Friday, September 25, 2009

The Best Contrary Indicator We’ve Ever Seen


Every day our inbox contains at least one missive packed with seductively scientific jargon professing to predict the future of the stock market.

This jargon is known as technical analysis, and it is appealing to many investors thanks not so much to its proven worth, but to its relative air of exactitude and certainty, what with precise levels of “support” and “resistance” and the like, not to mention comforting equations of logic: “If the market does this, it will do that…but if the market does that, it will do this…”

Technical analysis also has a solid place in the history of our business. After all, as a chartist once pointed out to me, before the SEC came along and companies had to file regular earnings reports, about the only way anybody could look at what was going on at a business—aside from inside information—was to look at patterns of accumulation and distribution by those insiders via charts and “tape reading.”

And sometimes it really works.


In the early 1980s, while a junior number-cruncher in the Merrill Lynch oil group, a man came bursting into our offices one morning waving a chart-book opened to the page of a dull, overlooked company whose stock had suddenly come to life.

The man was Chuck Setty—a chart guy who worked with the legendary Bob Farrell—and the stock was Marathon Oil.

“What’s happening with Marathon?” Chuck asked my boss—who was one of the all-time great sell-side analysts, but a firm believer in the sanctity of data as opposed to charts and graphs and 50-Day Moving Averages.

“Nothing,” my boss said. “The stock is up a little. So what?”

“So this,” said Chuck, showing us a chart of the stock, which was solidly rising in an otherwise languid oil tape. He then circled with his pen a massive rise in volume running along the bottom of the chart. “Somebody is buying a lot of it,” he said.

That “somebody” turned out to have been an oil company by the name of Mobil.

A few days later, Mobil announced an $85 a share tender for control of Marathon, and I signed up for a course in technical analysis at The New School.

Hey, even Warren Buffett was into charting early in his career.

Over time, however, I have come to believe, like Buffett, that staring at charts often gets in the way of finding good, inexpensive businesses to buy—and bad, overpriced businesses to sell short.

In particular, wallowing in the day-to-day ups and downs of the market as a whole, the ups-and-downs of which only get magnified by the CNBC Talking Heads, has zero to do with getting prepared, as Buffett would have all good investors be, for those rare occasions when opportunity presents itself in individual stocks.

Indeed, such wallowing tends to reduce the likelihood that one will take advantage of those occasions.

Witness these actual excerpts from actual emails received during the course of one of the biggest stock market rallies in history:

March 16, 2009

The overall technical trend for the major equity market averages remains down, and there are no major bases in place yet. New lows for the averages were confirmed by new lows in the NYSE advance-decline line and consolidated tape on balance volume as well as by deterioration in our Volume Intensity (VIM) and VIGOR models.

March 31, 2009

Technically, SP500 futures' failure to hold 780 will target 767 (38.2% retracement)-764 (filling of gap) as next major support level (per P Dauber).

September 1, 2009

Technically stocks are doing damage here (breaking under 1015 support from last week, breaking under 1010 20day MA….recall JPMorgan’s M Krauss is looking for a close below 1013 to confirm pullback to ~980). 1000 on the sp500 being watched closely today….


All wrong, and all completely overlooking the fact that on any given day, there are stocks to buy and stocks to sell, regardless of whatever a market average is or is not doing.

But we here at NotMakingThisUp write not to bash chartists or their tea-leaves.

Indeed, whoever was paying Chuck Setty-like attention to the option activity in Perot Systems in the days leading up to Dell’s desperately uneconomic bid for that company would have seen something happening—thanks to what appears to have been some good old-fashioned inside information going around according to a newly reinvigorated SEC.

Whoever acted on those price and volume patterns in Perot Systems—like Chuck did, back in the Marathon Oil days—would have made some dough.

And making dough, rather than predictions, is what this business is about.

But instead of worrying about the 50-Day or the 200-Day or the Green Line crossing the Blue Line, we suggest a different market indicator.

