“April is the cruellest month, breeding lilacs out of the dead land, mixing memory and desire, stirring dull roots with spring rain” TS Eliot, The Waste Land, 1922
“October is the cruellest month, longs are going down on good numbers, shorts are going up on profit warnings, it’s getting darker outside with cold rain” BJ Norris, Argonautica Blog, 2018
Most investors will have been frustrated by the apparent cruelty of the stock market during October. Glamourous growth stocks got crushed. Cyclical value opportunities got cheaper. Consensus shorts squeezed. Only dull stocks with no narrative were safe. In reporting season, stocks often seemingly moved in the opposite direction to their reported earnings. This all led to a very poor month for hedge funds and active money in general. Let me explain my thoughts on the October rout and what we might learn from it.
First, the macro. October saw the first tangible signs that President Trump’s trade tariffs were starting to really hurt the Chinese economy, where there has clearly been an inventory destock and a tightening of financial conditions. This will likely deteriorate further in the absence of either powerful domestic stimulus or a de-escalation of the trade war with the USA. Should Trump go through with additional trade tariffs in January, then there will likely be an Asian led global manufacturing recession leading to a deflationary scare. Ironically, companies are currently noting cost inflationary pressures but neither equity or bond markets nor central banks are discounting these as transitory, which led to a nasty pincer movement on equities of falling profits and rising rates. The Federal Reserve currently looks way too hawkish relative to the strength of the global economy.
Second, corporate profits. The Q3 reporting season has been negatively perceived with slowing top line growth and rising costs leading to margin squeezes. The most widely affected industries have been automobile and semiconductors. Some of the issues affecting automobiles are temporary, with all new European diesel vehicles subject to a more stringent certification process. Additionally, Chinese new car sales have also slowed dramatically. Semiconductor stocks are two quarters into a cyclical downturn owing to over-capacity in NAND and DRAM production. Demand is also stalling for technological reasons such as a decline in growth of smartphone unit sales and industry confidence has waned owing to trade war tensions. This does not tell the full story of the stock market as a whole: even in cyclical sectors reporting stellar results, the market reaction seemingly called the top of the cycle in its punitive response.
Third, position crowding. There has also clearly been a big crowding issue amongst hedge funds and active money in general. This has meant that glamourous growth stocks have been amongst the worst performers. It has also meant that popular shorts, often in sunset industries, which are already being negatively affected by the economic slowdown held up better than perhaps they should have during the month as funds reduced gross exposure. This resulted in a situation where good results could be greeted with a negative share price reaction and conversely other share prices rose on profit warnings, leading to much frustration amongst fundamental investors. As such, short books have generally failed to hedge as hoped against a falling market.
So, what happens next? In terms of the global economy, the Chinese government would now seem intent on a renewal of massive industrial stimulus which historically at least has been unwise to bet against. It would be logical to presume that Trump’s trade tariffs are a game of economic chicken in which both China and the USA are now more motivated to de-escalate. Therefore, a de-stocking cycle could turn to a re-stocking cycle and whipsaw investors. The Democrats winning back control of Congress could be a market positive in terms of controlling the Trump agenda (though the President retains his discretionary powers with regard to trade). There should now be a Brexit agreement between the UK government and the EU. More hopefully, the Fed may not be as hawkish in December and the strength of the greenback may be peaking. Given the extent of the market falls and pairing back of risk appetite, sentiment can quickly move to the glass being half full, rather than today’s half empty. Nevertheless, the global economy is losing momentum and as such we anticipate Q4 results will generally be worse than Q3. On a fundamental basis this will put a premium on non-cyclical growth. However, the bottom line is that a more dovish Fed and a resolution of global trade disputes are probably both required for a new bull market to commence.
Our process is based around our identification of earnings surprise. Predicting earnings better than the market is not easy: it requires a lot of hard work, diligent research and experience. However, there are circumstances whereby even when we are successful in our stock analysis with regards to earnings this is not rewarded by the market and leads to frustrating and inconsistent outcomes. When macro is relatively stable we are almost always consistently rewarded for stocks demonstrating earnings surprises. But, when macro becomes more volatile, idiosyncratic stock analysis can be drowned out. Although investing with a macro mind-set can help mitigate this risk and occasionally be spectacularly successful, predicting the future path of economies and interest rates, particularly when they can be binary in nature, is a much less repeatable skill than analysing stocks. Therefore, it would seem logical that greater consistency in outcome can be achieved through isolating stock picking ability from capricious macro and risks of “unknown unknowns” through a structural allocation of more capital to core non-cyclical idiosyncratic ideas.
It would also seem clear that the “crowding” problem witnessed in the October rout has been exacerbated by the decade long successful run of “growth” stocks over “value” stocks. However, as any European “value” investor will know all too well, producing returns at different times to peers is very different to producing consistent positive returns. Moreover, the hopes of a benign macro normalisation which could have buoyed “value” stocks sustainably, has morphed from late cycle to the end of the cycle all too quickly, meaning that “value” stocks, especially in cyclical sectors, did not perform particularly well either during October. Moreover, “value” stocks in general are unlikely to thrive if the market now begins to worry about a Chinese deflationary bust. Time horizons are also a big issue for “crowding”. It would also seem clear that a high proportion of market volumes are driven by highly leveraged quant or prop shop money with very short time horizons which can infect our process, crowding trades when short-term sell-side consensus beats are likely. The smart way around this is to become longer in our investment horizon when attempting to value earnings surprise. Such violent reversals caused by unwinding of crowded investment positions would be less prevalent if the industry as a whole was not so focused on constant instant gratification for process validation.
Winning on earnings but still losing in the short term because of position unwinds or macro is cruel. However, we should not plan for markets to always be fair minded and accept that many of the challenges of delivering positive, consistent performance go beyond simple stock selection. The market dislocation witnessed during recent weeks has created in our view significant opportunities and we are focusing our capital on high conviction idiosyncratic ideas where our process has the best probability of consistent, future success.
Barry Norris
Argonaut Capital
November 2018