A View From the Top
Friday, 12th February 2021
Markets Change but Humans Don’t
Whether it is through technology or bad management or a combination of both, companies come and go all the time. Kodak was a component company Dow Jones component for the Industrial index from 1930. The introduction of the digital camera in the late 1990’s saw Kodak’s core business diminish until it was ultimately removed from the Dow in 2004.
Change is a constant in the world of investing, but the one thing that never changes is human behaviour. As long as humans have been investing, there have been manifestations of irrational behaviour. The recent GameStop gyrations are a prime example of how the retail sector of the market are always last to the party and their rise is a classic sign that the underlying cycle is at an end.
We can look back to Charles Dow, the founder of the Dow averages, to explain the classic cycle of investing. Charles even developed a Dow Theory of behaviour that says markets follow 3 distinct phases: accumulation, participation and distribution.
The accumulation phase occurs at the very start of a bull market, when strong hands accumulate stocks from those with weak hands. (People with money buy from those desperate to sell). It is generally considered that the weak hands are retail investors.
In the next phase, there is general participation in the market as the economy is improving and a broad sector of the financial industry participates.
In the final phase, speculation and leverage become the dominant theme, with the strong hands distributing stock (a spike in IPO’s is a classic sign) to the weak hands. This is when market tops occur, according to Charles Dow. To learn more of his theory, which was written in the late 1800’s, click here.
Bear markets do the opposite. Smart money is already exiting when the prices collapse. The end of the bear stage is when the sellers become desperate and look to sell at any price.
The concept that the retail sector of the market is less sophisticated than the professionals is wrong. There are plenty of market professionals who make common mistakes and we don’t have enough room to create a list, but the acquisition of Bitcoin by Tesla to the tune of US$1.5bn has all the hallmarks of late mania buying impulses.
Humans tend to herd when they are under pressure, which is why people buy in greater numbers at the top and sell at the bottom. They simply cannot take the mental pressure of a bull or bear market and it becomes easier to go with the herd.
Insiders give us a clue
One sector of the market that should be watched closely but is often ignored is what the directors of listed companies are doing with their personal holdings. This cohort are called the Insiders as they have intimate knowledge of their company’s performance.
You would think that people would be alert to whether this cohort is buying or selling or if there is a distortion in the ratio of buying or selling their own stock.
Below we can see that currently the Insiders are selling out like never before. There has to be a reason the Insiders are selling so much.
Irrational Behaviour (Buying Mania)
We have mentioned in previous issues that this market is exhibiting all of the signs of a buying mania. To reinforce this view we can look at the rise of a segment of the market that is eerily reminiscent of the tech wreck of 2000.
Special Purpose Acquisition Companies (SPAC’s) are a method to raise cash via the share market without having to go through the cumbersome requirements of having a profitable business to float.
Recently, Wall St has managed to raise over US$100bn for SPAC’s, which is a record. It appears that everyone is doing it (even NFL players) and the reason is simple; money.
For a promoter of a SPAC, all they require is a small amount of money to be placed in the SPAC with a promise of 20% of the money raised. As long as the company finds a business to invest in within 2 years, the sponsor gets 20% of the entity.
So if someone raises US$250m and the SPAC buys a company within 2 years, the sponsor gets a US$50m stake, irrespective of the performance of the newly acquired business.
The requirements to raise money are so lax that when the SPAC announces a merger with an existing business, the SPAC is allowed to make forecasts that prove to be inflated or simply non-existent. Often the companies that are merging with the SPAC are simply unprofitable.
For the sponsor or promoter, this is irrelevant, as they now have a 20% stake of a listed vehicle. They can sell the shares to cash in or use the stock to borrow against.
The nature of a SPAC raising means that the sponsor is paid before any performance occurs. We are not talking about paying someone for their performance, people are being paid before the performance. This is a classic sign that the market is topping.
This lack of financial performance or profitability does not stop the public from buying these shares.
The chart below shows us the mania in full bloom. Since the crash last March, the Non-Profitable Technology Index has soared 400%.
Ironically, the sponsor of the new SPAC does not have any fiduciary duty to the investors in the acquired company. This means that the price paid for the new business doesn’t matter as there is no obligation to get 3rd party price validation. The only constraint for the promoter is that the money has to be spent within 2 years.
Technology has seen the rise of High Frequency Traders, which are algorithms (called robots) that can trade 1000 shares every millisecond or faster. This means that the market is distorted as there is no chance for a retail investor to compete.
Exchanges have been known to give these companies early access to price sensitive news. This means the robot has started trading even before the average investor has absorbed the news.
To level the playing field, a transaction tax could be placed on every order, this would cause the High Frequency Traders to rethink their business model. It would have little effect on the average investor.
Commonwealth Bank makes a forecast
Commonwealth Bank reported their earnings during the week and unsurprisingly, they made a large profit. They also included a forecast for the Australian economy and included both an optimistic forecast alongside a pessimistic forecast.
Provided all goes well, the bank sees the unemployment rate remaining steady at 6.4%, house prices climbing 8% and spending improving by 2.8%. As the biggest lender in the Australian housing market it is not surprising they see prices going up.
The interesting part is that the bank also produced a pessimistic forecast of what may happen if the economy doesn’t recover as predicted. Remember, economists use forecasts that are based on old news. Their predictions are similar to driving a car while looking out the rear window.
However, the bank has a large deferral program in housing payments of about $9bn half of which comes out of Victoria.
If there is another outbreak of COVID-19 and a delay or failure in the soon to be released vaccine, the downside projections would come into play.