Friday 31 July 2020

Cash flow strategies and profits


June 1st, 2020 / By: IFAI / Resources

By Mark E. Battersby

Cash flow is the lifeblood of every business. In fact, according to a recent U.S. Bank study, poor cash flow management causes 82 percent of U.S. business failures. Although seemingly counterintuitive, many experts advise putting cash flow management before profits.

While profits are how a fabrication business survives, a failure to manage the operation’s cash flow can mean running into problems that one profitable accounting period might not be able to offset. Another study, this one by Intuit, revealed that

  • 61 percent of small businesses around the world struggle with cash flow and 
  • 32 percent are unable to pay vendors, pay back pending loans, or pay themselves or their employees due to cash flow issues.


Cash flow management 101
In essence, cash flow is nothing more than the movement of money in and out of the business. 

  • Cash flows into the business from sales of goods, products or services. 
  • Money flows out of the business for supplies, raw materials, overhead and salaries in the normal course of business.


An adequate cash flow means a steady flow of money into the business in time to be used to pay those bills. How well the fabricating professional manages the operation’s cash flow can have a significant impact on the bottom-line profits of the business.

Often, an operation’s cash inflows will lag behind its cash outflows, which leaves the business short of money. This shortage, or cash flow gap, represents an excessive outflow of cash that may not be covered by a cash inflow for weeks, months or even years.

Properly managing the operation’s cash flow allows that cash flow gap to be narrowed or closed completely before it reaches the crisis stage. This is usually accomplished by examining the different items that affect the operation’s cash flow—and looking at the various components that directly affect cash flow. This analysis can answer important questions such as the following:


  • How much cash does the business have?
  • How much cash does the business need to operate and when is it needed?
  • Where does the business get its cash and where does it spend it?
  • How do the operation’s income and expenses affect the amount of cash needed to operate the business?



Controlling inflow
In a perfect world, there would be a cash inflow, usually from a cash sale, every time there is an outflow of cash. Unfortunately, this occurs very rarely in our imperfect business world, thus the need to manage the cash inflows and outflows of the business.

Obviously, accelerating cash inflows improves overall cash flow. After all, the quicker cash can be collected, the faster the business can spend it. Put another way, accelerating cash flow allows a business to pay its own bills and obligations on time or even earlier than required. It may also allow the business to take advantage of trade discounts offered by suppliers.



Controlling outflow
Outflows are the movement of money out of the business, usually as the result of paying expenses.

  • A manufacturing business’s biggest outflow most likely involves the purchase of raw materials and other components needed for the manufacturing process. 
  • If the business involves reselling goods, the largest outflow will most likely be for the purchase of inventory
  • Purchasing fixed assets, paying back loans and paying bills are all cash outflows.


Fabricators can regain control over their operation’s finances by adopting best practices and proper tools. A good first step involves how the operation pays its bills. An important key to improving an operation’s cash flow can be as simple as delaying all outflows of cash as long as possible. Naturally, the operation must meet its outflow obligations on time, but delaying cash outflows makes it possible to maximize the benefits of each dollar in the operation’s own cash flow.

Many credit cards have a cash back bonus program. Even if the program offers only 1 percent cash back, that could equate to a sizable monthly amount for many businesses. Of course, because credit cards tend to have a higher interest rate, they should only be used if the balance can be quickly paid off in full.



Improving invoicing
Improving the invoicing process is another key step in cash flow management. A business can adopt incentive strategies to be paid faster. A business enjoying a 10 percent gross margin that offers a 2 percent rebate in exchange for early payments might not be appropriate. Giving away small extra services, on the other hand, might work. Incentives might include the following:


  • Small additional services
  • Discounts for early payments (balances paid before a certain date, or yearly invoice versus monthly)
  • Greater flexibility (for instance, a down payment required to book a delivery date)
  • Some customers are just late payers and need to be nudged. The way that dunning is handled can, however, greatly affect the collection process. Timing and the quality of message content are the two main factors in the success or failure of these prods.


How the business gets paid not only affects its profitability but also its cash flow.

  • Today, paper checks remain the standard method of payment. 
  • However, paper checks are slow, highly susceptible to fraud and bear “hidden costs” such as additional work and back- office processing. 
  • They are also inadequate for recurring invoicing.


Something as simple as asking customers to switch to electronic funds transfer (EFT) or Automated Clearing House (ACH) payments, and providing incentives to switch, are among the steps that can ensure faster, more secure, more reliable and cheaper payments.



Improving cash flow
Profit doesn’t equate to cash flow because, as mentioned, cash flow and profit are not the same. There are many factors that make up cash flow, such as inventory, taxes, expenses, accounts payable and accounts receivable.

The proper management of cash outflows requires tracking and managing the operation’s liabilities. Managing cash outflows also means following one simple but basic rule: Pay the operation’s bills on time—but never before they are due.

Having a cash reserve can help any fabricating business survive the gaps in cash flow.

  • Applying for a line of credit from the bank is one way to build that cash reserve. 
  • Once a business is qualified, lenders will grant a predetermined credit limit that can be withdrawn from when needed.


Yet another option might be frugality.  Aim to keep the business lean by constantly evaluating it.

