David Merkel wrote this a year ago; Its a brilliant set of observations of what market tops look like.

David starts by noting he is "basically a fundamentalist in my investing methods, but I do see value in trying to gauge when markets are likely to make a top or bottom out."  He adds that his methods "are somewhat vague, but I always have believed that investment is a game that you win by being approximately right. Precision is of secondary importance."

Item 1: The Investor Base Becomes Momentum-Driven

Valuation is rarely a sufficient reason to be long or short the market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.

You’ll know a market top is probably coming when:

a) The shorts already have been killed. You don’t hear about them anymore. There is general embarrassment over investments in short-only funds.

b) Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.

c) Valuation-sensitive investors who aren’t total-return driven because of a need to justify fees to outside investors accumulate cash. Warren Buffett is an example of this. When Buffett said that he "didn’t get tech," he did not mean that he didn’t understand technology; he just couldn’t understand how technology companies would earn returns on equity justifying the capital employed on a sustainable basis.

d) The recent past performance of growth managers tends to beat that of value managers. In short, the future prospects of firms become the dominant means of setting market prices.

e) Momentum strategies are self-reinforcing due to an abundance of momentum investors. Once momentum strategies become dominant in a market, the market behaves differently. Actual price volatility increases. Trends tend to maintain themselves over longer periods. Selloffs tend to be short and sharp.

f) Markets driven by momentum favor inexperienced investors. My favorite way that this plays out is on CNBC. I gauge the age, experience and reasoning of the pundits. Near market tops, the pundits tend to be younger, newer and less rigorous. Experienced investors tend to have a greater regard for risk control, and believe in mean-reversion to a degree. Inexperienced investors tend to follow trends. They like to buy stocks that look like they are succeeding and sell those that look like they are failing.

g) Defined benefit pension plans tend to be net sellers of stock. This happens as they rebalance their funds to their target weights.

Item 2: Corporate Behavior
Corporations respond to signals that market participants give. Near market tops, capital is inexpensive, so companies take the opportunity to raise capital.

Here are ways that corporate behaviors change near a market top:
a)  The quality of IPOs declines, and the dollar amount increases. By quality, I mean companies that have a sustainable competitive advantage, and that can generate ROE in excess of cost of capital within a reasonable period.

b) Venture capitalists can do no wrong, so lots of money is attracted to venture capital.
c)  Meeting the earnings number becomes paramount. What is ignored is balance sheet quality, cash flow from operations, etc.

d)  There is a high degree of visible and/or hidden leverage. Unusual securitization and financing techniques proliferate. Off balance sheet liabilities become very common.

e) Cash flow proves insufficient to finance some speculative enterprises and some financial speculators. This occurs late in the game. When some speculative enterprises begin to run out of cash and can’t find anyone to finance them, they become insolvent. This leads to greater scrutiny and a sea change in attitudes for financing of speculative companies.

f) Elements of accounting seem compromised. Large amounts of earnings stem from accruals rather than cash flow from operations.

g) Dividends become less common. Fewer companies pay dividends, and dividends make up a smaller fraction of earnings or free cash flow.

In short, cash is the lifeblood of business. During speculative times, watch it like a hawk. No array of accrual entries can ever provide quite the same certainty as cash and other highly liquid assets in a crisis.

These two factors are more macro than the investor base or corporate behavior but are just as important.Near a top, the following tends to happen:

1. Implied volatility is low and actual volatility is high. When there are many momentum investors in a market, prices get more volatile. At the same time, there can be less demand for hedging via put options, because the market has an aura of inevitability.

2. The Federal Reserve withdraws liquidity from the system. The rate of expansion of the Fed’s balance sheet slows. This causes short interest rates to rise, making financing more expensive. As this slows down the economy, speculative ventures get hit hardest. Remember that monetary policy works with a six- to 18-month lag; also, this indicator works in reverse when the Fed adds liquidity to the system.

Source:
The Fundamentals of Market Tops
David Merkel
01/13/2004 03:41 PM EST

http://www.thestreet.com/p/rmoney/davidmerkel/10136569.html

Category: Investing, Markets

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

7 Responses to “The Fundamentals of Market Tops”

  1. nate says:

    precision vs. accuracy-

  2. Eclectic says:

    Quoting from your piece [comments by Eclectic]

    “…. they buy what is going up, and sell what is going down.”
    [in other words, they play the firecracker game, but just play it with Lady Fingers and not M-80s]

    “…….Momentum strategies are self-reinforcing due to an abundance of momentum investors.”
    [the party on the other side of the bridge is so compelling, the crowd formerly hesitant to cross is now breaking for the bridge in droves.]