In fact, based on past performance, we think we’ve stumbled across the best possible indicator of all: what the apparent knuckleheads in charge of handling cash flow at America’s largest companies do with their cash.

And what they do, it seems, is this: they throw it out the window.

Well, not in an actual physical sense, but they might as well, for they seem to buy their own stocks back at exactly the wrong time, and then they proceed to not buy their own stocks back at exactly the wrong time.

Here’s the story, courtesy of the indispensible StreetEvents:

S&P 500 stock buybacks hit record low

Standard & Poor's announced that S&P 500 stock buybacks have fallen to their lowest level since the first quarter of 1998 - when Standard & Poor's began tracking the data.

According to Standard & Poor's Index Services, preliminary results show that S&P 500 issues spent $24.2 billion on stock repurchases during the second quarter of 2009, representing a 72% decline from the $87.9 billion spent during the second quarter of 2008, and an 86% decline from the record $172.0 billion spent on stock buybacks during the third quarter of 2007.

All this, of course, turns the old theory of technical analysis on its head: insiders should be buying not at the top, but at the bottom, and selling the opposite way. And in the old, pre-SEC, pre-Beat-the-Number-by-a-Penny days, pre-Dilutive-Stock-Option-Grants-Up-The-Wazoo, that might have been the case.

But not, apparently, any more. Nowadays, Bulls should keep a wary eye on corporate buybacks.

And Bears, it seems, should rejoice.


Jeff Matthews
I Am Not Making This Up


© 2009 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews.
Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

22 comments:

Mark said...

I don't understand your conclusion. If corporate stock buybacks have turned into a great contrary indicator (primarily happening at "the top") and few of them are happening right now, wouldn't this be bullish for stocks? Why, then, should bears (of which I happen to be one) "rejoice"?

Re. TA: It's useful for two reasons, and you only touched on one (the evidence of "accumulation/distribution). As you noted, a chart is a great way to see when a beaten-down individual stock (prime hunting grounds for the "value investor") is coming alive again, as well as a good way to avoid catching a falling knife. What you didn't mention is that the other reason TA is useful is the "self-fulfilling prophecy" factor; i.e., there are certain key levels that "everyone else" watches, and thus they become useful entry and exit points around which one can trade.

But What do I Know? said...

***All this, of course, turns the old theory of technical analysis on its head: insiders should be buying not at the top, but at the bottom, and selling the opposite way.***

I think this anomaly should cause us to think about our assumptions--and which ones are being violated in this case. To me, the assumption that companies are price-sensitive in their stock purchases (buy more when the price is low, and less when the price is high) which is so intuitively correctly, is actually wrong. Companies for the most part (other than the borrow to buyback morons you have rightly excoriated) are buying back stock with their cashflow--when the cashflow goes away as it did at many companies last year, the buybacks stop.

To me, this tendency highlights a worrying trend: that company buybacks are putting a floor in their own stock prices, the corollary of which is that when they end or slow the buybacks, there are no other size buyers and prices will drop precipitously. Compare the performance of PG (which did not stop or slow its buyback significantly) with a MMM (which did). I haven't looked at this systemically, so I'm pretty much just throwing this out as conjecture, but it would make sense, in light of the fact that very little new money seems to be flowing to large-cap domestic equity funds over the last five years.

I mean, after all, I haven't ever heard a company say--you know, we're going to suspend our buyback this quarter because although we have the cashflow, the stock price is too high.

W said...

One of the best allocators of capital was the late Henry Singleton of Teledyne. His timing was remarkable. He would routinely buy Teledyne stock at its lows and use the stock to finance acquisitions when he thought it was dear. Unfortunately for shareholders, most corporate chieftains do the exact opposite and follow the herd. Buffett himself considers Singleton a master.

Kid Dynamite said...

sorry Jeff - i'm confused. aren't you saying that company buybacks are a contrarian indicator? and that companies buy high and sell low or don't buy low? so, currently, we have low buybacks - wouldn't that be good news for the bulls - from a contrarian perspective?

note: i'm uber-bearish

Gone to the blogs said...