  • Is the purchase of new equipment really necessary? 
  • Is hiring new employees really cost-effective? 
  • Weighing the pros and cons of all business needs and wants enables a business to retain cash flow and avoid unnecessary expenses.




Cash flow gaps
Remember, however, the cash flow gap in most fabrication businesses represents only an outflow of cash that might not be covered by a cash inflow for weeks, months or even years. Any business, large or small, can experience a cash flow gap—it doesn’t necessarily mean the business is in financial trouble.

In fact, some cash flow gaps are created intentionally.  That is, a fabricator will sometimes purposefully spend more cash to achieve some other financial results.  The business might, for example,

  • spend extra cash to purchase additional inventory to meet seasonal needs,
  • to take advantage of a quantity or 
  • early payment discount, or to expand its business.


Cash flow gaps are often filled by external financing sources:

  • revolving lines of credit, 
  • bank loans and 
  • trade credit are just a few external financing options available to most businesses.




Cash flow loans
Cash flow-based loans rely on the value of the operation’s cash flow. 

  • If the operation has a strong cash flow stream, it can be used to get significant loan amounts even if there are few business assets. 
  • Although cash flow loans can be expensive, they play a key role in a business that is expanding.


An advantage of cash flow loans is the repayment period.

  • These loans are usually designed according to the needs of the borrower, with repayment periods often between five and seven years. 
  • And, since cash flow loans are different from asset-based loans, rarely does collateral have to be put up.




Flowing cash flows
Assessing the amounts, timing and uncertainty of cash flow is the most basic objective of cash flow management.

  • Positive cash flow indicates the liquid assets of a business are increasing, enabling it to settle debts, reinvest in its business, return money to shareholders, pay expenses and provide a buffer against unanticipated financial challenges. 
  • The impact of a negative cash flow can be profound, with many businesses operating on margins so thin that frequent lost opportunities will put them on the path to closing their doors.


Obviously, every business can improve its cash flow. Of course, for this to happen businesses need to adopt best practices in the way they invoice, follow up with customers and monitor outflow. With the help of a qualified professional, these cash flow best practices may be easier to achieve.

Mark E. Battersby writes extensively on business, financial and tax-related topics.


https://fabricarchitecturemag.com/2020/06/01/cash-flow-strategies-and-profits/

Tuesday 21 July 2020

How to Handle a Reverse Stock Split (consolidation of shares)

A corporation can decrease the number of its publicly held shares through a reverse split.

-  The board of directors does not need to get stockholder approval to authorize a reverse split.

-  The board selects the reverse split ratio, such as issuing one share for every 10 shares owned, and announces the date the split takes effect.



Whether this helps or hurts your stock portfolio depends on the company’s reason behind the split.

A reverse stock split may result in a loss of shares for minority shareholders. Unfortunately, these individuals have little legal recourse if such an act occurs.



Reverse Splits and Minority Stockholders

-  If you are a minority stockholder, a reverse split could extinguish your position and force you out.

-  Unfortunately, there is not much you can do as long as the reverse split follows legal procedures and you receive the correct number of new shares.



Reverse splits can signal good news for investors or bad news. 

Reverse Split Advantages

-  A reverse split can signal that a company is financially strong enough to be listed on an exchange. The stock price will increase enough to meet the exchange’s minimum price requirement.

-  If you own stock in a small company that has seen increased sales and profits, the stock price should continue to rise after the reverse split.

-  Stocks newly listed on an exchange can attract new buyers, especially institutional investors who avoid over-the-counter and pink sheets stocks. Although you will end up owning fewer shares, they will be worth more as the price continues to rise.



Reverse Split Disadvantages

-  If your stock is listed on an exchange, a reverse split could herald a potential delisting as a consequence of its fallen price. If the stock remains below the exchange’s minimum price, the company’s stock is delisted and relegated to the over-the-counter market or the pink sheets.

-  The reverse split may boost the stock’s price for a while, but if sales have stalled or the company posts consecutive losses, the stock price will continue falling. Left unchecked, the stock will eventually be delisted off the exchange.

Wednesday 15 July 2020

Glove stocks uniform trading pattern sparks intrigue



Justin Lim
theedgemarkets.com

July 15, 2020


KUALA LUMPUR (July 15): All seven glove stocks on Bursa Malaysia took a nail-biting roller-coaster ride together during the final trading hours yesterday.

The seven counters plummeted simultaneously shortly after 4pm, but rebounded soon after, right before the closing bell. Share price charts show a uniform V-shape pattern among the rubber glove makers (see charts), whose share prices have rocketed at least several folds since March.


What was intriguing was that there was no negative news flow about the rubber glove industry that could possibly have swung the share prices in such a drastic and uniform fashion.

The sudden plunge among the seven glove stocks during the final trading hours was in the range of 15% to 25%. The big drop on Top Glove Corp Bhd and Supermax Corp Bhd dragged the FBM KLCI down by 1.8% to its intraday low of 1,577.33 before it bounced back to above 1,600-level to close at 1,598.75 points, down 7.68 points.

Investment analysts were baffled by the share price trend.

Some experts suspected that algorithmic trading activities could be at play. Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions that account for variables such as time, price, and volume.

Malacca Securities Sdn Bhd head of research Loui Low did not rule out the possibility that algorithmic trading activities could be involved.

