Critical Thinking: Cyclical Stock Potential
At a time when many investors are taking a hard look at their portfolios, good information is more important than ever. Sadly, it is even harder to come by. There is no substitute for applying your own critical thinking skills to the opinions you see. A featured guest on CNBC, Senior Investment Analyst for a major firm, provided a test of that skill. (CNBC put the interview behind their paywall, but I record these programs to verify my analysis.
The guest had just issued a downgrade for the industrial sector.
- His first reason was that the stocks were back to levels at the start of 2019. He questioned the 30% rally in the sector when earnings were only up 10%. He called the 20% difference a “ballistic move” in the stocks, pushing them to excessive valuations bordering on those of the late 90’s.
- The size of the stimulus package proves that the economy was weak at the start of 2020.
- Expected year-over-year declines in consumer spending are “multiples of what they were in 2008-09 and back to levels of the 1930’s.
- Industrial production in a downturn is leveraged to about four times the consumer spending decline. A 2% decline from consumers means an 8% decline in industrial production. Their economists’ estimates for consumer spending would imply a 40% reduction in industrial production, although he didn’t think it would be quite that bad..
Asked about the impact of the stimulus bill, he had a rather lame answer that he did not analyze politics and wasn’t sure what the impact would be for the group.
Critical thinking begins with Asking the Right Questions. (My favorite professor wrote the book on this topic, now in the 11th Edition). Here is my own analysis. Some of it does require a little background, but nothing that is a surprise to a knowledgeable investor.
- Using comparisons that begin with calendar 2019 is extremely misleading. The market collapse of December 2018 cannot be ignored. The popular explanation is that the Fed “pivoted” from prior statements reducing recession fears. Whatever the reason, December represented recession expectations and the 2019 record includes a reversal of that sentiment.
- This is an amazing statement. The size of the stimulus package reflects estimates of the size of the problem. It tells us nothing about the pre-coronavirus economy. Please compare this statement with the subject’s answer at the end of the interview.
- With most of the country staying safe and in place, there is naturally a reduction in many types of expenditures. It will certainly be sharp and affect many businesses. The exact size cannot be estimated without knowing the extent of the COVID-19 effects. Anyone claiming a solid economic forecast right now is blowing smoke.
- The industrial production relationship is obviously some sort of regression analysis relating the two variables. There are some tipoffs in the summary. It refers to “declining periods.” How many of those are used and how much data? What is the margin of error of that result? Even more important is the comparability of the current situation. The past cases involve economic downturns affecting everything. The current crisis targets certain economic sectors. Industrial production is much broader than the consumer sectors, including things like utilities, mining, and consumer and office products still in demand. The 4-1 ratio is just silly under these circumstances.
One problem with research from big firms is that they do not share the underlying data and are not very specific about the methodology. I have read thousands of these reports. Very few would stand up to a peer review, although nearly all would benefit from such criticism.
Suppose your job requires regular reports, market recommendations, and getting visibility for your firm. You must always have an opinion even though the evidence supporting it may be scant. The result is a constant flow of unsupported opinions, each a trap for the individual investor.
I am working on my own project for identifying the survivors and thrivers on the other side of the crisis. It begins by admitting what we do not yet know. The next step is to have a sound factual basis for conclusions. (Write to me via info at inclineia dot com to get on our Great Reset email list).
For now, I do not have specific sector recommendations. I am confident that the analysis I am discussing here is seriously flawed. While the conclusions might be “right for the wrong reason” I am leaning the other way on industrials.