Wall of Worry. Why bull markets NEED bad news.
In the later stages of a bear market, our job as investors changes.
Yet, many experts resist that change.
They lament: It’s crazy the market is up with this bad news (layoffs, high inflation, fed still raising, etc.).
Experts often focus on the wrong thing (that’s why in my piece on bear market guides, I recommended only following this set of experts during bear markets, as they are often late to pivot).
It’s not just that markets discount ahead (not always true)
It’s not just that all the bad news is in (often it’s the opposite).
Instead:
The most sustainable bull markets structurally NEED bad news as fuel to drive them higher.
We are now entering the part of the bear market where each rally could be the start of a bull market or another bear market rally. We need to do our best to tell the difference, and not fall into the simplistic trap of thinking bad news is bad for markets.
In the first 2 weeks of January we had a spectacular crypto rally.
Why does this matter?
“No one want’s to get rich slow.”
- Warren Buffet on why no one copies him.
Least of all crypto investors!
If investor risk appetite was a dog, crypto is the tip of the dog’s tail. Dog moves, tail moves more, tip of the tail experiences wild swings!
Crypto staged a strong 2-week rally, with Bitcoin up 26%...
Even if you “don’t care about crypto” you should watch it to understand investor’s risk appetite. Total crypto market cap is $995B, just shy of a trillion dollars. Crypto is big enough to matter.
That increased investor appetite (of the biggest risk takers) underpins the bear market rally in stocks. Tech-heavy NASDAQ is like the middle of the tail of the dog, thus tech was up 10% vs bitcoin up 26% in the same time period.
As the first-movers of risk takers (crypto investors) go from risk-off to risk on, those who are also equity investors take that new risk appetite to the stock market.
Then bad news is not as bad as feared, thus good. But as I wrote last week, this move from risk-off to risk-on may be the start of a bear market rally.
Just as you saw crypto investors make 26% in 2 weeks, equity bear market rallies can be fast and furious, with gains of 25-40%, sometimes even 50%. Nothing to sneeze at after a year of losses.
Looking at investor risk appetite doesn’t mean ignoring fundamentals.
However, focusing entirely on fundamentals could make us miss the beginning of a real market rally.
What are upcoming catalysts the market must face and rally through?
1. Earnings
As I mentioned in 3 Times The Pros Buy, in slower economic times, buyers go risk-off and buy more from larger companies.
Larger companies report earlier, thus the first two weeks of earnings may be “not as bad as feared”, and then when the rally starts to lose a bit of it’s “bouncing back from oversold” energy, we head into smaller company earnings which may be more challenging and show bigger misses or guide downs vs expectations.
2. Inflation + Fed Rate Raises
Both of these are less bad than Q4, BUT they may linger longer (and the market will panic about them from time to time, ie the 600 point drop in the Dow due to inflation worries on Jan 18th).
Inflation is down, but may take a while to get back to 2%. The Fed is unlikely to keep raising at 75bps per meeting, but they will raise at 50-25 bps per meeting for longer than we hope, especially if inflation continues higher than 2% for longer than we hope.
3. Left-field events
The term “Black Swan” is overused. It’s supposed to be once in a lifetime or less. Left field events come out of left field, thus are unexpected.
In a backdrop of rising rates, left field events are the unintended consequences in a complex economy of one of the fastest contractions of money supply in the past 100 years. We haven’t seen the full extent of the second order effects of monetary policy, or the nearly 10% drop in the USD in 3 months (a lot for a reserve currency).
4. General exhaustion.
Just like a rubber band, if markets go down for too long too many days in a row, they get exhausted, and stage a relief rally.
Once that rubber band is no longer taught, ie we are a few weeks into the relief rally, then markets need additional fuel to keep going, otherwise they roll right over and start moving down again. Bad news becomes bad and good news becomes not good enough.
Need cheering up after that awful list?
Bad news is the best foundation for a bull market!
Just like bad news becomes good when it’s not as bad as feared, and good news becomes bad when it’s not as good as expected, and most important, bull markets NEED bad news.
Strong bull markets are built on a Wall of Worry.
Here’s how it works:
Ever build a fire?
No, you say, it’s 2022 and we are not campers, we are investors…
Pretend you did, or your parents or grandparents did. Even a fire in your fireplace…
There are two types of fires. Ones that burn fast and hot. Lots of paper and kindling, and you get that fire burning in a hot minute. Great for those of us who are impatient.
20 minutes later? No fire, just burnt up paper and sticks.
Alternatively, build a fire with paper as the starter, smaller sticks as kindling, medium sticks to keep the fire going, and large logs for a full long night of a beautiful fire. It takes longer to get those logs burning, but the embers may still be glowing when you wake up the next morning. (In the woods, put the embers out with water, otherwise Smokey Bear will come arrest you!)
The setup for markets is similar to the setup for your fire.
A bull market doesn’t start when there is no more bad news.
A bull market NEEDS bad news as fuel for a long-burning fire.
Here’s how markets climb a wall of worry.
At the end of a bear market, most investors have sold risky assets, own conservative stocks like Procter and Gamble (everyone needs toilet paper and toothpaste), and have cash. Investors are worried.
Then one investor says to herself: “It’s not THAT bad, and these prices for my favorite stocks are attractive. Maybe I’ll buy a large cap tech stock.” - more risk than P&G but less risk than a small cap tech stock with no earnings. We converted one person from low risk to medium risk.