Another possibility, he believed, could be that the glove counters had triggered the stop limit for various investors and brokers.

MIDF Research senior analyst Imran Yassin Md Yusof, meanwhile, commented that investors had started to take profits following the strong share price rallies.

Top Glove, Supermax and Hartalega Holdings Bhd shares all settled in the negative territory yesterday, after closing at their record highs on Monday.

Supermax experienced the steepest drop with a 25.2% plunge to a low of RM12.52. It closed at RM15.90.

Similarly, Top Glove sank 15.4% to its intraday low of RM20.50, but bounced back to close at RM23.16. Hartalega sank 15.02% to a low of RM15.28, but later pared most of its losses to finish at RM17; Kossan Rubber Industries Bhd slid 14.2% to RM12, before closing at RM13.50.

Comfort Gloves Bhd's share price also tumbled 19.2% to RM3.33, before settling at RM3.84. Careplus Group Bhd fell 21.7% to RM1.48, then rebounded to close at RM1.76, while Rubberex Corp (M) Bhd dropped nearly 18% to RM3.22, to eventually settle at RM3.65.


https://www.theedgemarkets.com/article/glove-stocks-uniform-trading-pattern-sparks-intrigue

Investors can think long-term but managers are a harder case

Research shows executives are tempted take short-cuts to hit quarterly numbers
WEI JIANG

Are our markets really too focused on immediate results at the expense of long-term growth?
Wei Jiang JULY 25 2019


Charges of short-termism have been aimed at financial markets and companies for decades, but concerns have intensified recently. Now US regulators are asking whether rule changes are needed to address the issue.

But are our markets really too focused on immediate results at the expense of long-term growth? As an academic finance professor, I believe we can rely on empirical research on how the market values highly innovative companies. Innovation, after all, is the ultimate proof that companies are investing for the long haul.

First, let’s look at whether companies are discouraged from risky investments aimed at ambitious discoveries or from deploying unconventional methods. A 2013 study found that highly innovative companies — as identified by high levels of research and development spending are fairly priced, rather than heavily discounted as “market short-termism” would predict. Their future stock returns are comparable with those earned by other companies in the same class.

In fact, the study found that many high R&D companies with lower past success — as reflected in their ability to convert R&D spending future sales growth — are, if anything, overvalued for an extended period of time. That suggests public market investors are rather tolerant of failure.

We must consider, too, the impact of hedge fund activists, who often seek payouts through share buybacks. Critics say that these reduce the value of the companies in the long run by leading to reduced investment in innovation. But not all R&D spending is created equal. A study that three co-authors and I published last year found that while corporate spending on R&D does tend to fall in the year following interventions by shareholder activists, the R&D spending that remains becomes more productive.

At such companies, the number of new patents increased by 15 per cent, three to five years after the activists’ intervention, and the number of citations per patent — an indicator of patent impact or quality — also rose by 15 per cent. That suggests increased R&D efficiency and additional innovation.

Some investors, then, are more than willing to take the long view. But what about corporate managers? Evidence suggests that executive shortsightedness is not only a possibility, but can be a likely outcome in today’s markets.

Here’s why: most businesses are at risk of “stakeholder runs.” Creditors, suppliers and employees may seek to flee at the first sign of trouble, so the perception — possibly distinguished from the reality — of financial health is vital. Hence managers will often take actions that favour current observable results — think earnings here — to convince (or in some cases mislead) the market about a company’s fundamental health.

Investors are typically not fooled: they understand the incentives for managers to set and then beat earnings targets, and they correctly suspect that there will be “short-termist” efforts to meet those targets — stuffing inventories into the supply chain or cutting productive R&D if necessary.

Once it becomes clear managers are willing to play the earnings “game”, investors adjust when pricing the stock. For such companies, missing forecasts by small amounts can trigger a big sell-off because investors expect executives to exhaust all possible resources to meet their targets. Companies can short-circuit this unproductive cycle by avoiding quarterly earnings guidelines and a number of them have done so. This allows them to focus on other measures of performance, such as R&D spending and patent filing.

While short-termism can be a problem for our financial markets, the long-term is, of course, nothing more than a continuous series of short-terms. Investors can make it easier for companies to arrive at the right long-term mark by encouraging them to pick intermediate goals that keep them on the right path.

The writer is a Columbia Business School professor of finance



https://www.ft.com/content/3249bce4-ac8c-11e9-b3e2-4fdf846f48f5

Buy and Hold Works….Until It Doesn’t


by KenFaulkenberry | Portfolio Management

Buy and Hold
Buy and Hold is considered by many to be the holy grail of investing. Its current popularity has become a cult-like strategy that draws criticism to its critics and disdain towards those who dare speak out against the beloved investing strategy.

I’m going to explain why a buy and hold strategy is useful for some investors and a good strategy at certain periods of time. We’re also going to explore why buy and hold is not the best strategy for many investors, and is a poor strategy for everyone at certain periods of time.

Buy and Hold Strategy Definition
Investopedia provides the following definition:

“Buy and hold is a passive investment strategy in which an investor buys stocks and holds them for a long period of time, regardless of fluctuations in the market.”

There are many different ideas of what buy and hold means, but I like this definition because it’s fairly simple. The only wiggle room in the definition is: What is “a long period of time”?

