With Dan out for a few days on vacation, I will be filling in here a little. And I wanted to work through some thoughts about the underlying state of today’s market landscape after a 6 year bull run (the 4th longest in U.S. history).
Last week was another demonstration of the peculiar nature of market price action in the U.S. over the past few years. The S&P 500 index rallied 55 points last week, or 2.7%, retracing almost the entire pullback over the prior three weeks. The rallies continue to be faster than the selloffs, in direct opposition to what most traders learn through experiencing markets in times of greed (slower, trending moves higher) and fear (rapid, volatile declines).
What the heck is going on? What’s different about the current market environment that leads to such divergent price action compared to typical markets?
First, the current bull market has only seen the V-shaped rally mentality really take hold in the past 2 years. From 2009 to 2012, the market price action was actually more typical, with grinding, low-vol rallies interrupted by severe, high-vol selloffs. One possible explanation in my mind relates to the differences in momentum and value investing, the two dominant strategies employed by successful traders in history.
Let us assume the extreme case where every potential asset buyer is either a value investor or a momentum investor. In the case of the value investor, a purchase is made when the assessed value of a security is far below what he considers to be fair value for that asset. From that point forward, the price of a value-investor-focused asset usually increases for one of two reasons.
In the first case, other value buyers make the same determination, and the price of the security increases. That increase continues until enough early value buyers decide that the appreciation has gone far enough for them to be willing to part with their asset at the same time that potential new value buyers no longer view the security as attractive.
In the second case, the business itself performs much better than expectations, leading to new investors who might be of the value or momentum type (momentum investors are rarely interested in stagnant or poorly performing businesses). As the business outperforms, the stock attracts new investors, and this situation has a greater chance of turning a value stock into a momentum stock (the best situation is when a stock has both groups at its back, such as AAPL or AMGN in 2014).
What about a momentum-investor-focused asset? That stock initially attracts interest due to the price increase in the stock in the first place. The important point here, though, is that the best performing momentum stocks are situations where buyers become price insensitive. In other words, if buyers don’t care what price they pay, and simply want to own more of a specific security, then demand is likely to outstrip supply for quite a long time, and usually take valuation well past fundamental norms. That’s why many momentum leaders are often “story” stocks that attract price-insensitive buying. In fact, many times the best momentum names are those that are the most difficult to value through traditional means.
A second crucial point about momentum situations is that liquidity (or the lack thereof) is a key variable that determines the extent of the move higher (and the potential fall from grace). For example, in low liquidity stock markets, as we have experienced in the past few years, price insensitive buyers have an inordinately large impact on the price of stocks or the market as a whole compared to a situation where there is ample liquidity. What do I mean by ample liquidity? Well, before the financial crisis, there were a far greater number of short-term market players (investment banks in particular) who had large balance sheets and were willing to take on significant market risk to meet the supply and demand of large orders. Since the size of that market cohort is now much smaller, price insensitive buyers have a bigger impact.
In this context of value and momentum, one possible theory is that the 2009-2012 period was dominated by value strategies, with momentum players much less active given the market environment. However, the 2013-2015 period has been dominated by momentum strategies, with value players generally less active. As long as the long-term uptrend remains intact in the U.S., the momentum players are not perturbed by overvaluation or small selloffs, and the low liquidity exacerbates the moves higher.
In stock markets, it’s usually forced selling due to margin calls that leads to major, severe declines. I expect that that is how the recent bull market will eventually end as well. However, it’s always important to keep in mind that momentum-driven situations actually benefit from low liquidity as long as the uptrend remains in tact, with buyers overwhelming potential sellers simply because of market dynamics rather than fundamentals. That lack of liquidity can lead to big upside moves, similar to what we’ve seen in the U.S. stock market in the past couple of years.