Dell is paying about 11x forward EBITDA for Perot...layup cost synergies probably bring that down to 8-9x. Perot is a well run company with some nice embedded assets (payer software, policy writing platform, etc). Your lack of background research notwithstanding, what exactly might cause you to suggest that this takeover is "desperately uneconomic?"

RichL said...

Do the same "knuckleheads" act similarly with regard to their personal funds?

My observation over the years indicate that insiders are often selling for the personal account at the same time there is a corporate buyback in place. Perhaps that is a conflict of interest, but it isn't irrational for their personal accounts. Analysts applaud this behavior as returning value to shareholders.

finiverse said...

Great article. Thank the TA's for letting us get in on juicily priced stocks in early March! TA's are the plankton on which deep value investors survive.

You Are Making This Up said...

To quote you:
“And making dough, rather than predictions, is what this business is about.”

Yes, it is about making money, and I know people who do it consistently using both technicals and fundamentals. Does that mean that one type is better than the other? Not really – it is about making money, right? As long as it is legal, who cares if it is technicals or fundamentals?

You claim you are not bashing technicians, but the whole post reads like a huge anti-technicals missive. You picked three horribly bad calls from technicals newsletters, but what does that mean? I am sure anyone that reads your blog can go and find three, just as horrible, fundamental calls. In fact, I am sure that if you have been involved with the markets, you can probably point to three investments you have made that turned out wrong. Does that make fundamental investing useless? No! Some people are phenomenal at making money using fundamentals, but so are some people using technicals.

In fact, think about it this way, most money managers in the world do not use technicals, they use fundamentals. Yet, most money managers have subpar returns. Does that mean that fundamentals don’t work? Not at all. It just means that all of us, in this business, like any other profession, are on a bell curve – most people are average, some are very bad, others are exceptionally good. All that matters is where on the curve you are. Whether you are a fundamentalist or a technician doesn’t matter.

This post shows nothing but a huge bias and narrow mind. You can claim it is not to bash technicians, but that is all it does and in fact is kind of pointless. Very disappointing.

Steve said...

Well said... but the answer for why corporate buybacks are so poorly timed is because management is spending shareholder money, not their own. Most S&P 500 buybacks, as you noted, are a form of financial engineering employed to only partially offset the dilution from stock option / RSU grants and dampen the resultant "share count creep." "Real" buybacks occur opportunistically, are enacted swiftly and are not part of the everyday CFO anti-dilution toolkit.

Andy T said...

I think you're getting your info from the "technical" types who don't know too much. No technician I know, and I know some good ones, would say that insider buying is a sign of good things or that a lack of insider buying is bad thing. RIDICULOUS.

In fact, insiders are oftentimes the WORST, because the insiders running companies are actually better managers than they are traders or technicians. (See: Aubrey McLendon or any Airline CEO who decided to hedge oil in 2008.)

They're vulnerable to the very same human emotions that dictate the movement of the market. They are the same as the rest of the Sheeple investors.

It was a poor article Jeff, and I actually do read your stuff regularly. So, I know the difference.

You lump technicians into one pile. We're like every other group. There are some good technicians and there are some poor technicians...

You're picking and choosing data/anecdotes to make a point that's impossible to substantiate in reality.

Good Luck with the FedEx. Andy.

Stupid Acquisition said...

I had to comment on "Gone to the Blogs" emotional defense of Dell's retarded acquistion. Yes, Perot was an ok/decent asset. But it was trading at a big premium to the group (look at ACN, GIB, CSC, or even the Indian players), was predominantly in the hospital vertical (how is this relevant to Dell??!), and Dell payed 30x earnings for a GDP+ grower. Your defense of this acquistion is laughable, one can tell you are a Dell shareholder.