Some investors might consider one year a long period of time. I believe we are living in an era where investors have “short-term-itis”. Many more people would consider 3-5 years a long period of time. This may be because in relationship to 1 year it is long.

However, for our discussion I’m stipulating that a long period of time is 10 years or more. Anything less than that it’s difficult to use reasoning or logic that includes probabilities. The shorter the time period the more randomness and fluctuations affect returns. If your not thinking longer than 10 years, you are not really thinking “long term”.

Advantages of Buy and Hold Investing
Easy to implement. The ultimate in passive investing: buy and hold. Simple as can be?

Saves on taxes. Long term capital gains and dividends are taxed lower than short term capital gains.

Efficient. Saves on commissions, transaction fees, etc.

No Need For Market Analysis. Market timing is avoided, volatility is ignored.

Investment Vehicles Add to Simplicity. Low-cost index and ETF funds are perfect investment vehicles for buy and hold investing.

Disadvantages of Buy and Hold Investing
Premium Prices. Most of the stocks worthy of buying and holding are priced at a premium. (Buying high) If you’re going to buy a stock to hold for more than 10 years, it better be a premium company!

Investor Panic. Many investors who claim to be buy and hold investors change their mind after large losses, leading to large drawdowns. (Selling low)

Volatility is ignored. Volatility is not always a bad word. Many successful value investors look at volatility as opportunities to buy bargains and sell trendy overpriced investments.

Ignoring Market Analysis. Market analysis can determine periods of time where it is problematic to be heavily invested or opportunistic to be aggressive.


“The underlying theory of buy and hold investing denies that stocks are ever expensive, or inexpensive for that matter, investors are encouraged to always buy stocks, no matter what the value characteristics of the stock market happen to be at the time.”
Ken Solow (Buy and Hold is Still Dead)

Find the Best Strategy For YOU
If you are the type of person who has little interest in learning how to invest, buy and hold may be the right strategy for you. The problem is you may not have much interest in your investments until they have major declines in value.

A buy and hold strategy requires equal attention to the “hold” part. You can’t sell after you have a 50% decline and be a true buy and hold investor.

In the long run a true buy and hold passive investor will most likely achieve average rates of return. If you systematically invest over your lifetime you will make purchases at bargain prices and at expensive prices. It may all equal out.

A buy and hold strategy does well in bull markets when stocks are consistently rising. But the reality of the stock market is that stocks go through long periods where values decline or stay flat. Sometimes these periods last a couple of decades. Usually these periods are preceded by periods when stocks become very expensive and overvalued when compared to their historical relationships to earning, cash flow, book value, etc.

For an investor willing to make the effort it makes no sense to take the same approach to buying stocks when they are bargains versus when they are expensive. An investment has more upside and less risk when its price is low. That same investment has less upside and greater downside risk when the price is expensive.

“In almost every walk of life, people buy more at lower prices; in the stock market they seem to buy more at higher prices.”
James Grant

This kind of behavior makes no sense. Therefore, buy and hold passive investing works when prices are bargains or even fairly valued. At any other time, your probability of success is greatly reduced.

So buy and hold works….until it doesn’t. People will quote all kinds of statistics “proving” that buy and hold works. Its the trend of our day. This is nothing new. Bull markets make buy and hold look good. Bear markets make buy and hold look bad.

Consider where you think we are in the valuation cycle before you make your buy and hold investing strategy decision!



https://www.arborinvestmentplanner.com/buy-and-hold-strategy-definition-advantages-disadvantages/

50 Reasons Why We Don’t Invest for the Long-Term

DECEMBER 18, 2018

Investment is a long-term endeavour designed to meet our long-term financial objectives, so why do we spend so much of our time obsessing about the short-term and almost inevitably taking decisions that make us worse off?  Well, here are 50 reasons to start with:

1: Because it is boring.

2: Because markets are random and it’s difficult to accept.

3: Because of short-term benchmark comparisons.

4: Because we are remunerated based on annual performance.

5: Because of quarterly risk and performance reviews.

6: Because there is always something / somebody performing better.

7: Because we watch financial news.

8: Because we think we can time markets.

9: Because even good long-term investment decisions can have disappointing outcomes.

10: Because the fund we manage charges performance fees.

11: Because short-term losses are painful.

12: Because we forget about compounding.

13: Because we are obsessed with what is happening right now.

14: Because we are poor at discounting the future.

15: Because we will be in a different job in three years’ time.

16: Because we extrapolate recent trends.

17: Because we check our portfolios every day.

18: Because it is so easy to trade our portfolios.

19: Because we think poor short-term outcomes means that something is wrong.

20: Because we make decisions when we are emotional.

21: Because we think we can forecast economic developments.

22: Because we think that we know how markets will react to economic developments.

23: Because we compare our returns to the wrong things.

24: Because it is hard to do nothing.

25: Because regulations require that we must be notified after our investment falls by 10%.

26: Because it feels good to buy things that have been performing well.

27: Because there is too much information.

28: Because we don’t know what information matters.

29: Because we don’t want to lose our job.

30: Because nobody else is.

31: Because we need to justify our existence.

32: Because we think we are more skilful than we are.

33: Because we work for a listed company.

