The twists and turns of the markets are not easily known

To pretend that you know what the market is going to do next can be hazardous, but the signs learned from the past seem to indicate that we have not yet reached the bottom of the market in the present downturn, 

argues Piet Viljoen.

“Our knowledge of the way things work, in society or in nature, comes trailing clouds of vagueness. Vast ills have followed a belief in certainty,” remarked Nobel laureate and author of I Know a Hawk from a Handsaw, Kenneth J. Arrow.

According to Benjamin Graham, “Pascal said that ‘the heart has its reasons that the reason doesn’t understand’. For ‘heart’ read ‘Wall Street’.”

One of the questions our clients ask most frequently is whether we are at the bottom yet. As with many such questions, the prudent advisers answer that they don’t know. These advisers tend to not know very much at all, and pinpointing tops or bottoms of markets is one of them. They know just as much as every economist who tells us in hindsight exactly what happened, and they know just as little as the most celebrated market commentator about what is going to happen in the future.

A key difference, though, is that they know they don’t know. In fact, that is one of their strong competitive advantages. It is also a competitive advantage that is not replicated easily by their competition.

Most analysts don’t know very much, but they are too proud to admit it. They will attribute any positive short-term performance to skill; adverse outcomes are then properly attributed to bad luck.

This is simply human nature; we mean no disrespect to our colleagues in the industry – we ourselves are sometimes prone to such bouts of self-delusion.

However, if you know enough to know you don’t know very much at all, it protects one from the worst mistakes – the ones related to predicting (or trying to predict) the future.

Recognising good value in the here and now is a much more powerful tool than trying to estimate value based on unknowable future outcomes.

So, in order to answer the question posed at the start, we can begin to describe what previous bottoms looked like – and we can do this with 100% accuracy, because we are talking about the known past.

We know future troughs will look slightly different, but they will share most of the attributes of previous troughs, in one form or another. With this knowledge, we can look at the world around us, and see whether it resembles a trough area.

The following is a sum of the collective wisdom on what market bottoms look (and feel) like, from the team of analysts of which I am a part.

It is worth pointing out that none of these attributes mentions valuation. This is for good reason: just as stocks can become ridiculously expensive on the upside, they can become ridiculously cheap on the downside.

Just because the market is pricing an asset at half its intrinsic value, doesn’t mean there is a floor under the price. If it can trade at half intrinsic value, why not a quarter? Why not an eighth? What does provide a floor is human psychology, and how it influences money flows.

We have identified the following eight signs that all speak to this aspect of the market.

Public apathy, low volumes

Basically, this factor relates to a lack of participation in the market. When prices have been declining for an extended period of time, even the most ardent speculator will give up.

At this time, common opinions include “why bother with stocks, everyone just loses money in them” – or the one that was very prevalent in 2002/2003: “Why buy property in South Africa, when the rand just continues to depreciate and we have all this political uncertainty?”.

Upon hearing this, property investors stood on the threshold of making obscene amounts of money.

So, listen to your friends at the braai on Saturday night – when they become disgusted with stocks, you’ll know the bottom is near. Of course, the reasons given for being disillusioned will sound very rational. Don’t let that fool you, as the stock market is a discounting mechanism that discounts the future, not the past. And one of the few things we know, is that the future is always different to the past!

At the moment volumes are still very high, in fact, during the weeks of the financial crisis, the JSE enjoyed record volumes and values of transactions. We are still a long way from apathy!

Investment horizons contract

When the going gets tough, no one is willing to take a long-term view. The same investors who were willing to take a 20-year view on some start-up mining exploration company finding, developing and producing something worthwhile, will run a mile when approached by a promoter at a market bottom. “Growth as far as the eye can see” is replaced by “Show me the money”.

Of course, neither of these positions is in itself correct – they merely describe the prevailing sentiment in the market.

As always, the truth lies somewhere in the middle.

Bottom line: sell when the market discounts long-term growth, and buy when the market isn’t willing to look forward more than six months. This mindset still needs time to develop but, on the positive side, we are getting there.

Delistings of good companies suffering from poor price performance

Investment banks are smart. They will sell you a pile of rubbish at very high prices, and buy really good stuff from you at really low prices. How? By taking advantage of the one thing that distinguishes us humans from animals: emotion.

When the price of your favourite stock continuously declines, one tends to associate that with a poorly performing business, forgetting that even the best businesses sometimes go through tough periods. However, once our horizons contract (see above), we cannot distinguish temporarily poor business conditions from a permanent impairment of the business.