She moved from the base of the tail to a bit further up the tail of the dog of her risk.
Then another investor sees that large cap tech has started to move up (because a few investors made that same shift) and doesn’t want to miss the rally. Bad news is everywhere, but good news in the form of stocks going up is enough to dip his toe in.
And so on.
If every day you convert a few investors from doubters to less doubters, to believers, prices go up as demand for risky higher potential return stocks goes up.
If everyone believed there was no more bad news and therefore it was safe for everyone, then they all would own high return potential risky stocks. Who would the next buyer be?
No more bad news is the definition of a market top, not bottom.
The market needs a wall of worry to climb.
Each day, the market converts one worrier to less worried as FOMO takes over. Often these investors are also executives in companies, so they start spending more for the upturn. Then the upturn becomes a self-fulfilling prophecy (especially as time goes by and year over year comparables are easier).
This is what we saw in all the greatest long bull markets.
Every day, I would show up to work and there would be plenty to worry about. SaaS was overvalued. Asia currencies were moving around. Semiconductor shortages was affecting certain companies’ ability to make numbers. Several times we would have a segment of tech like software go down 30-40% in 3 months, but not be a large enough portion of the S&P, thus that period (4Q18), was still considered part of the bull market.
Those big pullbacks and worries, even more recently March 2020, actually extend the length of the bull market, because it refreshes the wall of worry for us to climb again.
Only in arrears do we look back at bull markets and say how easy it was to make money.
Where does that leave us today?
As the bear market marches on, our jobs as investors changes.
We were sitting on our hands to avoid catching falling knives. Patience is the name of the game early in a bear market.
Since we don’t know in advance how long any bear market is, as time passes, our focus must change or we’ll miss the new bull market rally.
Your biggest wins will come from being in the rally at the ground floor.
How can we determine if this is the start of a new bull or another bear market rally?
Have the patience to wait for the real bottom and recognize false charges, falling knives, and dead cat bounces
Balance patience with open-mindedness. Those who miss the new bull are those you will notice digging in their heels about “what is” i.e. economic numbers, valuations, bad news, instead of embracing that the market looks ahead, and needs a wall of worry to fuel a sustainable bull market.
The key is, when is that point?
That’s the art of investing.
My cop-out answer is that you don’t know the start of a new bull at the time, but I don’t really believe that.
In markets, you have sectors, like tech, internet, housing, etc., that lead you down, and those that lead you out of the bear.
In 2000, it was internet that led us down, and tech was such a bloodbath that 70% of tech companies were selling for LESS than their cash on hand in the summer of 2003. A different set of small-cap tech companies led us out with strong growth.
In 2008, housing and bank failures led us down, but they were so badly damaged, that investors didn’t buy them right away.
I bought BofA at the bottom only to watch it languish for a year.
March 2009, FASB changed the accounting standards to say insolvent banks could “fake it till they made it”, ie not say what their actual assets were right at that moment. That technical accounting change gave investors confidence it wasn’t going to get so much worse, and they bought tech to start the new bull market.
Each time the reason for bottoming is different, yet history rhymes. In March 2009 (and in October 2008) my valuation metrics simultaneously hit my prediction for where value buyers would buy each individual stock, on 85% of the stocks on my spreadsheet. And those were indeed the bottoms in those stocks.
But valuation alone didn’t drive the new bull.
Otherwise, the new bull market would have started in October 2008. Instead FASB’s decision, COMBINED with the valuation bottom, CATALYZED the new bull market.
You may be wondering…
Emmy, is it just because you were a tech analyst and PM that you think tech leads us out of every bear market?
Fair question!
It’s been so long since we’ve had a recession and bear market. We’ve forgotten about sector rotation.
Sector Rotation
During certain parts of an economic cycle, it’s better to own certain segments of the economy.
Think we are in a recession? People will keep buying toilet paper and toothpaste, thus consumer staples do well.
Think we are leaving a recession? People will buy more tech to increase productivity before hiring more workers (a more permanent increase in costs).
Tech (specifically high-flying work-from-home stocks, space stocks, and electric vehicle stocks) rolled over starting in the summer of 2021, as there was no one left to convince.
Every investor was all-in.
Tech should lead us out as this was a broad-based bear market, with everything (stocks, bonds, real estate) overvalued, and for classic bears, tech leads the market into the next bull.
If we don’t need all the bad news to be behind us, what do we need for the bear to be over?
This is what I saw in 2008-9 and in 2002-3
True Capitulation (not everyone asking when they should buy, but people have no interest in tech stocks because they have lost so much.
Cycle valuation lows. Valuation matters far less than sentiment in day-to-day trading, but capitulation of growth investors means they dump all tech and value investors and wait to buy till they are at 2X sales, leading to an air pocket in stock prices and valuations. We are not there yet.
Percentages will surprise you. It doesn’t matter if something is down 80%. The difference between down 80% and down 90% is a 50% decline. 100 → 20 = down 80% 20 → 10 is down 90% from 100, but also down 50% from 20. Percent down doesn’t matter to value buyers. Valuation does. Nor does quality of the company. Cisco went from $88 to $4 in the 2000 to 2003 time period.
We are not there yet. The ONLY time I focus on valuation is by looking at whether we have reached a point where value investors will start buying from growth investors. That is what we'll see at the end of each bear.
Then we start the process of building our bull on a wall of worry.