34: Because we don’t want to lose clients.

35: Because we think one year is long-term.

36: Because assets with high long-term return potential can be disappointing in the short term.

37: Because we think performance consistency is a real thing.

38: Because we don’t want to spend much of our time looking ‘wrong’.

39: Because the latest fad is alluring.

40: Because there is a new paradigm.

41: Because we vividly remember that short-term call we got right.

42: Because we can’t tell clients we haven’t been doing much.

43: Because we think we are better than other people.

44: Because we have to justify fees.

45: Because we don’t want to be invested through the next bear market.

46: Because we think short-term news is relevant to long-term returns.

47: Because short-term investing can be exciting.

48: Because we have to have an opinion.

49: Because there are so many experts and they are all so convincing.

50: Because it seems too simple.

Adopting a genuinely long-term approach to investment is one of the few genuine edges or advantages any investor can hope to exploit.  Unfortunately, it can feel as if everything is conspiring against our attempts to benefit from it – but that does not mean we should not try


https://behaviouralinvestment.com/2018/12/18/50-reasons-why-we-dont-invest-for-the-long-term/

Tuesday 14 July 2020

The glove put warrants poser


Lai Ying Yi 
 theedgemarkets.com 

 July 14, 2020 KUALA LUMPUR 

(July 13): It is undeniably a bull market for the glove makers currently. 

However, an interesting trend has also emerged in the local market on Monday — an equally frenzied buying of two newly-listed structural put warrants on Top Glove Corp Bhd (Top Glove-HA) and Supermax Corp Bhd (Supermax-HB). 

The strong interest in the derivatives that hedge against a fall in share prices of Top Glove and Supermax has made many in the investing fraternity perplexed. 

The prices of the two derivatives, a bear market tool, rocketed over 200%.

Top Glove-HA soared by 207% and Supermax-HB by 291%, on the day when the two underlying stocks climbed to their all-time highs. Supermax saw its biggest ever share price leap of RM2.36 to RM15.98. Top Glove’s share price gained RM2.08 or 9.5% to RM24. 

The large trading volumes recorded were another evidence of the strong interest in the two derivatives. TOPGLOV-HA was the most traded securities on Bursa on Monday, with 613.47 million units having changed hands, while Supermax-HB was the third most traded counter with 567.9 million units done. 

In a nutshell, put warrants grant holders the right to sell the underlying shares at a specified price (exercise price) within a limited period of time (maturity). Structured put warrants are hedging tools. Investors tend to use structured put warrants to hedge against any big drop in the underlying share prices. 

Some market observers commented that the surge in interest in the two put warrants, which made their debut just two weeks ago, could be attributed to the increasing number of glove bears in the market, although the bulls still swarm the market in general. 

“No one could deny that the downside risk on those glove counters are heightening, as their share prices are trading at such hefty premiums. Such put warrants would allow investors to hedge their long position on the underlying shares,” said a market observer. 

Even so, the spike in the prices of the two put warrants has been astonishing, to say the least. Given that the premium of the two derivatives are near 100% based on the closing price on Monday, the hedging tools themselves have also become highly risky. 

Based on the exercise price and conversion ratio, the put warrants are pricing the mother shares at RM2 for Top Glove and 30 sen for Supermax. 

“Investors will only make money if the underlying mother share drops below these two levels (assuming the investors hold onto the derivatives until the expiry dates). Is that possible?” explained a warrant specialist. 

 Nonetheless, structured warrants are a trading instrument so investors are unlikely to hold onto the derivatives until expiry date. In this case, the warrant holders who bought in earlier would have made handsome gains after the price rally on Monday, if they locked in their profits.





Saturday 11 July 2020

The Anatomy of a Rally (Howard Marks)

Memo from Howard Marks: The Anatomy of a Rally


The background is well known to all.

  • On February 19, the U.S. stock market hit a new all-time high, with the S&P 500 reaching 3,386.

  • Then investors began to price in the novel coronavirus, causing the market to make its fastest trip ever into bear territory, with the S&P 500 down 34% in five weeks to a low of 2,237.

  • That low was reached on March 23, the day the Fed announced a major expansion of its response to the Covid-19-induced shutdown of the U.S. economy.

  • Following that, the stock market – along with the credit markets – began a recovery of massive proportions.

The advance started off with a bang – a 17.6% gain for the S&P 500 on March 24-26, the biggest three-day advance in more than 80 years – and by June 8 it had lifted stocks from the low by almost 45%. The market rose on 33 of the 53 trading days between March 24 and June 8, and on 24 of those 33 up days (including the first nine in a row), it gained more than one percent. By June 8, the S&P 500 was down only 4.5% from the February peak and even for the year to date.


I’m writing to take a closer look at the market’s rise and where it leaves us. The goal as usual isn’t to predict the future but rather to put the rally into perspective.


The questions I get are always indicative of what’s going on in investors’ minds at the time. Around the early-June high and in the time since, the most frequent ones have been, “How can stocks be doing so well during a severe pandemic and recession?” “Have the securities markets decoupled from reality?” and “Is this irrational exuberance?”


