Why Fundamentals Don’t Matter (until they do)

I often get questions about a company’s fundamental analysis. In my experience, fundamentals are of little value on their own. Oh, don’t get me wrong they do matter, but because they are a horrid timing tool, their most value is realized when looking in the rear view mirror. A good example is this year’s best performing stock, PLSE (up a trivial 320%). PLSE has no revenue, no profits and nothing from every other fundamental metric. As such, it would never show up on any fundamental screens that identified strong companies and would likely be missed by investors. That is unless they also (or instead) used technical analysis.

One common element to finding these “runners” is they will almost always start with a long basing period in which the stock price does nothing but chop around and go sideways. This action drives the bulls away and some of the bears eventually give up out of boredom.  The few that remain are the fuel to create a short squeeze driving buying volume higher acting as the impetus for a strong breakout. Like the basing pattern, volume is also clear when looking at a chart.

Taking a look at the PLSE chart below, we can see price chopped around sideways for about 20 weeks forming a rounded bottom. Price broke out from the blue horizontal resistance on light volume, fell back and retested that same line and then catapulted upward, pushed dramatically higher on more than 20 times the prior average volume.

This is a textbook example of accumulation. Prices can only rocket higher when the BIG guys (institutions) step in and buy. The good news for us little guys is that the BIG GUYS leave trails, not unlike when you are tracking elephants. In the case of institutions, we see their trails in volume patterns.

While this topic is one for another post, the opposite is true too in times of distribution. When the BIG GUYS begin to sell their shares, a topping pattern is typically formed and the elephant’s droppings are visible in the form of large selling volume.  Since it has been before Moses parted the Red Sea that we have seen distribution in the stock market, you are just going to have to believe me on this.

Caution Warranted. A lot More Downside in Store?

Yesterday’s stock market action was so ugly and sent a warning shot across the bow. The bearish setup and follow through that permeated so many US stock sectors did immense technical damage. Unfortunately, none of the market leaders were spared which is what you expect to see in a strong bull market and as such, it looks as if there is more pain ahead. I wrote about seeing this setup across many sectors (using the financial stock ETF as my example) over the weekend and the timing of the warning couldn’t have been better as they broke down yesterday.  Looking at the best performer since the 2011 bottom, the top 100 technology companies, QQQ, broke down hard too. Much harder than I would have liked to see if I were expecting more short term upside. In fact, its decline wiped out the last 20 days of gains.  This is a great illustration of how stocks move … stairs up and elevator down.

The negative momentum divergence that developed on the last push higher warned of a pullback and says there is still a lot more room to fall before it becomes oversold if the market wants to fall further. This combined with yesterday’s huge, confirming volume make it look like this pullback might have some legs.  

When the leaders that have driven the overall market higher (in this case the banks, technology and small caps) begin to take it on the chin, it immediately raises the yellow caution flag. As we know, one day does not make a trend but what happened yesterday got my attention. With any luck it was just a one day Trumper tantrum! If not, this may be the beginning of that long awaited pullback and volatility spike that has so eluded us.

Divergent Warning Signs Abound

Earning season is almost over and the market is entering into a seasonally weak period without any upcoming catalysts. Combining this with weakness in breadth and lack of leadership names points to the potential for a pullback. Market weakness is nothing new as I have mentioned for a few weeks how the US stock market is overbought and looks as if a short-term pullback is likely in the cards. Across virtually every strong sector, divergent high, rising wedges have formed. While these patterns are typically bearish and resolve to the downside, there are no guarantees since only 69% actually play out. This means sticking my neck out on the line on this warning of a potential s/t correction gives me a 31% chance of it getting chopped off. I’d love to have better odds but hey, it is only a warning.

A good example is that of the financial sector ETF, XLF, the big sector winner since the “Trump bump” rally. You can see in the chart below, a textbook 5-point rising wedge formed with the 4th point forming a divergent high. Since that high, price has consolidated sideways but with a downward bias and more importantly sits right on an essential support line. If the market wants to correct as the chart is warning, a break below current support provides a target below at the T1 level.  Since corrections can typically be quick, strong moves, if T1 fails to hold then the T2 area is where I would expect any downside to terminate.

Those not long financials and have sideline cash awaiting a pullback to enter, may find this potential near-term correction a compelling buying opportunity.  If we don’t see a correction, chalk it up to the underlying strength and conviction of the bulls as they are clearly in charge.

Bonds in a Box

The market has already baked in an almost certainty for a quarter point rate hike as the outcome from tomorrow’s FED meeting. The 30 year bond yield has risen almost 50% from last July’s bottom and currently sits in its consolidation “penalty” box as is seen in the chart below. Additionally, yields remain are testing the highs last seen in October 2014.

