for valuation purposes, since there is no risk-free rate to reference. One is justified, in theory, in applying a nearly infinite multiple to any future cash-flow since the risk-free rate is 0. You cannot falisify any discount mechanism.

So what’s the solution?

I’m not quite sure. But I think it’s fair to say that Market prices no longer have anything to do with quantitative valuation, since such a valuation is unprovable and logically unfeasible in the current financial environment.

The situation is in actuality no different than the demise of book value investing, as the economy moved away from factories to services and other businesses that relied mostly on intangible capital.

What’s needed, I guess, is a new valuation framework which relies heavily on qualitative and psychological factors that we agree are inherently meaningless.

Once one accepts the irrational nature of marketing pricing, one ceases to rely on indefensible quantitative methods, and instead one tries to understand the nature of irrationality. In general, the one proposition of irrationality that I think holds, since there is plenty of evidence for it, is that irrational events, such as the Market, tend to always reverse, as I’ve described here.

I enjoyed this quote from CNNMoney.com, since it highlights a typical misconception about commodity prices:

“How can people claim that there is a V-shaped recovery?” asked Michael Pento, senior market strategist with Delta Global Advisors in Huntington Beach, Calif. “If there was truly a lasting global recovery, these commodities would be rising. The only logical conclusion is that we are having a global slowdown.”

The only problem with this logic is that commodity prices, particularly oil, have absolutely nothing to do with fundamentals of real supply/demand (the same of course can be said about stocks). So the prices of commodities signal nothing about the strength or weakness of the global economy. In fact, if oil accurately reflected supply/demand, I think it would be trading at $30, peak oil theorists be damned.

Most commodities have, in fact, simply become a massive casino fueled by easy credit to big banks. Their prices are simply of a reflection of the irrational decisions of inveterate gamblers and the amount of money they are allowed to lose. In other words, finance has hijacked commodities. Even the price of gold has absolutely nothing to do with supposed fundamentals (i.e. a fear of inflation or a fear of currency dissolution), but is directly correlated with the amount of speculative money pouring into gold ETF’s like GLD. It’s basically a momentum game, just like the S&P 500 was in the 90′s during the height of the index fund craze.

For a good understanding of the role of speculators in commodity markets, I highly recommend reading hedge fund manager, Michael Master’s Testimony to the US Senate back in 2008.. Here is a favorite quote of mine from that speech:

“In the popular press the explanation given most often for rising oil prices is the increased demand for oil from China. According to the DOE, annual Chinese demand
for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion
barrels, an increase of 920 million barrels.8 Over the same five-year period, Index
Speculatorsʼ demand for petroleum futures has increased by 848 million barrels.9 The
increase in demand from Index Speculators is almost equal to the increase in demand
from China!”

So what does the current price of commodities tell us? Nothing more than that the big banks are getting more cautious and reigning in their gamblers, for a variety of reasons.

Today I read an interesting quote from the Chinese classic Tao Te Ching: “Reversal is the way of the Tao.” (Chapter 40; other translations of the same passage are: “The motion of nature
is cyclic and returning”.)

When applied to investing, this ancient wisdom from the Tao Te Ching, could read: “Reversal is the way of the Markets.” What seems clear is that Markets in general, and businesses, in particular, go to extremes, from which they tend to reverse. Big losses many times lead to big profits, while big profits invariably pave the way for losses.

Investment is the art of spotting these extremes and betting on a reversal, when appropriate (some businesses, of course, never reverse).

The difficulty in investing is two-fold: Spotting the correct extremes to bet on and predicting the timing of a reversal.

In terms of spotting the correct extremes, I think the situation is somewhat simple. The key is obviously to investigate “losers”, and look for factors that promote corporate survival (i.e. the balance sheet, business credibility/stability), while at the same time searching for factors that may lead to growth (i.e. the “hype” factor). Both of these factors imply long-term demand for the shares.

Predicting the timing of a reversal, is a different matter entirely, and something which with time, I’ve come to realize is simply impossible. To make money you must be early, so in essence any good investor will lose money initially when betting on a reversal.

Nevertheless, there are some clues, I’ve found to be useful in spotting a potential “upside” reversal. These include, but are not limited to,: a big writeoff, a stock price at multi-year lows, a change in management/strategy, a divestiture, debt/balance restructuring or refinancing, a lack of analyst coverage, and a mismatch between cash-flow and income statements. Some of these clues can show up together, while at other times they surface independently. Often times, a major positive reversal as evidenced by the financials (i.e. a company moving from heavy losses to cash-flow positive results, e.g. VG), is completely ignored by the Markets for one reason or another, providing a nearly risk-free investment situation. Interestingly, a major acquisition or spurt of merger activity, is often a clear signal that a formerly successful company is about to reverse, in a negative sense.