The process of answering these questions gives me an opportunity to dissect the breathtaking market rise. The world is combatting the greatest pandemic in a century and the worst economic contraction of the last 80+ years. And yet the stock market – supposedly a gauge of current conditions and a barometer regarding the future – was able to compile a record advance and nearly recapture an all-time high that had been achieved at a time when the economy was humming, the outlook was rosy, and the risk of a pandemic hadn’t registered. How could that be?


The possible reasons for the markets’ recovery are many and, as I write this memo, the list is growing as people find more things to take positively. (As usual, the higher the market goes, the easier it becomes for investors to find rationalizations for a further rise.) I’ll survey the apparent reasons below:

  • Investors placed great credence in the ability of the Fed and Treasury to bring about an economic recovery. Investors were cheered by the steps taken to support the economy during the shutdown, reopen it, put people back to work and begin the return to normalcy. Everyone understands that the recovery will be gradual and perhaps even bumpy – few people are talking about a powerful V-shaped recovery these days – but a broad consensus developed that recovery is a sure thing.

  • As the market recovery took hold, the total number of Covid-19 cases and deaths, and the statistics in states like New York that had experienced the earliest and worst outbreaks, were going in the right direction. Daily new cases declined to very low levels in many places, and the signs of a second-wave rebound were limited. The curve in most locations clearly had been flattened.

  • In short, the worst fears – things like massive shortages of hospital beds and PPE, and an immediate “second wave” as soon as reopening began – weren’t realized. This was cause for relief.

  • Rising optimism with regard to vaccines, tests and treatments added to investors’ willingness to write off the present episode.

  • People became comfortable looking past the pandemic, considering it one-of-a-kind and thus not fundamental. In other words, for some it seemed easy to say, “I’m glad that’s over (or soon will be).”

  • Positive economic announcements reinforced this conclusion. And the unprecedented extent of the economic carnage in the current quarter made it highly likely that we’ll see substantial quarter-over-quarter gains in the next three quarters and dramatic year-over-year comparisons in mid-2021.

  • Thus, overall, investors were glad to “look across the valley” at better times ahead. There will be a substantial dip this year in GDP and corporate earnings, but investors became willing to anticipate a time – perhaps in 2022 – when full-year earnings for the S&P 500 would exceed what they were in 2019 and had been expected to be in 2020.

  • With the outlook now positive, investors likely concluded that they no longer needed to insist on the generous risk premiums afforded by low entry prices, meaning purchase prices could rise.

  • In other words, with regard to economic and corporate developments, investors concluded that it was “all good” or at least heading in the right direction.

Monetary and fiscal actions made an enormous contribution to the market rebound:

  • The chant went up during the week of March 23: “You can’t fight the Fed.” Certainly the evidence convinced investors that interest rates will be what the Fed wants them to be, and the markets will do what the Fed wants them to do. The higher the market went, the more people believed that it was the goal of the Fed to keep it going up, and that it would be able to.

  • The Fed and Treasury demonstrated their dedication to doing absolutely everything they could think of. Fed Chairman Jay Powell and Treasury Secretary Steve Mnuchin acted early and dramatically, and Powell’s assurances that “we will not run out of ammunition” had a very positive effect.

  • The Fed said it would continue buying securities “for as long as it takes,” and since its actions suggested it was unconcerned about the ballooning deficits and debt, there was no apparent reason why its ability to keep buying had to have a limit.

  • When the Fed buys securities, it puts money into the hands of the sellers, and that money has to be reinvested. The reinvestment process, in turn, drives up the prices of assets while driving down interest rates and prospective returns.

  • There’s been a related expectation that the Fed’s buying might be less than discriminating. That is, there’s no reason to believe the Fed insists on good value, high prospective returns, strong creditworthiness to protect it from possible defaults, or adequate risk premiums. Rather, its goal seems to be to keep the markets liquid and capital flowing freely to companies that need it. This orientation suggests it has no aversion to prices that overstate financial reality.

  • Everyone is convinced that interest rates will be lower for longer. (On June 10, the Fed strongly indicated that there will be no rate increases through 2021 and possibly 2022.)

  • Low interest rates engineered by the Fed have a multifaceted, positive impact:

    • The lower the fed funds rate, the lower the discount rate used by investors and, as a result, the higher the discounted present value of future cash flows. This is one of the ways in which declining interest rates increase asset values.

    • The risk-free rate represents the origin of the yield curve and the capital market line. Thus a low risk-free rate brings down demanded returns all along these continua. All a priori returns on potential investments are viewed in relation to the risk-free rate, and when it’s low, even low returns seem attractive.

    • The pricing of all assets is interconnected through these relative considerations. Even if the Fed is buying asset A but not asset B, the rising price and falling expected return on A mean that B doesn’t have to appear likely to return as much as it used to, so its price can rise, too. Thus if buying on the part of the Fed raises the price of investment grade debt, the price of non-investment grade debt is likely to follow suit. And if the Fed buys “fallen angels” that have gone from BBB to BB, that’s likely to lift the price of B-rated bonds.

    • Lower yields on bonds means they offer less competition to stocks, etc. This is yet another way of saying relative considerations dominate. Fewer people refuse to buy just because prospective returns are low in the absolute.