Jeff, I agree with you on stock buybacks, although I wonder if we're going to start seeing a resurgence in them along with some "worse than expected" earnings reports, which is when companies tend to announce them.

pondering said...

At Government Station.

Michael Fang said...

Jeff, this is off-topic .....but anyway, just want to let you know that "Billie Jean" as a pacifier really works! Our 14-month-old loves the song and the groove. He has been having trouble falling asleep by himself. For the past 3 days, he has also been crying during the night. I suddenly remembered your "Thanks, Michael" post, so I used iTunes and burnt a CD with 12 consecutive "Billie Jean" songs. Works like a charm!

During the day, he'd also dance to the groove whenever we play the song, or even just humming it.

That's just an awesome. Thanks.

Jing said...

I don't think Jeff is doubting the usefulness of TA. Rather, I think he's critical of the use of TA without any rational thought nor fundamental understanding.

TA is, in essence, a form of modeling. The model works until it doesn't. Without external validation, it would be hard for the technician to discern signal from noise.

Taken to the extreme, TA becomes kind of like voodoo.

Anonymous said...

So how does this square with insiders like Bob Toll, who just weeks after talking up prospects - which I think you commented on at NMTU - for Toll Brothers, is dumping his stock as fast as he can? Bullish I suppose?

Gone to the blogs said...

In response to the poster "Stupid Acquisition"...

I took issue with Jeff's characterization of the Dell/Perot deal as being "desperately uneconomic" because the numbers suggest otherwise. On a pro forma basis, the deal is probably accretive out of the gate. On a GAAP basis, probably by year two. As for the healthcare provider concentration, who cares? It's a big market, it's a decent market, and besides, the rationale for the deal is not that Dell thinks it's going to sell a bunch of boxes to hospitals. I don't know where you came up with that.

Jeff is not shy about his distaste for all things Dell, and he is certainly entitled to that opinion. Timed well, that opinion could have made you a lot of money. But to casually dismiss the Perot transaction as "desperately uneconomic" was a bit petty and misinformed.

Also, it's interesting how your "Yahoo message board-type language" didn't meet the typical censorship standard on this blog. I guess the owner of an otherwise respectable blog can "overlook" offensive terminology provided that the author's opinion matches his own.

Kieran said...

Contrary indicator or no, it speaks jet-airplane-level volumes about the god-awful state of corporate governance in this country (and around the world). You would have thought that at least a few of the cash rich, well-run companies would have issued buybacks this Spring. Cisco, Microsoft? Anyone? Was there no company that thought, gee, we're selling at or below book value? We could increase shareholder value by buying our own stock.

Cynically, stock buybacks are simply easy ways to boost share price when money is easiest (2003-2007). Borders bought back stock a few years ago not because its stock was undervalued, it bought back stock because it could. Now, it doesn't buy back stock because it can't. It doesn't have any money. Certainly consistent with a broader pattern. I'm split about what to make of it. Maybe near-universal corporate incompetence is short-term bullish, but it's no long-term positive.

But if you wanted to invert it (paging Mr. Munger, paging Mr. Munger), and be a touch more optimistic, you could pick your stocks based on management that was bucking the trend and buying its own stock in March. I'd be curious to see how that portfolio would perform over time.

Jeff Matthews said...

We've been travelling in distant lands and have not had time to considerately review each comment. Here we go...

Mark: The market is up quite a lot from Q2, when buybacks were few, and down quite a lot from 3Q 2007, when buybacks were plenty. That's all. As for TA being useful in that there is a "self-fulfilling prophecy" to it, yes, this helps as a short-term trading tool, but nothing more in my view. Unfortunately, people get shaken out of great stocks at great prices because of this kind of thing.

But What Do I Know?: you make a great point--that companies don't press the 'stop' button on buybacks for the right reason (i.e. the stock is too high). They do it for the wrong reason: "there's too much uncertainty out there," ala Lubrizol and a hundred other companies that refused to touch their stock during the crash.

