Traditional trading rules suggest quickly cutting your losers and letting your winners run. When entering a trade/investment, it makes sense to not only have a stop on the downside but also a profit target on the upside that should be a multiple of what you are willing to lose. When the initial profit target is achieved it makes perfect sense to then remember to continue to let your profit run by merely raising your stop. Oh, and then stick to it. It all seems fairly simple right? I lay out those simple rules with little emotion as there is no $ on the line and thus no emotion to cloud my judgement. All too often, we rationalize poor price action in stocks that we own as we become attached to them. That means we fail to stick to our discipline, which is supposed to remove emotion and remember they are merely stocks. In a raging bull market, like the one we are in today, traders/investors have been afforded the luxury of being sloppy, and in most occasions have gotten bailed out on the long side.
Bull markets like the one we have been in since March 2009, with the SPX up 200%, can cause bad habits. The fact that we are in the longest period in almost 20 years without a 10% pull back obviously speaks to complacency, which does not exactly mean we are near a top, but as Forrest Gump used to say to anyone who happened to be listening, “Stupid is as Stupid does”. I know, I know, a lot of you think I am just trying to rain on the bull market parade, and truth is, I am not at all. The takeaway here, is stay long, have a ball, just remember that prior to the real top we are likely to finally have that 10% pullback, and very likely to retest the prior highs before it’s all said and done.
Low levels of volatility on a broad market basis can last for a very long time and the past 3 years are a testament to that. I do think it is important to note that for most of 2014, there has been considerable single stock volatility on a case by case basis, DESPITE unusually high levels of corporate buybacks.
Buybacks have been a central feature of the current bull market, and their pivotal impact should not be underestimated. More details from a recent Harvard Business Review article:
The allocation of corporate profits to stock buybacks deserves much of the blame. Consider the 449 companies in the S&P 500 index that were publicly listed from 2003 through 2012. During that period those companies used 54% of their earnings—a total of $2.4 trillion—to buy back their own stock, almost all through purchases on the open market. Dividends absorbed an additional 37% of their earnings. That left very little for investments in productive capabilities or higher incomes for employees.
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Why are such massive resources being devoted to stock repurchases? Corporate executives give several reasons, which I will discuss later. But none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay, and in the short term buybacks drive up stock prices.
I suspect that at some point, C-level suites will be less inclined to buy back their stock hand over fist at record high share prices simply because the bang for buck that they get as the share price moves higher is less appealing. In addition, executives might get more concerned about too much leverage, though we have not seen that so far given record debt issuance. However, this sort of buyback cushion that investors have become accustomed to will not last forever, and its decline could cause broader market volatility. The most recent example would be the sell off that we saw from February to early May, where high valued social media, biotech, 3d printing and cloud stocks had little to no support making a series of what felt like never-ending lower lows. Now many of these stocks have come back, as investors once again became comfortable with the backdrop for owning equities, but few of them reached their prior highs.
In any case, the outperformance of large cap stocks over small cap stocks in 2014 might be one indication that buybacks have been one of the last drivers of incremental demand for stocks after 5 years of a major bull market. Smaller cap companies have less cash for buybacks, while large caps have continued to mop up shares. As a result, if and when market sentiment finally turns, the small caps should see a sharper fall, as corporate buybacks won’t be there as an additional buyer as sellers search for buyers at lower and lower prices.