  • In all, the Fed created capital market conditions that gave rise to readily available financing, bond issuance at record levels, and deals that were heavily oversubscribed. As long as money-losing companies are enabled to refinance their debt and borrow more, they’re likely to stay alive and out of bankruptcy, regardless of how bad their business models might be. Zombie companies (debt service > EBITDA) and moral hazard don’t appear to trouble the Fed.

Obviously, behavioral factors also had a significant impact:

  • Although suspended from February 19 until March 23, the ever-hopeful “buy the dips” mentality and belief in momentum quickly came back to life. The large percentage of trading in today’s markets accounted for by index funds, ETFs and other entities that don’t make value judgments probably contributes to the perpetuation of trends like these once they’re set in motion.

  • Investors have been cheered by the fact that today’s Fed seems to be offering a “Powell put,” a successor to the Greenspan put of the late 1990s/early 2000s and the Bernanke put induced by the Global Financial Crisis. The belief in the Powell put stems from the view that the Fed has no choice but to keep the markets levitated to reassure financial market participants and keep the credit markets wide open for borrowers.

  • Thus FOMO – fear of missing out – seemed to take over from the prior fear of losing money, a transition that’s always pivotal in determining the mood of the market.

  • Retail investors are said to have contributed substantially to the stock market’s rise, and certainly to its most irrational aspects, like the huge gains in the stock prices of some bankrupt companies. In the exceptional case of Hertz, it seemed for a while that the buoyant stock price might enable the company to sell large amounts of new equity, even though the equity would probably end up worthless. (Equity capital raised by a company in bankruptcy is extremely likely to end up going straight to the creditors, whose improbability of otherwise being paid gave rise to the bankruptcy filing in the first place.) Large numbers of call options have been bought in recent days, and it was reported that small investors accounted for much of the volume. Developments like these suggest the influence of speculative fever and the absence of careful analysis.

  • There’s a widely held theory that government benefit checks have been behind some of the retail investors’ purchases. And that makes sense: in the last three months, there’ve been no games for sports bettors to wager on, and the stock market was the only casino that was open.

  • Importantly, fundamentals and valuations appeared to be of limited relevance. The stock prices of beneficiaries of the virus – such as digital service providers and on-line merchants – approached “no-price-too-high” proportions. And the stocks of companies in negatively affected industries like travel, restaurants, time-sharing and casinos saw massive recoveries, even though their businesses remained shut down or barely functioning. Investors were likely attracted to the former by their positive stories and to the latter by their huge percentage declines and the resulting low absolute dollar prices.

In all these ways, optimistic possibilities were given the benefit of the doubt, making the terms “melt-up” and “buying panic” seem applicable. We saw numerous records smashed in the 11-week recovery of the stock market from its March 23 low.


To sum up and over-simplify, as my partner Bruce Karsh asks in his role as devil’s advocate: can the Fed keep buying debt forever, and can its doing so keep asset prices up forever? In short, many investors appeared to conclude that it could.




And on the Other Hand . . .


I’m not going to go to the same lengths in cataloging the negatives that exist today. Especially given their appeal to my cautious bias, I’ve done so plenty in recent memos. But they certainly have been and are out there:

  • The likelihood that, since the U.S. engaged in a more voluntary and less sweeping shutdown than the countries that were most successful in suppressing Covid-19, the reopening of the economy would trigger a second wave of the disease.

  • The simultaneous likelihood that, due to fatigue and because many consider “the cure to have been worse than the disease,” there won’t be the same enthusiasm for a new shutdown, meaning there may be significant stress on the health care system and/or large numbers of fatalities.

  • The possibility that we won’t have a vaccine as soon as hoped, or that it will be limited in its duration or its effectiveness with various strains of the disease.

  • The reporting of actual GDP declines on the order of 20-30% for the second quarter and 5-10% for the full year, and of an unemployment rate around 10% in late 2020 and into 2021.

  • The impact on the economic recovery if the return to work is slow, large numbers of small businesses never reopen, and millions of jobs turn out to be permanently lost. In particular, the slow return of customers and the regulations that limit the scale of operation may prevent newly opened public-facing businesses from being much more profitable than they were when they were fully closed.

  • Worry that political or financial considerations will keep the Fed and/or Treasury from renewing their monetary and fiscal tools to combat the economic slowdown.

  • The significant long-term damage done to state and city finances.

  • The likelihood that there’ll be widespread defaults and bankruptcies despite the Fed and Treasury machinations.

  • The impact of potentially permanent changes to business models in industries like retail and travel, and on office buildings and high-density urban centers.

  • The possibility of increased inflation (or, some say, deflation), long-term damage to the reserve status of the dollar, a downgrade of the U.S. credit rating, or an increase in the cost to finance our vastly expanded deficits.

There are always positives and negatives, and we can list them, consider their validity and try to assess what they boil down to. But what matters most at a given point in time in determining market behavior is which ones investors weight most heavily. Following the March 23 low, the emphasis certainly was on the positives.


Does It Make Sense?


Yes, there had been something approaching a selling panic between mid-February and late March in response to the pandemic, with the S&P 500 collapsing and the yields on high yield bonds tripling in just four and a half weeks. And yes, the Fed and the Treasury seem to have averted a depression and put us on the path to recoveryBut was there justification for the stock market’s 45% gain from the low and the halving of high yield bond yields from their high? And were the resulting security prices appropriate? In other words, some recovery was not unreasonable, but was the magnitude of the one that occurred justified?