The market has a tendency to do exactly opposite of what everyone expects. With the dumb money currently long yield and the smart money short, I find this setup up very fascinating and am interested to see how it all plays out. If the FED response is to push rates higher and the market follows, I would expect we see much higher yields (lower bond prices) in the future as the bull flag pattern that has developed points to a 30 year yield north of 4%. While that will be good for bank stocks, bond holders, especially those holding long-dated maturities and those buying or refinancing property will be likely be in for some pain.

Surviving the Continuous Chain of Disappointments

I thought I would repost an article written last week by Morgan Housel talking about one of the greatest investors, Ed Thorp. For those of you who may not have heard about him, Ed Thorp was the first person to systematically beat casinos at blackjack. He made piles of money, and wrote a book laying out a formula showing how you could do it too.

But not many people did.

Card counting is simple on paper and maddeningly hard in practice. That’s partly because casinos are good at catching card counters. But it’s mostly because even successful card-counting means long, tiring stretches of losing money, which most people can’t stomach.

The casino usually has a 0.5% edge over blackjack players. Thorp’s system titled the stakes, giving players about a 2% edge over the house.

A 2% edge is enough to secure a fortune in the long run. But it also promises hell in the short run, since Thorp was still likely to lose about half his hands. His road to success was paved with agony, as he writes:

I lost steadily, and after four hours I was behind $1,700 and discouraged. Of course, I knew that just as the house can lose in the short run even though it has the advantage in a game, so a card counter can fall behind and this can last for hours or, sometimes, even days. Persisting, I waited for the deck to become favorable just one more time.

The key to Thorp’s system was the ability to survive losing long enough for the 2% edge to materialize. It meant constantly absorbing manageable damage. Many people can’t, or refuse to, do that. Thorp once enlisted a partner, Manny, who was fascinated by the counting system but couldn’t stand the long bouts of losing. “Manny became in turns frantic, disgusted, excited, and finally close to giving up on me as his secret weapon.” As did most who attempted Thorp’s system.

It’s ironic that the secret to winning was learning how to put up with losing, but there it was. “Having an edge and surviving are two different things,” Nassim Taleb once wrote.

This is a great analogy for most business and investing endeavors.

Capitalism doesn’t like edges. It unleashes competition to bang them back toward zero. When edges do arise they’re usually small. A system that gives you a 55%, or 65% chance of success is phenomenal, but it still means you’ll spend close to half your life getting beat up. Since 100% odds of success are either not lucrative, illegal, or ephemeral, the ability to survive losing is a prerequisite to any shot at eventually winning. The business world is a continuous chain of disappointments – recessions, bear markets, brutal competition, employees quitting, supply chain breakdowns, whatever – so every chance at success has to be framed as a net reward down the road amid a constant state of battle and hassle. Thorp understood this. Most of his disciples did not. Most people don’t in general.

Two things come from viewing success as the ability to absorb loss:

It’s easier to be an optimist. Optimism is usually defined as a belief that things will go well. But it’s not. It’s a belief that the odds are in your favor, and over time things will balance out to a favorable outcome even if what happens in between is filled with misery. I’m optimistic about the economy because the odds of success are in its favor. But I still expect a chain of recessions, panics, pullbacks and upheavals. Same for businesses. There are companies whose future I am extremely optimistic about but whose quarterly investor updates I expect to be peppered with setbacks. The two are not mutually exclusive.

You value the margin of safety. Many bets fail not because they were wrong, but because they were mostly right in a situation that required things to be exactly right. Room for error – often called margin of safety – is one of the most underappreciated forces in business. It comes in many forms: A frugal budget, flexible thinking, and a loose timeline – anything that lets you live happily with a range of outcomes. It’s different from being conservative. Conservative is avoiding a certain level of risk. Margin of safety is raising the odds of success at a given level of risk by increasing your chances of survival. Its magic is that the higher your margin of safety, the smaller your edge needs to be to have a favorable outcome. And small edges are where big payoffs tend to live, since most people don’t have the patience to wait around for them.

The point is that short-term loss is usually the cost of admission of long-term gain. It’s a price worth paying, but takes time for the product to be delivered.

Some may be wondering how this all relates to my investing blog. Besides his casino beating system, his Princeton Newport Partners fund, which was set up in 1969, is recognized as the first quant hedge fund (one that uses algorithms). Over 18 years it turned $1.4m into $273m, compounding at more than double the rate of the S&P 500 without suffering so much as one quarter with a loss. Thorp’s then revolutionary use of mathematics, options-pricing and computers gave him a huge advantage. Ed’s moneymaking abilities have made him the “godfather” of many of today’s greatest investors.  The takeaway here is that to be successful at Investing, gambling or any endeavor that puts capital to work in an attempt to profit requires both patience and also an “edge”.