Kid Dynamite asks I'm not saying stock buybacks are bearish: no, I'm saying tongue-in-cheek that, in hindsight, corporate buybacks have been absolutely the best coincident indicator of stock market peaks, while lack of corporate buybacks have coincided with market lows.

Gone to the Blogs asks where I got the notion that Dell's bid for Perot is "desperately uneconomic." While I didn't listen to Dell's call on the deal, I don't view acquisitions being good or bad based on their being accretive to EPS. I view them as being good or bad based on their price relative to the business' earnings power.

Dell is paying 11.7x EBITDA, 19X EBIT and 30X earnings (all trailing 12-month) for Perot. That's rich "desperately uneconomic" in my book for a 17% gross margin business that has historically earned around 6% on assets. But you may disagree.

Gone to the Blogs also takes issue with "Stupid Acquisition" for Yahoo Message Board-style language.

For the record, I let "Stupid Acquisition" slide in under the wire, because a) he raised reasonable points about the deal, and b) there was no profanity.

However, the line about GTTB's defense of the deal being "laughable" and accusing GTTB of being a Dell shareholder is, in truth, Yahoo Message Board language, and GTTB was right to call it out--though wrong to accuse us of a double-standard.

In this case, however, it detracted more from "Stupid Acquisition" than from GTTB.

You Are Making This Up gets a bit emotional defending TA, but he raises a very good point: some people use only technicals, and make a career out of it. My point is that most investors--Investors with a capital "I"--get hung up on technicals or tape watching or directional stuff when they should be out looking for companies to invest in.

It is very true that fundamental analysts--including yours truly--make terrible investment decissions too. We wouldn't have a blog if there wasn't so much really silly stuff coming out of Wall Street.

"Andy T" takes much the same point of view as "You Are Making This Up," but I think mixes up the point by arguing that insiders often have terrible track records buying their companies' shares...yet this is exactly the point I was making: many CEOs and CFOs have terrible track records buying their companies' shares.

As for both chartists' criticism that we were highly selective in the technical calls we included in the blog...for the record, those 3 examples of really terrible technicals calls were not hard to find. I spent no more than 5 minutes doing a Google search of my inbox from the periods when I recalled chart guys trying to talk down the market. There's plenty more where those came from.

I'm sure "Andy T" and "You Are Making This Up" are much better technical analysts than the folks we quoted.

"Jing" sums up the issue, I think, very well. And, by the way, the exact same view of technical analysis holds for "fundamental analysts": anybody who hangs their hats on doing ridiculous 5-year, to-the-penny spreadsheets, without kicking a company's tires, is going to get hosed.

Garbage in/garbage out.

JM

Jing said...

Personally, I think the combination of fundamental and technical analysis is very valuable.

It allows you to fundamentally derive an 80% "correct" investment thesis. For the other 20% that is uncertain, use TA to manage the downside.

hayseed said...

technical analysis, and i studied it statistically for years, is correct about 50% of the time, that's right, a coin flip. now i grant you that certain levels, overbought/oversold points, breakouts, breakdowns et al, work great as you look at history, but try to trade a stock or a market based on them... you then are right as often as a coin flip. besides, technical analysis has been around for over 100 yrs - if it worked so well, why doesnt everyone already use it?

bottom line is that nothing based on prediction ever works - prediction is IMPOSSIBLE on a significant basis, whether we are talking about football betting, horses, stocks, weather etc. NOW, having said that, probabilistic bets are the way most smart guys make the most money. when the odds of a situation are in your favor, the stock then is out of favor, and you think a reasonable risk/reward exists, then that is the typical bet that the really successful investors make. and many of them, and most wont admit it, are correct less than 50% of the time. but, they typically cut their losses quickly, and let the stocks run as long as the stocks want to... again, as no one has ever given a correct target price on any stock.

Tor Hershman said...

Communism = Impossible
Capitalism = Terrorism
Everything = Meaninglessness

Terry Pratt said...

So Pam Dauber became a stock analyst after Mork and Mindy?