Of course, the answers to these questions lie in the eye of the beholder. If there were a straightforward, reliable and universally accepted way to arrive at appropriate security prices, (a) securities would likely sell at or near those prices and (b) over-optimistic highs and over-pessimistic lows wouldn’t be reached. But the most optimistic psychology is always applied when things are thought to be going well, compounding and exaggerating the positives, and the most depressed psychology is applied when things are going poorly, compounding the negatives. This guarantees that extreme highs and lows will always be the eventual result in cycles, not the exception. (For a few hundred pages more on this subject, see my 2018 book, Mastering the Market Cycle: Getting the Odds on Your Side.)


Maybe it’s the increased availability of information and opinion; maybe it’s the popularization of investing; and maybe it’s the vastly increased emphasis on short-term performance. But for whatever reason, things seem to happen faster in the markets these days. That certainly has been true in the last four months. In the current episode, the 34% decline from the all-time high to the crisis low took less than five weeks, and the 45% recovery to the June 8 high took only 11 weeks. These fluctuations were incredibly swift and powerful.


In my memo, On the Couch (January 2016), I wrote that:


That’s one of the crazy things: in the real world, things generally fluctuate between “pretty good” and “not so hot.” But in the world of investing, perception often swings from “flawless” to “hopeless.”


Thus far in 2020, the swing from flawless to hopeless and back has taken place in record time. The challenge is to figure out what was justified and what was aberration.


The Bottom Line

I tend to return to a select few investment adages to make my points, for the simple reason that these time-honored standards contain so much wisdom. And I’ve written often about the first one shared with me by an experienced investor in the mid-1970s: the three stages of a bull market. There’s a usual progression in market advances according to this beauty, and as far as I’m concerned, it’s absolutely accurate and fully captures the reality:

  • the first stage, when only a few unusually perceptive people believe improvement is possible;

  • the second stage, when most investors realize that improvement is actually taking place; and

  • the third stage, when everyone concludes everything will get better forever.

Looking back (which is the main way we know these things), the first stage began in mid-March and culminated on March 23. Certainly very few people were thinking about economic improvement or stock market gains around that time. Then we passed briefly through stage two and went straight to stage three.


Certainly by the time the interim high was reached on June 8, it felt like the market was being valued in a way that focused on the positives, swallowed them whole, and overlooked the negatives. That’s nothing but a value judgment on my part. It’s just my opinion that the imbalance of attention to – and blanket acceptance of – the positives was overdone.


I had good company in being skeptical of the May/June gains. On May 12, with the S&P 500 up a startling 28% from the March 23 low, Stan Druckenmiller, one of the greatest investors of all time, said, “The risk-reward for equity is maybe as bad as I’ve seen in my career.” The next day, David Tepper, another investing great, said it was “maybe the second-most overvalued stock market I’ve ever seen. I would say ’99 was more overvalued.”


On the days those two spoke, both the plain vanilla forward-looking p/e ratio and the Shiller cyclically adjusted price-to-earnings ratio were well above normal levels, disregarding all the uncertainties present and the big declines that lie ahead for GDP and earnings.


And yet, over the next four weeks leading up to the June 8 high, the S&P 500 rose an additional 13%. What this proves is that either (a) “overpriced” isn’t synonymous with “sure to decline soon” or (b) Druckenmiller and Tepper were wrong. I’ll go with (a). On June 8, Druckenmiller described himself as “humbled.” (In this line of work, if you never feel humbled, it just means you haven’t realistically appraised your performance.) All I know is that a lot of smart, experienced investors concluded that asset prices had become too high for the fundamentals. Time will tell.

*          *          *

There’s no way to determine for sure whether an advance has been appropriate or irrational, and whether markets are too high or too low. But there are questions to ask:

  • Are investors weighing both the positives and the negatives dispassionately?

  • What’s the probability the positive factors driving the market will prove valid (or that the negatives will gain in strength instead)?

  • Are the positives fundamental (value-based) or largely technical, relating to inflows of liquidity (i.e., cash-driven)? If the latter, is their salutary influence likely to prove temporary or permanent?

  • Is the market being lifted by rampant optimism?

  • Is that optimism causing investors to ignore valid counter-arguments?

  • How do valuations based on things like earnings, sales and asset values stack up against historical norms?

Questions like these can’t tell us for a fact whether an advance has been reasonable and current asset prices are justified. But they can assist in that assessment. They lead me to conclude that the powerful rally we’ve seen has been built on optimism; has incorporated positive expectations and overlooked potential negatives; and has been driven largely by the Fed’s injections of liquidity and the Treasury’s stimulus payments, which investors assume will bridge to a fundamental recovery and be free from highly negative second-order consequences.


A bounce from the depressed levels of late March was warranted at some point, but it came surprisingly early and quickly went incredibly far. The S&P 500 closed last night at 3,113, down only 8% from an all-time high struck in trouble-free times. As such, it seems to me that the potential for further gains from things turning out better than expected or valuations continuing to expand doesn’t fully compensate for the risk of decline from events disappointing or multiples contracting.


In other words, the fundamental outlook may be positive on balance, but with listed security prices where they are, the odds aren’t in investors’ favor.



June 18, 2020