Investor confidence undermined by market shifts

In the stock market until recently, just about any news was good news. Company earnings stumbled? Investors shrugged them off, sending shares higher. Economic growth disappointing? So what.

But that is changing.

Consider the recent trading in Apple, the world’s most valuable public company and a stock market darling. It announced third-quarter results on July 21st that were “amazing,” according to chief executive Tim Cook. Revenue rose 33 per cent over the same period last year, and earnings per share were up 45 per cent.

But investors seized on the fact that demand for the iPhone and new smartwatch didn’t meet expectations. Apple’s shares have lost 11.3 per cent since then.

“I thought the break in Apple was a pretty big deal,” said veteran money manager Bill Fleckenstein. “They made all the numbers, but units were light. Maybe that is a precursor to what the entire tape is going to show us.”

The reaction to China’s devaluation was even more telling. Instead of viewing it as a competitive tool to lift exports and stimulate growth – as was the case when Japan took steps to devalue the yen – global investors were rattled, fearing it meant the Chinese government was convinced its economy was in much worse shape than conveyed by official statistics.

Investor attitudes

As investors absorb the meaning of these moves, they also seem to be opening their eyes to other market wonders. The question is: are we seeing signs of a seachange in investors’ attitudes?

Another example is the recent rout in shares of Keurig Green Mountain, the maker of specialty coffee and single-cup brewing systems. A former high-flyer that traded as high as $137 in January, the stock collapsed after the company warned on August 5th that sales and earnings would decline this year. The shares lost 30 per cent the following day and are down 62 per cent year to date.

Trying to plumb the mindset of investors is always a tricky exercise, of course. But when one investment assumption is questioned – a perpetually strong Chinese economy, say – other bits of conventional wisdom go under the microscope too.

Doubts may be creeping into the notion that companies with no earnings should trade at sky-high valuations. Some are starting to wonder whether corporate profits are being artificially elevated by share buybacks or other tactics.

Then there’s the biggest assumption of them all: that the Federal Reserve will always be there to save the day.

An ageing bull market often coincides with investors’ starting to question these kinds of assumptions, strategists say.

“This is the third-longest bull market in 80 years, and we are starting to see some deterioration develop,” said James Stack, president of InvesTech Research. “If you look at market breadth, the number of stocks participating has been narrowing.”

Even as the Nasdaq was reaching new highs this year, for example, other indexes, including those made up of transportation stocks and utilities, were trading well off their highs. This divergence was not the sign of a healthy market, Stack said.

Francis Gannon, co-chief investment officer at Royce Funds, also thinks we are at an inflection point. The upside-down market – where untested companies’ shares vastly outperform those of more solid companies – may be in the process of righting itself, he said.

Gannon said one-third of the companies in the Russell 2000 stock index did not earn any profits, the highest percentage in a nonrecessionary period. And through the second quarter, a majority of the performance in the Russell 2000 index came from companies that lost money before interest, taxes, depreciation and amortisation, he said.

“The laws of finance have been suspended for quite some time,” Gannon said last week. “Now this is starting to crack. I think we are on a road to normalisation.”

Downturn

If market sentiment is changing, Stack is concerned many investors may be quick to sell their shares in a swoon, amplifying a downturn. He’s especially worried about two groups: investors who have bought shares on margin, using borrowed money, and those who have been pushed into the market in search of returns because of low interest rates.

Certainly the use of leverage to buy stocks is very near its peak. According to the New York Stock Exchange, margin debt stood at $505 billion in June. That’s down just a bit from the April peak of $507 billion but up 9 per cent from the same period last year.

“Money borrowed to buy stocks tends to be nervous money,” Stack said.

Equally nervous may be the legions ofsavers who felt compelled to buy equities to generate a yield on their investments. “The multigenerational low in interest rates has driven a lot of people into stocks who would not normally be there,” Stack said. “That money could exit the markets quickly once rates start to normalise.”

Gannon he is eager for a market in which investors behave more rationally.

“This particular cycle has been affected by the actions of the Fed and the many unintended consequences of what the Fed has done,” Gannon said. “We think we are at a point where that is beginning to change.”

Distinct market shifts are visible only in hindsight, of course. Still, it's probably not a bad idea to be watchful for them and for the profits – and losses – they may bring. – (New York Times service)