The Weekly (6/21)

How can you tell it’s time to get out of the market?

As the story goes, in 1929 Joseph Kennedy, an American businessman and the father of JFK, supposedly realized the party was over upon hearing a young shoeshiner sharing stock tips. Joseph proceeded to exit his positions in the market and bought short positions that bet on the market going down.

In 2000, the top was in when nearly twenty ‘dot com’ companies took out multi-million dollar Super Bowl advertisements.

And in 2022, Roaring Kitty’s emergence on social media might have been the only thing you needed to see to know markets may be peaking.

The S&P 500 index is hitting new highs every other week, fuelled by enthusiasm about artificial intelligence and the prospect of lower interest rates in the not too distant future. The cyclically adjusted price-earnings ratio, made famous by Robert Shiller of Yale University, is at nearly 36. The last time it was this high? 2000 and 2022. 

On June 18th the market’s insatiable appetite for AI made Nvidia, a chip designer, the world’s most valuable firm. The last time a big provider of computing infrastructure was the most valuable U.S. company? Cisco in 2000. 

A correction, in theory, can happen at any moment and investors are by and large unable to predict exactly when it might happen. If we were to believe that even the best investors can’t truly time the market, attempting to anticipate the exact moment of a market’s peak is likely futile. 

A better question to ask, though, might be does the rally have further to go? After all, pricey shares can always get pricier if investors keep bidding them up.

To help understand why stocks may be able to go higher, consider the concept of “duration”, a concept typically applied to bonds. 

In short, it’s the average time until a bond’s future payouts, including both coupons and repayment, weighted by the size of each payout. Unusually in financial math, which tends to be messy and littered with countless assumptions, duration has a rather elegant meaning: it is the sensitivity of an asset’s price to changes in interest rates.

Here’s an example: a long-duration asset like a 30-year bond, is hammered by rising interest rates. If interest rates fall, that same bond appreciates. Cash, the value of which is invariant under such changes, has a duration of zero.

So what does this mean for stocks?

Intuitively, shares of a company derive much of their value from earnings in the distant future and must be closer in duration to the long-maturity bond than to cash. In other words, although the stock market is expensive today, it benefits from having a long duration. With interest rates set to fall, could they act in the same way as other long-duration assets? 

A bear could point out this overly simplified analysis is exactly that: overly simplified. They could easily argue that the recent climb in stocks in the face of higher yields proves that the duration analysis is worthless. 

Ultimately, the quest to identify the market peak is a quest for clarity amidst complexity—a journey marked by uncertainty and informed speculation. Speculation being the most important part of that sentence.

Which brings us back to Joseph Kennedy. 

Did he make money off his shoe shiner trade? Absolutely. It's estimated that he made somewhere north of $150 million during that period, which equates to roughly $3.5 billion in today’s dollars. Was he speculating on the market moves? Absolutely. 

Based on how you look at the current market conditions, stocks could be cheap or they could be expensive. What’s great about investing is that there’s two sides to every trade: a buyer and a seller, both of which have wildly different viewpoints on the asset in question.

So we suppose only time can tell who is on the right side of the trade.

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