Kostolany on What Makes Stocks Go Up; Capital Flows and Technicals

Andre Kostolany on What Makes Stocks Go Up

I was doing some reading on Andre Kostolany and found something interesting. According to him, what makes stocks go up can be summarized in one simple formula: Cash availability + Sentiments = Market Trend. Basically for a market to go up, people need to have cash to buy stocks, and they have to want to buy stocks. Of the two, cash is the more important one, since high liquidity creates a rising market which would then drives sentiments.

Kostolany gave convincing examples where markets go the opposite way of underlying economic conditions. In a weak economy, people scale back consumption which increases savings rate. Since confidence about the real economy is weak, those savings get channeled to the securities market. Likewise, when central banks loosen monetary policy to support a weak economy, much of that extra cash goes to prop up the markets.

In this framework, what makes stock market go up is about monetary policy, available cash on the side lines, international capital flow and FX. Fundamentals are part of the equation, but mostly serve to influence public sentiments and expectations, as well as rationalize prevailing biases. In fact, an improving economy might lead to negative sentiments regarding corporate earnings, if higher labor and input cost lower profit margins.

This all makes a lot of sense to me. As a result I spend some time on macro the past few weeks, particularly on the topics of international capital flow, balance of payments…etc. 

International Capital Flow and Implications

My rudimentary credit analysis on the USA follows. The U.S. has current account deficit running $400-500bn the past few years, it finances that with capital inflows, which represent foreign claims on U.S. assets and effectively depletes national wealth over time. But that national wealth is incredibly high. The household sector alone has ~$83 trillion of net worth, so technically that current account deficit can persist for 150+years before U.S. networth gets depleted.

So solvency is not an issue, but how about liquidity? For now, foreigners are choosing to finance U.S consumption, presumably because 1) political stability, 2) economically U.S. being one of the “cleaner shirts” among nations, and 3) to a lesser extent strong USD appreciation the past year. Political stability will likely stay around in the coming decades, but relative economic position could change. At some point the U.S. may have so much debt that growth is weighed down by interest payments, while recovery in China and Europe can both draw capital away from the United States.

China is not helping either. In the past decade China piled up U.S. treasury bonds in its FX reserves. That helped to keep the RMB down and sustain its trade surplus. But now it seems to prefer exporting capital to other emerging markets, which not only helps the trade surplus but also enhances its influence and prestige abroad.

If capital reverses direction, that out flow could start a vicious cycle. Capital outflows would weaken the dollar, accelerating withdrawals of hot money. The Fed can raise rates in an attempt to attract capital, but that would tighten money and credit and kill the markets. The economy would have to adjust by consuming less - leading to deflation. At that point decades of accumulated foreign capital at the U.S. could rush out the door and a deflationary cycle sets in.

Value investors like to say “no one gets the macro right”. That’s probably true. I do believe though, that you have to be planned for all scenarios instead of just assume things will be fine in the long run. In terms of money management, it’s not so much trying to guess what the economy will do, but planning out how I will react to different scenarios.

A Technical Experiment - Game Planning

“Stock market goes up in the long run” is a mantra that take hold at top of markets, conveniently serve to justify ever higher valuation - “this stock trades at 25x P/E? Doesn’t matter, buy it anyways because over the long run I’ll be fine.” This mentality has two implications, 1) at some point the public become fully invested – there’s no buying power left, and stocks have nowhere to go but down on the next sign of economic weakness and 2) the market increasingly trade on technicals.

I’m convinced that the broader market is trading on macro/technical with “fundamentals” being merely an excuse to buy stocks. According to this report from Factset, market prices have grown at a faster pace than earnings expectations the past few years. Earning expectations have steadily declined since beginning of the year yet the market trickled upward. The same report also pointed out that market is reacting less to earnings beats and misses than the past – an indication that fundamentals have taken a backseat to technicals.

What to do? A sensible thing to do is target stocks that are less correlated to the broader market: small/microcap/illiquid stocks, special situations, turnarounds..etc. A major portion of my portfolio is mid/large cap value stocks though, and there I sense the fundamentals valuations are becoming less relevant – (and will be even less relevant if the market keep marching upward).

I’m in the middle of an experiment in timing the market with technical analysis. I use SPDR S&P 500 ETF (“SPY”) as a proxy for the market. Here’s the plan.

Current Trading range & initial set up

• Current trading range is 205-212 and we’re currently at $212 per share. We are very close to a strong resistance around 212-213, a line that have held up since February. SPY tested that resistance 3 times the past month with no success. If it fails to break through again, my suspicion is that we’re due for a 5-10% correction. 
• I shorted some SPY with 213 as a stop, so that if it breaks upward past 213 my loss would be limited. This short is ~18% of portfolio equity, with w.a. cost basis of 208.3. So I stand to lose 40bps if I get stopped out at 213.

• I left my single names untouched. Some of them have their own stop losses anyways. These single name exposures are about 90% of equity.
• Note that I’m actually violating proper technical trading principals here in the sense I’m jumping the gun even before a clear breakout or trend emergence. As discussed later, I risk being whipsawed)

If SPY breaks to the upside

• My shorts get stopped out so I take 40bps of loss. But my single name exposures would still be there to take advantage of any potential uptrend.
• Should I reverse course and get longer (would put me on leverage)? Only if a breakout proves that it established a new pricing range. That to me requires the emergence of a new support level (say 213-214 area) – mostly in the form of a retracement and subsequent bounce.

If SPY moves down

• My short position would be showing a profit, but probably not enough to offset losses on my single names. I would think about adding to the short. But only if SPY breaks below support levels such as 205 or 200. 

If SPY moves up past 213, but that turns out to be a false move and SPY reverse downward back to say 208. Instead of establishing a new pricing range, that move would have merely expanded the range.

• This would be tough to swallow. I would have incurred 40bps of hedging cost with no gains to show for it. That’s what you get for jumping the gun before a clear trend emerges. Should I risk another 40bps and risk getting whipsawed yet again? Only if there are proof that a downward trend is emerging. That to me requires 1) Negative fundamental news dominating the headlines (perhaps worries about Europe & China), 2) technical indicators that confirms the trend in the form of ADX/DMI, a lower low…etc. 

The way market is going, I could be stopped out of this trade as early as tomorrow. In that case we might be in for a summer “melt up” as in 2014. I will not fight it.