When Mr Investment Banker arrives in his Ferrari to buy this business from us at a very low price, instead of thinking how he can afford such a nice car, we immediately accept his seemingly generous offer. After all, out of sight is out of mind, isn’t it? Of course, the fact that we bought shares in the same company at vastly inflated prices at the time of its IPO from the very same car owner, doesn’t cross our minds either.

In 2002/2003 we recall quite a few really good companies delisting: Nando’s, Aplitec, Pepkor, Powertech and Softline. Since delisting, these companies have been very successful, but were greeted with a collective yawn when they left – a sure sign of a bottom.

In our opinion, we are still closer to the top (IPO boom) than the bottom (delistings) in this cycle.

Investment banks scaling back or closing down their businesses

Ms Investment Banker likes fast cars, beautiful yachts and good food and wine.

When she can no longer afford these niceties, it is time to move on to greener pastures. As previously pointed out, Ms Investment Banker also makes her money from exploiting our emotions.

At market bottoms, the prevalent emotion is one of pessimism and fear. This leads to low trading volumes (see point one) and a general suspicion about the motives of market participants, such as Ms Investment Banker.

At that point, it is generally better to shut up shop and wait for the animal spirits to reappear.

Now, in the United States, investment bankers have been forced to close down or sell out – only two of the top five remain.

But this has been forced upon them by their own venality, driven by incentive systems that were very much a “heads I win, tails you lose” game. So, we need to wait for some voluntary closures before calling a bottom.

Business failures, sometimes with the tag of “what were they thinking” attached

The same critics would have been vocal supporters of the business model in the preceding bull market.

One of the wonderful things about the market is how short its memory is. When Dimension Data reached a price of R75 per share back in late 2000, its business model was widely described as being very sensible.

After all, if you didn’t know who was going to be the winner in the brave new Internet world (Pets.com, Webvan.com, Boo.com), it was easy to simply buy the company that would provide all the “plumbing” for these companies to do business on the Internet.

Never mind that it had no barriers to entry, low margins, a management team focused more on the share price than on the business and simultaneously huge sellers of the stock.

Of course, by the time it reached a price of R2 per share, all these failings – and more – were widely recognised. This was, of course, the bottom.

In 2002, the bottom of the property market was probably signalled by the failure of Monex – the developer of the eventually very successful Century City mall in Cape Town.

Many people criticised Monex, but with the benefit of hindsight, it was visionary.

When AMB private equity partners delisted in 2003, it was to a collective sigh of disgust.

No one in their right mind wanted anything to do with private equity – a sure sign of a bottom.

Of course, it was only four years later that private equity players could get blank cheque financing from banks – no questions asked – and institutions thought they were getting an uncorrelated asset they could add to their portfolios in unlimited quantities, thereby reducing risk and increasing returns.

When times are good, belief in flying pigs is surprisingly prevalent. We would argue we are still close to the top in this particular sequence of events.

The phrase “cash is king” is often heard, outflows out of risky funds into cash or similar funds accelerates

This is probably the best sign of a bottom. When investor preference shifts unquestionably to the one asset that offers no prospect of any capital gain at all, you know we are there or thereabouts.

At this point, with many investors still trying to time their entry into the commodity supercycle, or buy the least bad financial stock, we would argue there is still a way to go before we hit rock bottom.

Markets don’t sell off on bad news

You know the market is getting tired of going down when bad news hits and it doesn’t really react. Such a reaction speaks of investor exhaustion and apathy. 

Last year, the news of former president Thabo Mbeki’s firing and finance minister Trevor Manuel’s resignation was exactly such news, and it was disappointing to see the market sell off significantly. On this measure, we still have a way to go before we reach bottom.

Forced sellers, selling good assets (most often at a discount) to raise liquidity

This is the one we enjoy most. As managers of your capital, we really enjoy it when we are able to buy assets at low prices. It doesn’t happen very often, but when it does, we need to be ready.

We are already seeing some distressed situations leading to deeply discounted rights issues – Seardel, Super Group and Kap come to mind. FirstRand’s recent sale of a very large portfolio of “value stocks” is another positive signal.

However, our best guess is that more water needs to flow under the bridge before we can jump in and enjoy.

In summary: of the eight measures that indicate a bottom, it seems that none gives us any comfort that we have reached our destination. But, like a young child on a long car trip to a holiday, we will continue to ask, “Are we there yet?”

Piet Viljoen, BCom (Hons), CFA is a portfolio manager with 21 years’ industry experience. He is the founder and executive chairperson of RE·CM