What happens at a market top?
One advantage of living through the internet and housing bubbles is seeing market behavior at the extremes. There are two major players in the stock market: buyers and sellers—or issuers and investors. When equities topped out in 2000 and ’07, investors and issuers responded differently to the market’s financial incentives. What does this look like?
Investors begin to be driven by momentum strategies. Momentum doesn’t care about value, it just evaluates the trend. Newsletters focus more on the 50-day moving average and less on valuation, which starts to look more and more absurd. Prominent investors pull out, or say they just don’t “get” this new market. Growth dominates value as a strategy. Pundits on television start to look younger and younger.
Issuers respond as well. IPOs get bigger and bigger, even as their quality declines. Dividend yields get smaller, while stock buybacks grow. Meeting quarterly earnings goals becomes paramount, at the expense of cashflow, sales, and balance-sheet quality. Innovative financing and securitization techniques abound. Financial engineering sets the agenda.
Are we near a market top now? It doesn’t look like it yet. There are some extreme valuations, but earnings seem to be keeping up. As risk of a melt-up grows, investors seem to have nothing to fear but nothing to fear.
Douglas R. Tengdin, CFA
Chief Investment Officer