The stock market will stop quaking when the smart money is through selling.
That might sound glib or obvious — something that’s more or less true by definition of each market drop. But it’s a particularly fitting observation now, because the current market tremors are more a matter of Wall Street’s elephants running from risk than the ground giving way underneath the economic recovery.
The dominant themes of the sharp pullback have been a reversal of the winning investment trades of 2013 (which got very crowded and expensive), a rush by startup-backers and buyout artists to jam stock offerings into new investors’ hands, and heavy selling of shares by corporate insiders.
This is all on the up-and-up, and all are typical features of a bull market. Yet there was just too strong a sense in recent weeks that those early to many winning ideas were done pressing their bets and wanted to – or were forced to – cash them in.
The first quarter saw the highest volume of initial public offerings since 2000, with 70% of debuting companies having yet to turn profitable. About a third of the deals in the past month had traded below their offer price, a sign that supply was swamping demand or that the quality of the companies was slipping. The offering for Ally Financial Inc. (ALLY), while a relative victory for the U.S. government, which rescued it with a big investment during the financial crisis, has sagged in its first two days on the market, a decent example of supply-driven action. For good measure, Kenneth Moelis, the veteran investment banker who began at Michael Milken's Drexel Burnham Lambert ion the 1980s, is looking to take his 7-year-old advisory firm Moelis & Co. public at a $1.5 billion valuation.
Private-equity firms have been exiting rapidly from companies they bought in recent years. According to data tracker Dealogic, buyout firms have raised $13 billion this year in 31 IPOs of their portfolio companies, a record level to this point in any year. Blackstone Group’s secondary offering of 15 million SeaWorld Entertainment Inc. (SEAS) shares — about one-sixth of all outstanding equity — as the company reported weak results further sent a message of the sharp guys ringing the register.
Corporate insiders have been selling heavily in recent months, as executives take advantage of all-time highs in many stocks and the big indexes. While this isn’t a great market-timing indicator – and selling always tends to be active ahead of the tax deadline following a great year for stocks, as 2013 was – it fits neatly with the story that those with the best knowledge of businesses are not seeing good value in their shares.
Perhaps most important to the day-to-day action, certain popular hedge-fund positions — no doubt amplified by margin-borrowing balances at all-time highs — have been upended. Merrill Lynch global strategist Michael Hartnett points out that the winners so far in 2014 (emerging-markets stocks, bonds and gold up) match exactly last year’s losers and vice versa (with the Nasdaq, Japan and the U.S. dollar suffering).
Michael Block, chief strategist of Rhino Trading, points out some telltale behavior in certain instruments makes it obvious some big players were caught badly offside as momentum trades faltered.
The exchange-traded fund for Brazilian stocks, iShares MSCI Brazil (EWZ), has been almost perfectly negatively correlated with the U.S. Standard & Poor’s 500 index this week, as if they sat on opposite ends of a seesaw. Brazil has been a popular short, and the S&P 500 and Nasdaq’s growth stocks very trendy longs, and liquidation on some level is washing over it all. Similarly, Facebook Inc. (FB) has traded as the virtual inverse of Petrobras Argentina SA (PZE).
Another odd move? The surge in the price of nickel on the London Metals Exchange, another seeming beneficiary of desperate speculators being chased from bearish commodity bets, perhaps as their brokers demand they curtail risk exposures and investors withdraw funds.
As Block puts it: “This is all about pain. Managers came into this long growth stocks, and short things like emerging markets and metals. When someone yells fire, crowded positions take on a life all their own. I fear that we will hear more about certain managers taking losses in [the first quarter] and April in the coming days. There’s no two ways about it. Prime brokers are tightening reins, as are fiduciaries. That’s what this is. Trying to rationalize any of this by citing fundamentals is a dangerous wild goose chase.”
This doesn’t mean fears of a first-quarter lull in U.S. economic growth and a stalling housing recovery are irrelevant, or that China’s weak export data and broader slowdown signs are meaningless. Sure, the market is reassessing its expectations for a growth acceleration come spring and summer. Yes, there is nervousness about Federal Reserve intentions as it slowly dials down its asset purchases and eyes frothy financial markets. Long-term Treasury yields have receded while short-term rates have held steady, flattening the yield curve, which implies slower growth and/or marginally less-easy money down the road.
No dramatic real-economy developments
Yet none of these real-economy developments are particularly dramatic or new enough to account for the degree and character of this selloff. The corporate-credit markets have remained firm through all this, which likely wouldn’t be the case if markets were sniffing out the makings of a nasty economic shock or higher risk of U.S. recession.
That’s the good news. The bad news is that so many market sectors – especially the ones that led the push to new highs in late 2013 and early this year, such as Internet, biotech and small-cap stocks – had appreciated dramatically more than the pace of economic or earnings growth did. So there arguably could be plenty of room for the hottest, growth-iest parts of the market to re-price lower before this corrective market action is through.
Just in the past couple of days, the weakness broadened to other areas such as banks and large-cap industrial stocks that were being used as havens. That’s healthy, as are the emerging signs that individual investors are registering more fear about the declines.
These are the prerequisites for an enduring recovery, but plenty of damage to the uptrend has been done already. Before sounding an “all-clear,” investors should look for signs that stocks can react reasonably well to earnings news in coming weeks, which would indicate expectations have been pounded low enough. And they should hope for the IPO window to narrow or close, insiders to quit selling and the trendy hedge-fund trades to stabilize.
In the past year-and-a-half, this market has seen pullbacks halted a bit before all the signs of capitulation have lined up. We’ll soon see if this is yet another 2013 pattern that is now working in reverse.