Looking for answers to the recent sell-off, Wall Street’s spin machine can't be truthful about how hedge and private equity funds make hay. When valuations and price-to-earnings ratios get too high because of a bull market, it’s times for funds to take profits. Profit-taking is the least acceptable reason why Wall Street sells-off. Profit-taking sounds greedy, unlike better excuses like geopolitical problems in the Mideast, Ukraine or more typical reasons related to macroeconomics like slowdowns, recessions or changes at the Federal Reserve. Attributing downturns to profit taking isn’t fashionable. When funds decide its time to sell, temporarily go into cash or bonds, and wait patiently until share prices drop to buy back in isn’t easy to watch. Inflated valuations or overpriced stocks are number one reason why funds decide its time to sell and wait for prices come down.
When corporate profits and stock prices hit record highs, it signals time for a sell off to bring prices in line with historic moving averages. Profits can’t rocket upward indefinitely without taking a pause, regressing back to the mean. Profit margins, earning and stock prices all move together, suggesting that the correction help bring valuations into line with earnings, prompting more selling once inflated values come back to earth. With Federal Reserve Board Chair Janet Yellen speaking to the New York Economic Club next April 16, markets will be looking for guidance, especially about the Fed’s intention with quantitative easing, its bond buying program. Since former Fed Chairman Ben Bernanke started quantitative easing to counteract the Great Recession of [2007-2009], Wall Street has grown dependent on economic stimulus, also prompting the current sell off.
Yellen knows that taking money off the table by reducing QE3 could slow stock market growth by removing speculative capital in the market. Worried that the Fed was “taking away the punch bowl,” hedge and private equity funds have begun to take profits. Reducing the cash investment in Wall Street also creates suction, removing overall investment in stock funds. When less cash—whether borrowed on margin or not—comes into Wall Street, share prices start collapsing, bring price-to-earnings ratios down to more affordable levels. Because Yellen will continue pumping plenty of cash into Wall Street, the current sell-off should run its course, currently dropping the tech-rich Nasdaq 7% and blue-chip heavy Dow Jones Industrials and S&P 500 down 3%. Even some tightening by the Fed should not trigger a bear market but instead cause funds to eventually buy back into the market.
With bond yields at historic lows, it’s not likely that the current pullback will trigger a sustained rally in the bond market, driving more investors into cash or bonds. Whether taking a pause or not, equity investors haven’t given up on the current bull market. Watching share prices drop to more affordable levels should trigger the next market rally, raising share prices again to appropriate levels. Even if the current 3% drop in the Dow or 7% drop in the Nasdaq doubles, it doesn’t signal a bear market. As long as the correction accomplishes the goal of bringing share prices down, current profit margins and earnings should improve. Real market “corrections” are at least a 10% drop in share prices. Since we’re only at 3% to 7%, the current selling trend could continue into well into the second quarter. To meet profit targets, funds must sell shares high and buy them back at bargain prices.
When the bull market started March 6, 2009, the Dow stood at 6,443 compared with its Friday close of 16,026 or about a 150% increase. No bull market can sustain an endless upturn without trimming share prices. “There’s skepticism among investors about the outlook, and we’re getting into the first-quarter earnings season, so you’re going to see some positioning,” said Brian Jacobsen, strategist at Wells Fargo Funds Management in Menomonee Falls, Wisconsin. With S&P 500 companies looking at 0.9% earnings growth, Jacobsen sees more selling to bring price-to-earnings ratios in line with real growth. “You’ve seen small caps dominate,” said Jacobsen, hinting that, with more volatility, investors are shifting to quality blue chip large cap stocks over less stable small or medium cap stocks. Having milked profits from small caps, fund manager have shifted to blue chips.
When profit taking seizes markets, small investors shouldn’t panic and start bailing out of stocks. Big fund managers are doing their jobs dumping small cap stocks after record profits over the last two years. After hitting records profits, the Nasdaq’s biotech sector has been selling off for over a month, losing about 21% from the index’s record close Feb. 25. With price-to-earnings rations exceeding 34.4%, the biotech sector sold off trying to get more in line with the S&P 500’s 14.9 PE ratios. Taking profits in the highly speculative biotech stocks signals that hedge and private equity funds have become more conservative, rotating into large cap stocks. Exchange traded funds [ETFs] have watched weeks of outflows from speculative tech and biotech companies. “Valuations are going to start becoming relevant again, at least for a while,” said Uri Landesman, president New York-based Platinum Advisors, confirming that the “flight-to-quality” has begun.
About the Author
John M. Curtis writes politically neutral commentary analyzing spin in national and global news. He’d editor of OnlineColumnist.com and author of Dodging The Bullet and Operation Charisma.