    “…..Once momentum strategies become dominant in a market, the market behaves differently.”
    [and why wouldn't it? Its participants have played Russian Roulette with one bullet in the chamber, and they're winning, and now their neighbors are willing to play as well.]

    “….Markets driven by momentum favor inexperienced investors.”
    [dumb luck pays.]***disclaimer, currently Eclectic is not benefiting from dumb luck.

    “…..Near market tops, the pundits tend to be younger, newer and less rigorous. Experienced investors tend to have a greater regard for risk control, and believe in mean-reversion to a degree.”
    [what the coitus does that mean?... not my question, but what those younger pundits are asking.]

    “…..Near market tops, capital is inexpensive, so companies take the opportunity to raise capital.”
    [you don't shear the sheep when they're skin-bald.]

    “….The quality of IPOs declines, and the dollar amount increases.”
    [read Galbraith: "The Great Crash" or the update he wrote in, I think, the late 1980s.]

    “….Meeting the earnings number becomes paramount. What is ignored is balance sheet quality, cash flow from operations, etc.”
    [comes from irresponsible corporate (not individual) EBITDA pro-forma accounting, rampant over the last approx 15-20 years.]

    “….There is a high degree of visible and/or hidden leverage. Unusual securitization and financing techniques proliferate. Off balance sheet liabilities become very common.”
    [read Galbraith, "The Great Crash."]

    “….Cash flow proves insufficient to finance some speculative enterprises and some financial speculators. This occurs late in the game. When some speculative enterprises begin to run out of cash and can’t find anyone to finance them, they become insolvent. This leads to greater scrutiny and a sea change in attitudes for financing of speculative companies.”
    [you guessed it - Galbraith reported all this about that grand delusional time of now approaching 80 years ago]

  3. brian says:

    since Bush began his reign, the DOW has been basically flat-lined until recently (which I attributed to the revelations of Market manipualtion/chicanery -Anderson/World Com/Enron etc- and the ensuing exodus of “the sheep”)
    So have the sheep grown new fleeces?

  4. some_dude says:

    Those are fine flags for detecting the top of a great raging bull market. Unfortunately, those sort of markets only come along once every 30-40 years, and we’ve just finished one a few years ago.

    In this sort of range-bound, sideways market, most of that stuff is useless (the comment about liquidity by the Fed excepted).

    We’re pretty clearly at the top of the trading range right now, and given the macro situation likely to head down towards the bottom of the range over the next 18-24 months. Yet none of his flags (again excepting the Fed) are showing.

  5. dsquared says:

    Barry, mate, you missed the big one:

    “cash deals are bullish, stock deals are bearish”

    in other words, a sector or market is a big Buy when knowledgable industry players are prepared to make big acquisitions with borrowed money, and starts becoming a Sell when the dumber nuts in the sector are able to do big deals with highly-rated paper.

  6. Bubbles and the trouble with going short

    Keynes’ words have become one of the most tired clichés in finance. “The market can remain irrational for longer than you can remain solvent.” I can’t find date attached to the quotation, but since Keynes died in 1946, it’s a fair guess that…

  7. bernie leonard says:

    This is for David Merkel.
    David,
    The handsome Dan Fitzpatrick said that I should get in touch with you with a question that I had sent to Dan. The question will include Citigoup and J.P. Morgan Chase, but principally Bank of America. From what I have learned, Bank of America has by law the total amount of money permitted by congress on deposit which is around ten per-cent. I have read that BAC is near the maximum permitted whereas Citigroup is much lower and JP Morgan Chase is around seven per-cent. Being that Bank of America is at the max, it means that BAC cannot by law make domestic bank acquisitions. If congress lifts the limit on the amount of money permitted to be on deposit, then Bank of America should be able to expand domestically. My question is, what would happen to Bank of America stock price if congress permits the banks to have increased deposits? I believe, particularly, with Bank of America, that the stock price could increase substantially. I would like your thoughts on this. By the way, Dan wants me to let him know if I hear from you. Dan said that his is a very good question and you would be the best one to ask. From what I have read, you are a very smart man. Thanks for you time.
    bernie leonard
    p.s. I didn’t have an email address for you, so I went to Google.